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Back to Part II

By Mark Bern, CPA CFA

In Part I of the series I discussed the basics about my selection methodology in what constitutes a quality company from my perspective. It would be instructional for readers to review that article and the 10 rules I set out there to get the most out of this and other articles in the series. In Part II of the series I provided my overview analysis of the Food Processing Industry and an in-depth assessment of my overall recommendation from the industry, McCormick (NYSE:MKC). In this article I will provide a brief summary of the other two Food Processing picks that stand out for me, Smuckers (NYSE:SJM) and Hormel (NYSE:HRL). I will also try to provide a short review and explanations for why some other well-know and widely-held companies did not make the cut.

My second pick from this industry is Smuckers. Much of the world's population hasn't been exposed to the luxurious tastes available from this very well-managed company. Besides the Smuckers name we all know and trust, the company also owns several other brands, most of which will be very familiar; Adams, Bick's, Crisco, Dickinson's, Double Fruit, Eagle Brand, Hungry Jack, Laura Scudder's, Martha White, R.W. Knudsen, and Santa Cruz Organic, to name a few.

Smuckers

Industry Average

Grade

Dividend Yield

2.2%

2.6%

Neutral

Debt-to-Capital Ratio

37%

32.4%

Neutral

Payout Ratio

38%

42%

Pass

5-Yr Average Annual Dividend Increase

10.5%

N/A

Pass

Free Cash Flow Per Share

$2.15

N/A

Pass

Profit Margin

10.0%

6.3%

Pass

5-Yr Average Annual Growth in EPS

11.5%

8.5%

Pass

5-Yr Average Annual Growth in Rev. / Share

5.8%

5.5%

Pass

Return on Total Capital

8.0%

10.0%

Neutral

Six passes and three neutral rankings (return on total capital is close to a fail) is a good showing, but it falls short of the MKC results. I also like the 11.5 percent growth rate in dividends and the continued flexibility provided by the capital structure and the payout ratio to keep those dividends rising at a relatively high rate. It is also good to note that earnings per share growth did not skip a beat during the great recession, nor did dividend growth. The stock price did fall by 47 percent while the S&P 500 average dropped about 57 percent, but the company's stock price has rebounded since the bottom in 2009 and now stands 21 percent above its previous high achieved in 2008.

Now I will introduce my final list member from food processing, Hormel, an international manufacturer and marketer of branded meat and prepared food products. A few of the better known brands include Always Tender, Chi-Chi's, Cure 81, Dinty Moore, Hormel, Jennie-O, Kid's Kitchen, Little Sizzlers, Mary Kitchen, and my personal favorite Spam.

I realize that these are not the biggest names nor the most widely held stocks, but I don't really take that into consideration. I just want the stocks to be actively traded with adequate liquidity should the unforeseen event change the fundamentals and require a quick exit. Such events are the nationalization or destruction of major assets in a large market, war in one or more of the company's major markets, or an extended natural disaster that portends several years of unfavorable input cost prices that could squeeze margins, to name a few.

Here is a look at how Hormel ranks by the rules.

Hormel

Industry Average

Grade

Dividend Yield

2.1%

2.6%

Neutral

Debt-to-Capital Ratio

9.0%

32.4%

Pass

Payout Ratio

28.0%

42.0%

Pass

5-Yr Average Annual Dividend Increase

13.2%

N/A

Pass

Free Cash Flow Per Share

$1.08

N/A

Pass

Profit Margin

6.0%

6.3%

Neutral

5-Yr Average Annual Growth in EPS

11.1%

8.5%

Pass

5-Yr Average Annual Growth in Rev. / Share

7.4%

5.5%

Pass

Return on Total Capital

16.7%

10.0%

Pass

Seven Passes and two neutral ratings is a very good showing for this company, especially when we look at how close the profit margin is to being a pass instead of a neutral. But the dividend yield is very nearly a fail because it is a full half percent below the industry average. Any yield below two percent is also a fail in my system. I realized that I am probably being very liberal in this area, but the yield is less important to me than the quality and sustainability of the increases because over time a yield of two percent rising an average of 11 percent a year will produce more dividend income than a yield of 2.5 percent that is rising less than five percent a year.

Hormel's earnings never skipped a beat during the great recession; and for that matter EPS didn't dip after the Internet bubble popped either. The stock price dropped 42 percent during the great recession but it is now trading about 41 percent higher than the pre-recession high. I like that kind of resilience. Of my three favorites in food processing, Hormel actually offers the best value proposition at current levels as it is the only one of the group trading at what I believe is fair value while the other two are trading at 8 percent and 23 percent above fair value by my reckoning, for MKC and SJM respectfully.

