Hormel Foods: A Great Company... But Is It A Good Value?

| About: Hormel Foods (HRL)

Summary

Shows how to analyze your own portfolio using a unique valuation methodology based upon free cash flow return on invested capital.

Explains why we need to focus on company operations on Main Street rather than Wall Street analysis.

Introduces a conservative approach to investing by practicing "Capital Appreciation through Capital Preservation".

Introduction

I want to start out with a very appropriate quote from Warren Buffett, the Oracle of Omaha. It comes from his 2008 letter to shareholders in the Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual report:

This quote is especially important today considering the high valuations of most stocks trading on U.S. exchanges. My last article about AbbVie (NYSE:ABBV) contained other charts and explanations to explain my assertion of high valuations that may prove useful and interesting. I believe that Hormel (NYSE:HRL) is a great company with many years of good growth ahead of it. But is it a good value at its current valuation? There are many ways to value a company. I will provide several valuation methods, but I want to concentrate on one that is not so well known but very consistent with the methodology employed by the Oracle himself.

Finding value requires patience, and lots of it. You will find that theme in many of my articles. Cash is not trash; it is an option on finding value in the future. I tend to invest for dividends. I want to keep adding consistently rising streams of income for future use. I keep collecting those dividends and letting the cash pile up until I find something that I consider to be a good value. How do I define a good value?

I use three methods primarily: the DDM (dividend discount model), the simple P/E (price/earnings) relative to the historic P/E and the Friedrich method using FROIC (free cash flow return on invested capital). The latter method was new to me until about a year or so ago, but I have come to use it more and more.

Full Disclosure: I am now associated with the creator of the Friedrich algorithm. I would not associate with something that I did not trust.

Valuing Hormel

Hormel pays a current dividend yield of 1.92 percent annually. The dividend has increased by a compound average annual rate over the last five and ten years by 17.7 percent and 14.4 percent, respectively. However, the ten-year rate of increase is highly skewed by the more recent five years. During two periods of three to five years each during the last 12 years, the annual compound rate of dividend growth ranged between seven and eight percent.

I point out the varying growth rates because I believe we are entering a period of slowing growth, even for food processors, over the next five to ten years. My reasoning is not for the lack of population growth or on an expectation of a slowing in the number of people in emerging economies entering the consumer class. I believe that there are two primary factors that will inhibit dividend growth in coming years.

First, for Hormel and many other large companies, increasing the payout ratio much further could lead to less flexibility in capital allocation potentially slowing growth through investment or acquisitions. Ten years ago Hormel had a payout ratio of 27 percent. Today, the ratio is above 35 percent and close to the average for the industry. That increase in the payout ratio is a primary contributor to dividend growth, but may not be an option management will want to pursue in the future.

Second, Hormel may be great at controlling costs that are within its ability to control, but it cannot control some externalities that are outside of its influence. Such things as droughts and avian flu requiring depletion of herds and flocks will continue to affect margins going forward. By and large, Hormel's management does an excellent job minimizing the effects of such natural swings but cannot mitigate them fully. I expect to see more guidance of the sort issued in the recent quarter which caused a selloff in shares. The price of Hormel's shares has dropped by 20 percent since its March 2016 high.

For these reasons, and the rising possibility of a global recession that could temporarily reduce demand, I expect revenue growth to slow and margins to narrow on average over the next decade relative to recent past performance.

Having said all that, my DDM valuation for the company assumes the dividend growth rate to slow to about seven percent on average. I also want an average annual total return of ten percent from this industry. Those inputs result in a value of $23.78 per share which makes sense relative to the value produced using free cash flow later in the article.

Now, I would like to turn to the historical P/E ratio valuation as a check on the DDM. I know I will get receive some dissenting views about what average P/E ratio should be used. Some believe the five-year average is best, but I like to take a much longer view because any five-year period can be subject to either better or worse than average conditions. I like to use the 15-year average P/E which turns out to be 17.5 for Hormel. My reasoning is that I like to buy and hold investments for the long haul and that period smoothes out most of the ups and downs of booms and busts in the economy or sector. The current P/E of 21.4 is about 22 percent above the historical average. Applying the average P/E of 17.5 to fiscal 2016 income per share of $1.65 yields a value of $28.88. This may seem too conservative to some, but if growth slows, it may eventually look much more prescient in hindsight.

