Hormel Foods: Great Choice For Dividend Investors But Risks Ahead

Summary

• HRL is a dividend aristocrat with 53 years of dividend increases in succession.
• Low organic growth and dependence on acquisitions to achieve growth targets.
• Market leadership and strong brands, but still tough competition.
• Very solid financial situation.
• There is an overvaluation at the current price.

Stock Analysis: Hormel Foods Corporation

In my opinion, Hormel Foods Corporation (NYSE:HRL) is a company with a very secure business model with consistent cash flows, a superior market position and steadily increasing profits. Especially outstanding is the consistent dividend history with high growth rates. However, I see the low organic growth and the high number of acquisitions as problematic.

Cycle and business model

HRL operates in the consumer staples sector and therefore has a not very cyclical business model. This segment is characterized by relatively low operating growth, but operating cash flow and net income are stable and not subject to major fluctuations. For this reason, even in times of crisis, there have only been small periods of declining growth rates.

At the same time, HRL strives to further reduce its dependence on fluctuations and to reduce the risks. For this reason, important resources, such as pork, are hedged with the help of long-term contracts to secure the price over a longer period. Finally, HRL tries to concentrate on products with year-round demand in order to avoid seasonal fluctuations.

Overall, HRL is a very stable, non-cyclical and crisis-proof business model.

Growth

HRL operates mainly in the packaged food sector with a focus on meat products and a regional focus on the USA. According to a study by Statista, the market for meat products will grow by about 2.5% annually in the coming years until 2023. At the same time, the market for food products in the USA is expected to grow at an annual rate of 1.8% until 2023. These are the figures to follow when trying to predict the organic growth of HRL. It quickly becomes clear that it is a disadvantage in terms of growth that HRL is only active in the U.S. market, as the worldwide growth for packaged food is about 4.5% p.a., mainly driven by Asian countries.

HRL's profit growth is made up of several components: organic growth, improved margins, growth through acquisitions and share buybacks. Over the last 10 years, profit growth averaged 11% p.a., while organic sales growth was just 3.4% p.a. During this period, the operating margin improved at an average annual rate of 3.7%. As a result, the further EPS increase was implemented through acquisitions and share buybacks. The former, however, played a much greater role, as the share buybacks were relatively small. Consequently, low double-digit growth could only be maintained with the help of many acquisitions. Thus, according to my calculations, on average around 4.5% of total growth was financed by acquisitions. These played a significant role, especially for the high growth in 2015, 2016 and 2018.

In the long term, management is aiming for organic revenue growth of 2-3% and EPS growth of up to 10%. In my view, this goal can only be achieved through further acquisitions. In most cases, however, the acquired companies also show organic growth in the single-digit range, so that HRL will continue to depend on acquisitions in order to maintain the targeted growth.

This strategy entails some risks. HRL is dependent on finding the right takeover candidates. The company and its prospects must be assessed correctly, and a reasonable price must be paid. Finally, the successful integration of the company must take place. Although HRL has managed to implement these points very successfully in the past, these are risks which should not be neglected.

In my opinion, the current result of the year 2019 is mixed. While the segments Grocery Products (+1.3% y/y) and Refrigerated Foods (+2.0% y/y) were able to grow, the sales of Jennie-O Turkey Store (-0.5% y/y) weakened. However, the weakness of the turkey business is relatively short term, as the company had to deal with overcapacities and two take-back campaigns. The "International & Other" segment had to record a decline (-4.2% y/y), which can be attributed to the sale of CytoSport to PepsiCo Inc. (PEP).

In the future, the recognition of trends will play an important role for organic growth in a very slowly growing market. Here, the management of HRL has recognized that people's eating habits are changing, and consumers want products with less preservatives, fat and higher nutritional value. For this reason, I believe that organic growth can be maintained in the future. At the same time, growth will depend heavily on management's ability to successfully implement acquisitions.