Turning to the companies that almost made the list, but not quite, let's take a look at why Heinz (NYSE:HNZ), Hershey (NYSE:HSY), Archer Daniels Midland (NYSE:ADM) and Conagra (NYSE:CAG) didn't make the cut. Some investors will undoubtedly ask why Unilever (NYSE:UL), Nestle (OTCPK:NSRGY), Campbell (NYSE:CPB), or General Mills (NYSE:GIS) didn't make the list. I will work that up as Part IV of the series before I move on to the next industry, but for now please suffice it to say that these companies, while not bad companies, either failed the grade in too many categories or by too much in one or two major categories (like debt or inconsistency in EPS growth relative to the others).

I'll begin with a summary assessment of Heinz. The debt-to-capital ratio is 59 percent compared to the industry average of 32.4 percent leaving the company with less flexibility in its capital structure for my liking. The dividend growth of 6.5 percent over the past five years is sub-par compared to the leaders. I really like the rising income stream. EPS growth over the past five years, at 7.7 percent, is below the average for the industry and also below all of the leaders. The way I calculate the FCF the company shows a negative of $0.83 per share in 2011 and negative $1.10 in 2010. I can forgive one year, but not two in this category. Having said all that, if you own HNZ I'd recommend holding the stock as I model the future EPS growth to be right at 10 percent on average over the next five years. The stock seems priced a little on the high side right at the moment, but not so much as to warrant a sell.

Now let's take a look at Hershey. I like HSY as a company and I also like the products, but I can't let that sway my final analysis. HSY has a debt-to-capital ratio of 62 percent, well above the industry average. The company has grown EPS by only a 3.7 percent compounded average per year over the past five years, again well below the industry average. The dividend growth has also been sub-par rising an average of 5.6 percent a year and the payout ratio is above average for the industry as well, making it less likely that the company will be able to make much better progress in this area in the future. Hershey has some strong positives as well, but just not enough to make the cut. If you own the stock, though you should probably hold if you are long-term investor. At the current price the stock is a bit pricey, but not exorbitant. My analysis points to a total return averaging just above 10 percent per year over the next five years. Of course, an investor may need to hold the stock for the full five years to get that return.

ADM is another great company with excellent prospects. I actually think that it could be the best performer of the industry over the next five years with the potential total return of nearly 14 percent. But the ride could be bumpier, especially in the shorter term (translation: higher risk). The two biggest fails of ADM come in having negative cash flow ($3.40 per share) and low margins (2.5%). On the bright side, the payout ratio is only 19 percent, the revenue growth rate over the past five years has been 17.5 percent, and the P/E ratio (10.7) is significantly below its historic average (15). But the company, like others in the industry is facing a headwind in terms of high commodity prices that could last another year or so. Even though EPS held up during the great recession, the stock price is much more volatile that most of its peers. The biggest problem for me is the negative cash flow. If the company can bring that number into positive territory it will require another look as it is currently much undervalued, in my opinion.

Conagra is another fine company in the industry. But even though EPS did not dip during the recession it has remain flat in 2011 compared to 2010 and I expect one more year at the same level again in 2012. This is definitely not the best time to invest in CAG, but there may be a time in the next 18 months where it would make more sense. Commodity costs remain high pressuring margins in the company's largest division, consumer foods, which comprises about 64 percent of the company's total sales. The dividend yield of 3.7 percent is tempting, but the dividend has actually fallen by an average of 3.9 percent per year from levels of five years ago. Cutting the dividend is a big no-no with me, but the company's history prior to the cut in 2007 was excellent and the progress since then has been consistent, as well. I'll reconsider this company again once we see the earnings begin to regain momentum.

None of these companies is unworthy of your consideration. They just don't quite measure up to my personal investment standards. I hope you are enjoying the series so far as I plan on providing similar coverage to several other companies in each subsequent article. Part IV will cover the rest of the widely held companies in the food processing industry in order to bring some closure to this chapter of the Dividend Investors' Guide for Successful Investing.

Thanks for reading and, as always I enjoy your comments so keep them coming. Only through sharing our ideas, experiences and perspectives can we all learn to be better investors together. I wish you all a successful investing future!

Source: The Dividend Investors' Guide - Part III: Food For Thought