Illustrating The Dividend Cushion Through Aristocrat Hormel Foods

| About: Hormel Foods (HRL)

If the Linn Energy (LINE) situation brings anything to light, it is the importance of independent cash flow analysis. After all, the SEC has launched an informal investigation into how Linn may have been misleading investors via non-GAAP measures of cash flow. In this article, let's evaluate the investment merits of Hormel Foods (NYSE:HRL), as well as its dividend under our cash-flow based dividend methodology, the Valuentum Dividend Cushion.

Hormel's Investment Considerations

Hormel Foods' Dividend Analysis

Hormel Foods is a Dividend Aristocrat meaning it has raised its dividend in each of the past 25+ years (45+ in Hormel's case). But despite all those annual dividend hikes, the firm's dividend yield remains below average, offering just a 1.8% annual payout at recent price levels. We prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio. So Hormel Foods doesn't quite fit the bill thus far.

However, we think the safety of Hormel Foods' dividend is excellent (please see our definitions at the bottom of this article). We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.

That has led us to develop the forward-looking Valuentum Dividend Cushion™. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Hormel Foods, this score is 3.3, revealing that on its current path the firm should be able to cover its future dividends with net cash on hand and future free cash flow. Hormel's dividend coverage is among the best in our stock analysis universe.

Source: Valuentum

Derivation of Total Expected Cumulative 5yr Forecasted Distributable Excess Cash after Dividends Paid, ex buybacks

Source: Valuentum

Now on to the potential growth of Hormel Foods' dividend. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years, the company has a nice growth rate, and a nice dividend cushion, its future potential dividend growth would be excellent, which is the case for Hormel Foods.

And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Hormel Foods' case, we currently think the shares are fairly valued, so the risk of capital loss is medium. If we thought the shares were undervalued, the risk of capital loss would be low.

All things considered, Hormel has posted over 45+ years of consecutive dividend increases. We like the potential growth and safety of Hormel Foods' dividend, even though the current yield is a bit low.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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