Stability

HRL is a company with a solid balance sheet and stable cash flows. However, there are some things that stand out negatively. In my view, it is a disadvantage that 90% of HRL's sales are generated on the North American market, which means that there is a high degree of regional dependence. There is also a high dependency on individual customers. Walmart, for example, accounts for 13.5% of sales. In total, 45% of sales from the Grocery division, 35% from the Refrigerated Foods division and 52% from Jennie-O Turkey depend on the five largest customers which is not ideal from the perspective of HRL.

Although sales are generated by a wide range of products with strong market positions, the main products consist of pork and turkey. Therefore, the company is exposed to certain developments and events in this area, such as swine flu. On the other hand, the company has a strong focus on certain raw materials and a high level of expertise and volume advantages in this area.

As already mentioned, HRL has stable cash flows and has been able to pay for both investments in property, plant and equipment and acquisitions from its operating cash flow over the past few years. This means that the development and expansion of the company can take place without the need to take up debt capital, which is clearly shown by the figures in the following table.

Source: Created by author using data from Annual Reports

HRL generates a high stable FCF every year and can use it to finance both the dividend and the share buybacks. This shows that even in weaker years, such as the last crisis, the dividend could be increased and still be paid out of the FCF, which is a strong indicator for a crisis-proof business model with a strong positioning.

Source: Created by author using data from Annual Report 2019

It is also clear that the share buybacks are not financed by debt, as is the case with McDonald's (MCD), for example. In my view, this speaks for the management's foresight.

The financial situation of HRL is outstanding. HRL has a net liquidity of 672.9 million USD (2018: 459.1 million USD; 2017: 441.1 million USD) and is practically debt-free. Therefore, the key figures dynamic gearing and gearing are negative over the entire period of the last 10 years. The equity ratio is also at a high level, which indicates a stable balance sheet.

Source: Created by author using data from Annual Report 2019

In addition, there are about 400 million USD in unused credit lines, so that overall the company is in a very solid financial position and has enough liquidity for potential acquisitions and investments.

One negative aspect, in my view, is the high proportion of goodwill on the balance sheet. This has grown particularly strongly in recent years as a result of the numerous acquisitions and currently amounts to around 30% of the total balance sheet. Above all, this represents a risk for future depreciation and could have a negative impact on profits and the balance sheet.

Competition

The market on which HRL operates includes many competitors. There are larger companies such as Tyson Foods (TSN), Hillshire Brands or ConAgra Brands Inc. (CAG), as well as smaller locally operating companies. Accordingly, the market is highly competitive. HRL has the advantage of being the market leader for its main products and therefore enjoys a high level of recognition. For example, Jennie-O Turkey has a market share of 34% of the total turkey market. HRL pursues the strategy to convince with the well-known brand name and the quality and thus to be able to enforce higher prices. However, HRL also carries cheaper products in order to address different customer groups. Furthermore, products are also sold unbranded.

All in all, especially the brand names represent a moat, as HRL's products are substitutable and there are a lot of competitors on the market.

A disadvantage is the high dependence on a few large customers. This leads to the fact that they can exert pressure on HRL and thus the prices cannot be adjusted independently despite market leadership.

In summary, I believe HRL is in a sovereign situation and has a moat, mainly due to its brand awareness in its core products.

Profitability

The profitability of HRL is determined by several factors. One of the most relevant factors is the purchase price of the "raw materials". With about 50% of the ingredients of HRL's products, pork is in first place. Turkey also plays an important role with about 22%. Finally, the prices of peanuts, avocados and other plant products are also of high importance with about 18%. HRL concludes long-term supply contracts with suppliers for up to 10 years in order not to be influenced by price fluctuations. In this way about 93-96% of the demand for pork was covered. The own demand of turkeys for Jennie-O Turkey is covered to 79% from own rearing. However, the rearing costs are directly related to fuel and grain costs. If possible, their price is also secured by long-term contracts.

In order to increase the profitability of the company, foresighted investments are made in the modernization of plants and factories. This initially generates costs but pays off in the long term. For example, a new In-Housing Dry Sausage Production was completed in 2019, which will bring the company annual savings of 1-2 million USD.