According to the OSV (Old School Value) site, which I also like as a source of data, the normal (or average P/E at fair value) is 22.6 (five-year average); the current P/E (as of the market close on Tuesday, February 28, 2017) is 21.4. This would imply that the stock may be priced slightly below its value. OSV also uses two other valuation models appropriate for use in valuing Hormel. The DCF (discounted cash flow) model derives a fair value of $24.31; the EBIT Multiples model provides a value of $33.18. The EBIT model is similar to the P/E model, again based upon a shorter time frame of reference.

Next, I want to explain how to analyze a stock using free cash flow return on invested capital. We will take a deep look into the numbers for Hormel and at the same time explain the methodology involved in this analysis.

Main Street (the real world) is where Hormel operates and Wall Street (the hype casino) is where its shares trade. Hormel's shares available for purchase on Wall Street are in the public domain and the company has little control over the price at which each share will trade. Hormel is required to release its earnings reports each quarter and from time to time it also provides press releases to its shareholders (and the general public) giving updates on how its operations are doing on Main Street.

Main Street is where Hormel invests in its own operations, creates products/services that its customers can purchase. How well Hormel's management does in pricing and selling those products determines the profitability of the company. Wall Street then reacts based upon the success or failure of management to meet goals, set by analysts with guidance from Hormel's management. Main Street and Wall Street thus have a seemingly symbiotic relationship.

The disconnect that often occurs between the two is the result of perceptions and the ability of almost anyone to buy or sell any stock at any time. Expert analysis is not required to invest on Wall Street. The rise of such competitive forces such as hedge funds, dark pools and HFTs (high frequency traders - using algorithms) that account for the majority of trading volume most days has created a far different investing environment than that which existed 30 or more years ago when I got started as an investor.

It seems to me that we are subject to much more of a herd mentality and momentum investing than ever before. Fundamental analysis and investing for the long term have become unfashionable on Wall Street. That is probably because it does not produce as much revenue for the powers that be on Wall Street. They need ever-rising volumes to keep respective revenues and profits rising.

This results in advice coming from Wall Street to be very dangerous for individual investors. Many individual investors experience emotional swings about individual stocks and tend to follow the herd in and out creating more volume and revenue for Wall Street and often more taxable revenue for the government. During bull markets, investors experience euphoria as "the rising tide lifts all boats." But when a bear market suddenly shows up, these same investors tend to panic and stampede over the cliff like lemmings. Thus, we have the classic case of "greed vs. panic." It is the game that Wall Street plays to its advantage, not ours.

I am a fan and student of both Benjamin Graham and Warren Buffett. Our Friedrich algorithm was designed to assist all investors (both pro and novice alike) and give them the ability to quickly compare a company's Main Street operations to its Wall Street valuation. Friedrich can do this on an individual company basis or assist users in analyzing an entire index like the S&P 500, an ETF, mutual fund or an individual portfolio.

The Berkshire Hathaway's 1986 letter to shareholders contains a ratio which Mr. Buffett entitled "Owner Earnings." It is what we would consider to be a version of "Free Cash Flow." This is one of the many gems hidden throughout the letters and footnotes where one can find explanations from Mr. Buffett on the key ratios that he and Charlie Munger used in analyzing stocks. In that letter, he defined the term "owner earnings" as the cash that is generated by the company's business operations.

"[Owner earnings] represent A) reported earnings plus B) depreciation, depletion, amortization, and certain other non-cash charges…less C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume."

I like this free cash flow ratio as I believe that earnings can be manipulated but a company's ability to create cash flow is more representative of its underlying operational efficiencies and financial well-being. Arnold Bernhard, the founder of Value Line Investment Survey, was a big fan of free cash flow and probably introduced it sooner than Mr. Buffett did. Our 60-year backtest of the DJIA from 1950-2009 used data from Value Line.

In the backtest mentioned above, we demonstrated that if one can purchase a company whose shares are selling for 15 times or less its Price to Free Cash Flow Ratio that the probability of success will dramatically increase in most cases. We have renamed the ratio the Bernhard-Buffett Free Cash Flow ratio in honor of both men. The following is how that ratio is calculated.

Price to Bernhard-Buffett Free Cash Flow Ratio = Sherlock Debt Divisor/ [(net income per share + depreciation per share) - (capital spending per diluted share)]

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding)

The above are the ratios to use when analyzing a stock on Wall Street and below are the ratios we use when analyzing a stock on Main Street.

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) - (Capital Spending)]

FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)

What the FROIC ratio does is tell us how much forward free cash flow the company is generating on Main Street relative to how much total capital it has employed. So, if a company invests $100 in total capital on Main Street and generates $20 in forward free cash flow, it therefore has a FROIC of 20%, which we consider excellent. This is just one of the key ratios (66 in total) that we use to identify how a company is performing on Main Street, as it is our belief that if a company is making a killing on Main Street, that this news will eventually show up on Wall Street's radar.

