In February of this year, I revisited my investment thesis on Hormel Foods (HRL). I gave a lot of credit to the company and its management team for delivering on excellent organic and acquisition-driven growth, as well as conservative financial management.
Yet I issued some warning sounds as well, which included concerns about volume growth and a reversion of current very strong margins in the meat business, as Hormel was and still is relying heavily on strong and profitable meat sales.
I aimed to become a buyer if shares hit the low $30s on the back of financial room to make more bolt-on M&A moves or Hormel itself becoming a potential M&A target. As shares have now hit levels at $33 in the wake of the soft second quarter earnings release, let's revisit the thesis.
A Quick Look At The Business
Hormel posts sales of roughly $9.5 billion a year, divided across four segments including perishable, poultry, shelf-stable and miscellaneous. The perishable category makes up little over half of sales, mostly made up out of Jennie-O Turkey products, but other non-meat products as well. Poultry and shelf-stable makes up a fifth of sales, as the shelf-stable business includes products like peanut butter, tortillas and salsas as well. The miscellaneous segment makes up roughly 8% of sales, comprised of deserts and nutritional foods.
As referred to in February, the exact composition of meat-related sales is hard to determine, but it is safe to say that it exceeds 50%. As demand for protein has been strong in recent years, which combined with low feed costs results in strong margins, it can become a headwind as well. A reversal of fat meat margins and pressure on sales and volumes on the back of increased health consciousness could create real headwinds for the business.
Great Track Record, Current Challenges
Unlike most food players, Hormel has delivered on very solid growth over the past decade, as sales have risen by more than 50% to a current run rate, which makes the $10 billion mark come in sight.
Despite the volatile conditions in meat, in terms of margins and sales, Hormel has managed to limit the impact of these fluctuations on its business by focusing on meat brands. This gives the company some pricing power instead of being a pure commodity player, as it has diversified into non-meat areas as well.
Solid organic growth, operational excellence and strong meat markets have pushed operating margins up from 8-10% about a decade ago to >13% on a trailing basis. The challenge is to figure out which part of this margin gain has been the result of economies of scale and great operational performance, and which part has been driven by strong meat market conditions, which might reverse to "normal."
Noteworthy deals include the $140 million acquisition of Guacamole in 2011 and the 2014 purchase of Muscle Milk in a $450 million deal which added $370 million in sales. More recently, Hormel acquired Applegate in a $775 million deal, adding $340 million in organically processed meat revenues. Peanut butter brand Justin's was bought last year in a $286 million deal, which is set to add more than $100 million in sales. The company spent a little over $1.6 billion to acquire these companies, which added roughly a billion sales.
Despite the continued dealmaking and 50 years of uninterrupted rising dividends, Hormel has always operated its finances in a very conservative manner. Based on a 2% yield, the payout ratio is fair at 40% of earnings, allowing for sufficient cash flow generation in order to finance continued bolt-on dealmaking.
Hormel needs to speed up the pace at which it is diversifying the business. First quarter sales were down a percent but rose by 3% if we account for a divestiture. Adjusted volume growth of 5% was offset by lower turkey prices, as the company cut the full year guidance by three pennies to $1.65-$1.71 per share.
The second quarter results do not provide much relief. Sales fell by 5% to $2.19 billion but would have been up by 2% if not for divestitures and the acquisition of Justin's made by the company in the meantime. Those divestitures include the sale of Diamond Crystal Brands in May of 2016, and the sale of Farmer John in January of this year for a $136 million consideration.
The sale of high volume businesses resulted in a 11% drop in total volumes, as Hormel is shifting towards higher margin businesses as well, while it reduces the reliance on meat. Margins did indeed go up as a result of shedding these lower margin segments, being up 40 basis points to 14.5% of sales.
Another big headwind to the current results is the performance at the Jennie-O Turkey segment on the back of a 6% decline in volumes as a result of stiff competition, pricing pressure and higher operating expenses. Despite these challenges, Hormel is reiterating its full year guidance, yet warns that earnings are seen at the lower end of the range. To address the cost performance of the Jennie-O Turkey segment, Hormel is building a new $130 million plant, which should reduce operating expenses from 2019 onwards. The international business was a bright spot with sales growth of 38% driven by 17% volume growth, but unfortunately the segment contributes just over 6% of total sales.
The increasing struggles for the core business puts pressure on Hormel to engage in further bolt-on M&A action. Hormel's cash balances have increased to $549 million, as long term debt stands at $250 million. This net cash position of $300 million comes on top of the earning power of the business. With EBITDA running at $1.5 billion, the company has buyer power of $1.8 billion, even if it were to leverage up the balance sheet to just 1 times.
At $33 shares now trade at 20 times earnings, which seems like a full multiple, given the recent struggles, and reliance on the meat market. On the other hand, Hormel has a great track record and plenty of firepower to engage on a lot of M&A, or even engage in significant share buybacks. Management indicated in recent quarters that the pipeline for dealmaking is healthy, and with the company having sufficient power to engage in $2-$3 billion worth of M&A deals in the near to medium term, I bet that investors welcome the announcement of deals.
Not Very Cheap, But Decent Value
In today's low interest rate environment, a 5% earnings yield for a stable growing capital allocator might be justifiable. As shares peaked at $43 in early to 2016 on the back of low interest rates and stellar operating performance, shares have now retreated some $10 per share to current levels at $33. In part this results from a modest tick-up in rates, while the operating performance of the business has not been that great either, as of recent.
That said, great long-term capital allocation and very strong balance sheet of the position allows for further value creation, as I remain a buyer in the $30-$33 range, meaning that I will potentially pick up a few shares at slightly lower levels these coming weeks.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HRL over 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.