Source: Created by author using data from Annual Report 2019

Further investments are being made primarily in logistics. The construction of additional production facilities and logistics locations will generate annual savings there, thus increasing the margin in the long term.

The strong competitive position of HRL has a further positive influence on the margin. This gives it pricing power for many products, so that prices can be adjusted to different market developments.

In 2019 the development of the gross profit margin was slightly lower. This is mainly due to increased transport costs (+5.5% y/y) in the Refrigerated Foods and Jennie-O Turkey divisions. This contributed to the 0.9% reduction in the gross margin from 20.7% to 19.8%. Nevertheless, the gross margin remains at a high level, above the average of the past 10 years.

HRL was able to maintain the EBITDA margin at a superior level over a longer period and improve it permanently. However, it is also clear here that the margin is in some cases lower than that of HRL's competitors.

EBITDA-Margin 2005-2019; Source: Macrotrends.net

HRL has been able to achieve a high and relatively stable RoE over a long period of time, averaging 17% over the last ten years despite the high equity ratio of 73%. This again shows the strong market position of HRL. It also shows the management's ability to use capital efficiently.

Source: Macrotrends.net

In the future, the management aims to increase profitability by reducing costs through forward-looking investments and selling unprofitable brands.

Dividend

HRL is a dividend aristocrat. Thus, a dividend has been paid for the last 365 quarters and has been consistently increased over the last 53 years. In the last ten years, the dividend has always been paid out of FCF and had an average payout ratio of 37% in the last 10 years. Especially in the last few years, the payout ratio has risen to 47% because the dividend growth is relatively high. However, there is still enough scope for future growth.

Source: Created by author using data from Annual Report 2019

Over the last 10 years, the dividend has increased by an average of 17% p.a., which is a very good figure. This growth has slowed down a little in recent years and will, in my view, remain at a level of 10-12% in the medium term. This development makes sense, as dividend increases should go hand in hand with profit growth, which the management estimates at around 10% p.a.

The management of HRL follows a shareholder value approach and is interested in both dividends and share buybacks. Therefore, based on the figures and management's views, I don't think there is any need to worry about a long-term dividend increase.

Valuation

I have valued HRL in two different ways.

The first method is based on the relatively predictable return on equity, payout ratio and the profit to be derived from it. Based on this method, I have prepared a forecast for the profit and correspondingly the price of HRL. From my point of view, a share price of about 41 USD would be necessary if one wants to achieve a return of 10% p.a. over the next 5 years including the dividend. This value can be adjusted upwards or downwards depending on the investor's expectations.

The second way is a simple check to verify the value from the first valuation method. The method is called Fair-P/E and is described in a book by Nicolas Schmidlin. The point is to calculate a fair P/E ratio considering characteristics of the company such as stability, growth, competitive situation, etc. The result is also a fair value of the company in five years. Here, my valuations lead me to a fair value of 38 USD under the same conditions as used in the first method.

Under these assumptions, I consider HRL to be overvalued at the moment. However, this does not mean that investors with lower return expectations should not invest at the current price.

It should also be noted that these calculations assume growth of 8%. If management fails in delivering the expected growth figures in the future, it will be difficult to justify the current valuation.

Summary

HRL is a dividend aristocrat with long-standing and steadily rising dividends. These are relatively secure due to the non-cyclical and crisis-proof business model. At the same time, there is practically no debt and stable high cash flows are generated. Despite the strong competition, HRL can maintain its strong market position and achieve high profitability. The low market growth leads to low organic growth. HRL is countering this situation with an acquisition strategy. This has worked well so far but will bring challenges and risks in the future. In my opinion, the valuation of HRL is relatively high and is currently well above fair value despite the positive influencing factors. Despite all the risks and challenges listed, I believe that HRL would be very suitable for investors with a long investment horizon who are interested in a stable company with a secure and steadily growing dividend.

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.