So, let us begin our analysis and at the same time try to teach everyone how to do a similar analysis on one's own portfolio. In analyzing Hormel's Price to Bernhard Buffett FCF ratio, we must first analyze Hormel's Sherlock Debt Divisor. Here is a detailed definition of what that ratio is:

Sherlock Debt Divisor = A major concern that we have these days in analyzing companies is the amount of debt relative to its operating cash flow and whether management is abusing this situation by taking on more debt than it requires. Debt can be used wisely to create leverage and leverage can be extremely beneficial within certain parameters. On the other side of the coin, too much reliance on debt can be unsustainable and put a company's future in jeopardy. So, what we have done to determine if a company's debt policy is beneficial or abusive, is to create the Sherlock Debt Divisor.

What the Divisor does is punish companies that rely too heavily on debt and rewards those who successfully use debt as leverage. To do this we take a company's working capital and subtract its long-term debt. If a company has a lot more working capital than long-term debt, we reward it. Conversely, we punish those whose long-term debt exceeds its working capital. If the result of this calculation is higher than the current stock market price, then too much leverage is being employed. A company with too much leverage will generate a result of this ratio that will adjust our other ratios making the stock less attractive as an investment.

Having successfully defined the Sherlock Debt Divisor, we now need the following four bits of financial data in order to calculate it for Hormel. Since the company is on an October 31st end of fiscal year, I am using full-year fiscal 2016 data for the analysis.

Market Price Per Share = $35.37

Working Capital = Total Current Assets - Total Current Liabilities

Total Current Assets = $2,029,900,000

Total Current Liabilities = $1,053,200,000

Working Capital = $976,700,000

Long-Term Debt = $250,000,000

Diluted Shares Outstanding = 542,500,000

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding)

Sherlock Debt Divisor = $35.37 - (($976,700,000 - $250,000,000)/542,500,000)

Sherlock Debt Divisor = $35.37 - $1.34 = $34.03

Since Hormel has less long-term debt than working capital, we reward it by using the slightly lower price of $34.03 as our new numerator in all of our calculations.

Price to Bernhard-Buffett FCF Ratio = Sherlock Debt Divisor/ [(net income per share + depreciation per share) - (capital spending per diluted share)]

Sherlock Debt Divisor = $34.03

Net Income per diluted share = $890,100,000/542,500,000 = $1.64

Depreciation per diluted share = $132,000,000/542,500,000 = $0.24

Capital Spending per diluted share = $255,500,000/542,500,000 = $0.47

$1.64 + $0.24 - $0.47 = $1.41

Price to Bernhard-Buffett Free Cash Flow Ratio = $34.03/$1.41 = 24.13

The slight difference between my ratio and the one presented in the datafile below is due to the change in share price. Now, if one goes to our FRIEDRICH LEGEND (on what is considered a good or bad result), you will notice that our result of 24 is considered average.

We last ran our datafile for Hormel on February 5, 2017, and our Friedrich Algorithm gave a rating to our subscribers that Hormel is a "Hold" as our Friedrich datafile and chart below show. There you will also find the last ten years of Hormel's Price to Bernhard-Buffett Free Cash Flow results.

Now that we have shown everyone how to calculate our Price to Bernhard-Buffett Free Cash Flow ratio, let us now move on and explain how to calculate our FROIC ratio.

This is how we calculate it:

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) - (Capital Spending)]

FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)

Net Income per diluted share = $890,100,000/542,500,000 = $1.64

Depreciation per diluted share = $132,000,000/542,500,000 = $0.24

Capital Spending per diluted share = $255,500,000/542,500,000 = $0.47

Revenue Growth Rate (2016 vs 2015) = 2.8%

(($1.64 + $0.24) (1.028%)) - $0.47 =$1.46

Long-Term Debt = $250,000,000

Shareholders Equity = $4,448,000,000

Diluted Shares Outstanding =542,500,000

($250,000,000+$4,448,000,000) / 542,500,000 = $8.66

FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)

$1.46/$8.66 = 16.86%

FROIC = 16.9%

Now, if one goes to our FRIEDRICH LEGEND again (on what is considered a good or bad result), you will notice that our result of 16.9% is a good result and tells us that Hormel annually generates $16.90 in forward free cash flow for every $100 it invests in total capital employed. Better yet, if we scroll back up to the datafile table, we see that Hormel has been consistently churning out free cash flow like this for at least the last ten years. This is very good!

