Hormel's Earnings Prove Why It's Better Than Its Rivals

|
About: Hormel Foods Corporation (HRL), Includes: CAG, GIS, HSY, K, KHC, PEP
by: Ian Bezek
Summary

Hormel has continued to avoid the sickness that has hit so many food stocks.

The collapse of Kraft Heinz should serve as a reminder of why you need to take debt seriously.

As such, Hormel's debt-free balance sheet looks better than ever.

Hormel's small repeatable M&A strategy is working far better than the blockbuster deals that its peers are going for.

Hormel stock may look expensive, but it's worth that premium as the events of the past few years are demonstrating now.

There have been some questions and concerns about how well Hormel Foods (HRL) can do going forward. Given the carnage at Kraft Heinz (KHC), which is only the latest in a dour series of developments for the sector and it's no surprise that people are concerned. A recent Barron's article reinforced this idea recently by lumping Hormel in with struggling food companies. Seeking Alpha's news blurb covering the article stated that:

The publication warns that the big share price drop in food stocks doesn't necessarily make them appetizing. The steady growth of the old days for Hershey Foods (HSY), Hormel Foods, Kellogg (K), General Mills (GIS), and Campbell Soup (CPB) has been disrupted by "profound, durable" changes in how consumers buy food.

Let's take a look at those five stocks and how they've performed since the financial crisis:

Chart

Data by YCharts

As you can see, Hormel has crushed the field, driven by strong organic growth for several of its brands combined with smart bite-sized acquisitions. Hershey has also done reasonably well and has managed to hold its ground and reach new highs recently despite the meltdown in packaged foods stocks. That is likely driven by Hershey's extremely strong brands and the limited appeal of generic chocolate as compared to generic ketchup.

But yes, the others have certainly struggled, underperforming the market with a particularly nasty performance over the past three years. And that's even before considering Kraft Heinz, which has been a total fiasco as of late.

In any case, Hormel's latest earnings report showed more steady progress and reinforces my thesis that this is a superior company to most of its rivals. The company has a different DNA than most of its industry, and as such, it has prospered through thick and thin.

There are several things that make Hormel stand above the competition. For starters, it is still delivering organic growth from most of its key brands. Take the following, for example from the latest conference call:

Our efforts in brand building continue to pay off as retail brands like SPAM, Dinty Moore, Mary Kitchen Hash, Hormel Bacon toppings, Wholly Guacamole, Herdez, Hormel Pepperoni, Natural Choice, Columbus and Applegate, all showed solid growth this quarter.

Notice the operative word there, which is all. Across a wide range of brands, moving from the iconic SPAM business through to stews, guacamole, Mexican salsas, organic meats, and deli meats, you have a business that is still growing despite all the supposed reasons that consumers just don't resonate with brands anymore.

What sets Hormel's brands apart? They target smaller niches and then dominate them. As of this quarter, Hormel is now the #1 or #2 brand in 40 different food categories; that's up from 35 just last year. You face significantly less competition in these smaller market categories simply because a grocery store has limited shelf space. With a massive category like, say, ketchup, there is room for a variety of options as people consume a huge quantity of the stuff. With Hormel's products, there is far less. How many lines of canned hash is a store going to carry, for example?

There's another factor here as well. Hormel tends to earn far lower profit margins on many of its products than its rivals. Something like bacon is inherently a relatively low margin business because the input - pork belly - is quite expensive per pound. Something like cereal offers General Mills a far higher gross margin as the inputs such as corn and sugar are classic cheap carbs. However, that higher margin, which the foodmakers enjoyed for ages is now under vicious attack. It's easy for a store brand to undercut prices dramatically and still make a nice profit. That's much harder to do with protein-based products that never had delectably fat profit margins to start with.

The fact that protein-based products are in ever-increasing demand is another huge tailwind for Hormel, but one I've discussed at length previously and which I won't rehash here.

Cytosport: Even Hormel's Bad Brands Aren't A Disaster

Hormel took a ton of heat for its management of Muscle Milk protein drink maker Cytosport. Unlike Hormel's usual strategy of dominating a smaller niche, they stepped into the strongly competitive ready-to-drink field with the purchase back in 2014.

