As a buy-side analyst and an individual investor, one of my greatest strengths, in my opinion, is also one of my greatest weaknesses: "Breadth" rather than "depth". As I explained to a prospective client recently, sometimes extensive knowledge about a company and its industry and perhaps years of following it can lead to biases and a tendency to succumb to group-think. Often an outsider, with his or her fresh perspective, can come to a different and perhaps more correct conclusion about a situation. Of course, that same analyst risks overlooking significant facts that could affect the future of the company or its stock price. Like many of you, I know a little about a lot of things and hopefully a lot about a few. In the case of Hormel (HRL), I know very little, so be forewarned!
My approach to investing involves extensive screening and monitoring. Each weekend, and often several times during the week, I review several different types of screens that I have set up over the years. I have written about many of these in the past. While the screens focus on or constrain various aspects of the stock universe, including positive or negative price momentum, valuation, earnings revisions, dividend yield, balance sheet, or cashflow, each one has the ultimate objective of helping me to identify potential investment opportunities (or sells/shorts). I use these screens to create my watchlist, which I limit to 100 stocks, though the list is rather fluid I also maintain a secondary list as well. Almost always, I buy stocks that have been on my watchlist for at least a quarter, but the extremely volatile market has led me to make a few exceptions, including HRL, which I own and also include in my Conservative Growth/Balanced model portfolio.
So, why did I jump on HRL so quickly? As I will describe below in greater detail, I believe that HRL is one of the few types of companies that can grow in the challenging economic environment we face. With the potential bankruptcy of one of its peers, Pilgrim's Pride (PPC) and extreme concerns regarding another, Tyson Foods (TSN), I believe that perhaps this more balanced food provider with a significantly stronger balance sheet has been oversold. Additionally, with limited institutional interest in the name due to almost 1/2 the company being owned by the Hormel Foundation, investor awareness of the company most likely significantly trails its consumer brand ubiquity.
Let's get this out of the way quickly - yes, HRL makes Spam. I confess that I believe my father still eats this stuff. Stunningly, many people apparently do. A broad breakdown of their business would follow their business segments:
The Grocery segment includes traditional offerings like chili but also some exciting products like Compleats, which offers consumers a hot meal in 90 seconds from a package stored at room temperature. Growth has been strong in this area, with most of it unit-driven. Refrigerated Foods, which is primarily uncooked pork and beef products, has seen slow organic growth but was boosted by an acquisition that has helped also improve margins. This segment has seen strong retail growth (grocery stores), but, not surprisingly, flagging demand from casual dining. Jennie-O Turkey Store, which serves both grocery stores and foodservice, has seen top-line growth in both units and pricing, but it has been unable thus far to overcome soaring input costs (feed and fuel). The company expects these costs to moderate and for competitors to cut supply next year, but it doesn't forecast profit growth until the second half of next year. Specialty supplies spices, sugar substitutes and private-label manufacturing for retail and foodservice. Growth has been very strong and primarily unit-driven. Finally, Other, which is the company's international operations, is booming but quite small.
My big picture take on the company's operations is that their underlying demand is quite robust, but they are struggling with high costs. Maybe a better way to phrase that last observation is that they WERE struggling with high costs. While the time until it enjoys the better cost environment is several quarters due to contracting and hedging, clearly this should become less of an issue. Demand, on the other hand, should grow. While the company has exposure to restaurants (and institutions, which will mitigate some of that exposure), it has tremendous shelf space in the grocery stores. While I don't have the exact breakdown of their end-markets, I would expect that not only does their grocery store exposure outweigh their exposure to restaurants, but they are most likely much better positioned that TSN and other meat producers. While I guess there could be some broad switching in a tough economy from meat to less expensive grains or vegetables, I don't expect this trend to be too significant (Daddy, please pass the couscous and the lima beans). The bigger trends will be fewer lunches out and more brown-bagging, fewer meals out with the family and more meals prepared in the home. I believe that HRL should benefit from the switching from restaurants to grocery stores.
Quite fittingly, this major turkey processor will report its fiscal 2008 year-end earnings on the 25th, just in time for Thanksgiving. While I certainly don't expect to hear anything great about the short-term, hopefully the outlook for 2009 won't take a hit similar to the one endured when they last reported. As you can see in the chart below, though, typically the earnings and sales are choppy but steady. Not surprisingly, sales and earnings held up well in the past recessions (shaded). I believe that the fiasco in 1996, by the way, was a function of a huge spike in pork prices. The company seems less exposed to the substitution effect today with its increased exposure to turkey.
Besides its diversification on several fronts (types of meat, end customers, degree of processing), one area in which the company is highly differentiated from its peers and even the broader universe of Consumer Staples companies is the balance sheet. This actually isn't the first time I have mentioned HRL, as it made a screen that I constructed to identify high-quality growth stocks. I last wrote about these companies in July. HRL has actually increased its dividend every year since 1985 and now yields 2.8%. The company generates significant free cash flow and has a total debt to capital ratio of 18% before consideration of its cash. Even stripping out intangibles its balance sheet is underleveraged: $1.25 in tangible equity and net debt of $315mm. Clearly, this company can probably weather any storm. Contrast the balance sheet to a broad group of food processors in the table below. It stands out by far, as the median ratio is a whopping 57%. Adjusting for intangibles, the company would look even better.
Download hrl_peer_comparison.jpg
The table above leads nicely into the final aspect of HRL that I wish to consider: Valuation. Peer comparison is always a nice start, and I would share several observations on this front:
- Average PE for the group and average discount to its typical PE despite clearly superior balance sheet
- EV/EBITDA further illustrates this point - this is the major disconnect
- Margin pressure apparent in P/S valuation - but won't they improve soon?
- P/TB ratio is far superior to most - the lower ones tend to be heavily in debt and experiencing much lower margins
- Growth has been relatively robust but not aggressive
While it appears clear to me that HRL is being weighed down by concerns over its turkey and pork exposure (as its peers struggle), I believe that these fears are unwarranted. The company's far superior balance sheet and broader diversification not only protect it but put it in a position to take market share as its competitors are forced to retrench. Perhaps the company will end up buying cheap assets with some of its large cash position.
In absolute terms, while the "cheapness" of HRL is certainly not unique in this market, I believe that it is certainly very cheap. I will end this analysis with a long-term look at several metrics and let you be the judge. I believe that not only will demand for their products be strong, but eventually demand for the stock will return too, especially as investors get a handle on the timing of what I suspect will be major cost improvements. My target for what I consider a pretty boring stock is rather exciting, as I expect the stock to trade a year from now at 37 or 14X projected FY2010 earnings (rougly 37% higher before the 3% dividend). I don't expect that many stocks to show those types of returns unless the economy somehow gets back on track quickly.
Download hrl_valuation_history.jpg
In an environment of falling sales, plunging earnings and slashed or eliminated dividends, I think that HRL will stand out as an oasis of stability that offers potentially that which will be quite scarce: growth. For those of you concerned about the economic crisis leading to global chaos and the destruction of civilization as we know it (I ran into a bunch of these folks when I dissed gold recently in an article that not only reinforced the idea of the outsider's perspective perhaps having value but was also one of the most read and commented upon blogs I have posted), maybe the company benefits from the hoarding of canned goods. Kidding aside, I recommend that everyone set aside their fears of and negative associations with Spam and consider Hormel.
Disclosure: Long HRL
Comments