On Main Street, Hormel is doing very well, while on Wall Street it is not yet overbought. Now, if one can build a portfolio containing similar excellent Main Street results and buy all at attractive Price to Bernhard-Buffett Free Cash Flow ratio results, then your portfolio should be a star on both Main Street and Wall Street. Finding companies that have excellent results on Main Street and Wall Street (simultaneously) these days is, unfortunately, like trying to find a needle in a haystack. In order to prove this point, we have analyzed the S&P 500 Index using the exact same methodology and produced final Main Street (FROIC) and Wall Street (Price to Bernhard-Buffett FCF) results for the entire index.

The final results for the S&P 500 Index are:

FROIC = 12%

Price to Bernhard-Buffett FCF = 38.34

For FROIC, we consider any result above 20% to be excellent and any result above 10% to be good, so the S&P 500 index in having a FROIC of 12%, can be considered good and tells us (that as a group on Main Street) the components of the index are doing well.

The problem is that Wall Street has "overbought" the index, giving it a score of 38.34 for our Price to Bernhard-Buffett FCF ratio. That ratio considers a stock a bargain when it trades under 15 times and overbought when it trades over 30 times. Therefore, the S&P 500 index is some 8.34 points or about 28% in "overbought" territory. This is just one more indication of a stock market that is highly overvalued.

When analyzing the S&P 500 Index components, we set up certain rules to use when analyzing any group of stocks, such as one's own portfolio:

1) If a stock has a negative FROIC result, we automatically assign it a score of 100 for its Price to Bernhard-Buffett FCF ratio, in order to keep everything consistent and logical, as you can't have a negative Price to Bernhard-Buffett FCF ratio when analyzing portfolios.

2) Then at the same time, the maximum FROIC allowed is 100%, so we can keep everything consistent and logical as well, as anything higher distorts the results for the group.

3) We also give a zero result for FROIC for any "cash position" in the portfolio and a 22.50 result for the Price to Bernhard-Buffett Free Cash Flow, (which is 15 (buy) + 30 (sell) = 45/2 = 22.50). This was done to force one never to feel comfortable in cash, unless one has no choice in the matter, like we are now. Our real time research clearly shows that the markets are overvalued, as measured by our analysis of the S&P 500 index.

Going forward, if you want to duplicate this same analysis for your own portfolio, it will require some effort on your part, in order to calculate the FROIC and Price to Bernhard-Buffett ratio for each holding. For those who don't want to do the leg work on your own, we offer a service where we have done the calculations for 4,000 US stocks and soon (as early as mid-year) to be 16,000 global stocks from 27 countries.

Point and Counterpoint

I often like to include at least one well written article on either side of the valuation argument to give readers some other points of view to consider. Below are two on Hormel that I found interesting. Both authors like Hormel, with the first link wanting a better entry point (like me) and the second indicating that the current price offers a reasonable entry point.

Hormel Foods: Appeal Is Improving But Not Pulling The Trigger Yet

Hormel Lowers Outlook, Stock Drops 7%; What You Need To Know

Conclusion

It is my opinion that the slower growth I expect going forward does not fully warrant the current price multiple. Even though my DDM valuation came in near the current price, I would prefer to pick up shares of Hormel when the dividend is closer to 2.5 percent, the Bernhard-Buffett ratio is closer to 15 and the FROIC is closer or above 20. If that opportunity does not avail itself, I will invest elsewhere in a company with a profile. However, I do expect Hormel shares to come into my range within the next year or two. I will be patient.

It is my belief that free cash flow analysis is the ultimate tool when analyzing companies, and my hope is that you may add these ratios to your own investor tool box in order to help you in your own due diligence. If you have any questions, please feel free to ask them in the comment section below and don't forget to hit the "Follow" button next to my name at the top of this article. Now that we are able to analyze indices, we will begin the process of analyzing ETFs, mutual funds and certain popular portfolio managers' (gurus) portfolios in a series of articles here on Seeking Alpha. That effort will, of course, be in addition to providing analysis on individual stocks. Since most use the S&P 500 Index as the comparative benchmark, we can see how each is doing in a side-by-side comparison.

For those who would like to learn more about my investment philosophy, please consider reading "How I Created My Own Portfolio Over a Lifetime."

Disclosure: I/we 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.

Additional disclosure: This article is not an investment recommendation and should not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the Disclaimer at the end of this article. Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.

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