At that time, Hormel paid $450 million for a business doing $370 million per year in revenues. In subsequent years, revenues declined from $370 million down to $300 million. HRL stock bears couldn't stop referring to this huge error on management's part. Anytime you read a Hormel article, you knew there'd be comments critiquing the Cytosport deal.

Well, guess what? This quarter, Hormel sold the business for $465 million - that's right, a gain - to PepsiCo (PEP). Pepsi is Muscle Milk's distribution partner already, so this makes a great deal of sense.

What's fascinating here is that Pepsi is willing to pay more than 1.5x sales for the business, whereas Hormel only paid 1.2x. Presumably, it is worth more to Pepsi as they have far stronger pull in beverage distribution than Hormel. In any case, it speaks well to Hormel management's deal-making ability to buy an asset on the cheap and resell it at a significantly higher valuation despite declining fundamentals. Was it a good use of capital over the past five years? Clearly no. Is it a testament to Hormel's superior M&A culture that even their bad deals are at worst a wash for shareholders? Absolutely. Just look around the packaged foods sector to see what happens when companies really overpay for something.

Also, consider the deal size. Hormel has a $23 billion market cap. They spent $450 million - 2% of the current market cap - for Cytosport. Even in the unlikely event that the business had gone to zero, it still would have been a minimal write-off for the company as a whole. Over and over, Hormel makes acquisitions in the $100 million to $1 billion range that they can easily pay for out of cash flow. Most of these deals have worked and contributed to earnings. As a reminder, earnings have tripled since the financial crisis; try to find that at other food companies. Some of Hormel's deals, like Cytosport, haven't worked so well, but they've had a minimal impact on Hormel's overall upward trajectory.

Big Deals & Big Debt Lead To Big Problems

As opposed to Hormel's prudent strategy, you've seen other food companies take the opposite approach. Seemingly left confused by changing consumer behavior, these management teams feel the need to just do something and make a big move to try to satisfy shareholders, especially of the activist hedge fund variety. Kraft Heinz' troubles with its huge deal and subsequent crushing debt load have been discussed widely elsewhere.

But consider how many other companies have taken a similar approach. General Mills was buying back its overpriced stock when times looked good. Once the stock plunged, they then overpaid to buy a pet food company for $8 billion, issuing its stock in order to do so. They also jacked up their debt load to $12 billion as part of this move, leaving their credit rating clinging to the last tier of investment grade. As you saw with KHC stock, companies tend to cut a dividend before letting their debt get cut to junk.

In return for $8 billion, General Mills got a Blue Buffalo business that did just $1.3 billion and less than $200 million in net income for full year 2017. Management imperiled the balance sheet and left the dividend in great danger essentially betting the farm paying more than 4x sales and close to 40x earnings for a business (pet food) that doesn't even have many apparent synergies with their core competency.

Think about how different this is from your standard Hormel deal at something like 1.5x or 2x sales. With the case of Cytosport, they only paid 1.2x, so even though it didn't work out, they still made a little money. But when you swing for the fences, as General Mills did, you have to pay up. There are far fewer merger targets with an $8 billion price tag as opposed to a few hundred million dollars.

Similarly, you had ConAgra (CAG) recently buy Pinnacle Foods for $10.9 billion. ConAgra took on a ton of debt to pay for the deal. Pinnacle has failed to live up to expectations and CAG stock collapsed. Remarkably, ConAgra's market cap - the combined company including Pinnacle - is now worth slightly less than what ConAgra paid for Pinnacle just on its own last year.

Hormel, by contrast, has close to no debt and will have a net cash position as the CytoSport divestiture closes. Two years ago, no one cared about this stuff. At the time, many investors passed over Hormel stock saying that the dividend was too low and the P/E ratio was too high.

But Hormel was - and still is - growing organically and with smart manageably-sized buys. Its stock may look expensive today, but it's true quality as opposed to the potential value traps you see around much of the rest of the sector. And its debt-free balance sheet gives it huge flexibility to adapt to the changing packaged food environment, rather than being forced into desperation efforts that are felling competitors left and right.

Disclosure: I am/we are long HRL, CPB, CAG, KHC. 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.