Tickers in this Article: HRL, UL, GIS, CAG
Within the food and beverage sector there are certain stocks that just never get all that cheap, leaving investors with the uncomfortable choice of paying up (and hoping that the growth expectations come through) or waiting for the rare sell-off. In addition to companies like Nestle (OTC:NSRGY) and Coca-Cola (NYSE:KO), Hormel (NYSE:HRL) deserves a place on that list as the company has long combined good growth, improving margins, and strong returns on capital and delivered good stock market returns (more than tripling the return of the S&P 500 since the early 1990's).

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Fiscal Q2 Results Come Up Just Slightly Lacking
Management had warned investors back in January that 2013 was going to be a year of sub-normal growth, as the company expected to absorb higher input costs and proceed carefully with price hikes. To that end, it's hard to get too worked up about second quarter results.

Revenue rose 7% as reported, with volume up about 4%. On an organic basis, though, it would seem that sales were basically flat with the year-ago period. The company's largest business, Refrigerated, saw revenue decline 2% on a 4% volume decline, while Grocery rose 49% on the inclusion of Skippy and Don Miguel (on an organic basis, revenue was up about 4%). Jennie-O was likewise down 2% on a 4% revenue decline, while the Specialty business grew 7% on a 4% volume improvement.

Revenue was about 2% weaker than expected, but it didn't hit Hormel too badly in the margins, at least relative to expectations. Gross margin did decline 30 basis points from last year, but was almost in line with expectations. Likewise, reported operating income declined 4%, but adjusted income rose 9% and was within the range of most sell-side analyst estimates. Scrubbing out the corporate expenses and acquisition-related costs, segment profit declined 2% this quarter.

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Skippy Is Likely Just The Beginning
Without wanting to speak for Hormel management, I think they have made it pretty clear that they see the company's future as becoming more like General Mills (NYSE:GIS) or Kraft (Nasdaq:KRFT) and less like Hillshire (NYSE:HSH), Tyson (NYSE:TSN), or Smithfield (NYSE:SFD). In other words, it's no longer just about expanding the branded/processed food offerings (as Tyson and Smithfield are doing as well), but also expanding into new food categories.

To pursue that strategy, I believe Skippy will be just the most recent example of a series of acquisitions designed to make Hormel a more diversified branded grocery company. Having bought the Country Crock side dish line and Skippy from Unilever (NYSE:UL), maybe Hormel goes back again and tries to acquire the Ragu, Knorr, Hellmann's/Best Foods, and/or Wishbone businesses. Likewise, perhaps ConAgra (NYSE:CAG) will look to sell some under-performing branded product lines now that the Ralcorp deal is done.

Whatever the case, I expect Hormel to be prudently aggressive. Although the company paid up a bit for Skippy, I believe this deal will have a strong internal rate of return over the long term, as Unilever under-invested in the brand/business for quite some time. Along those lines, I could see management targeted other businesses where a little elbow grease and some expansive thinking (product line extensions, etc.) could generate meaningful better results.

The Bottom Line
It is my opinion that Hormel has excellent prospects as a business. The problem I have as an investor is that Hormel is a popular stock with smart investors and they rarely let these shares languish in the “cheap zone” for very long.

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Even if I project long-term revenue growth of 6% (against a trailing 10-year growth rate of 8%) and double-digit free cash flow growth, the implied fair value is only in the mid-to-high $30s. Perhaps some investors will argue that Hormel's demonstrated excellence deserves a lower discount rate, but I'd argue that the company's vulnerability to hog prices and grain merits some small penalty. In any case, I just don't see a food stock trading at over five times tangible book and over 12 times trailing EBITDA as “cheap”. While I'd love to buy Hormel at a more reasonable valuation, the bull market in consumer stocks has pushed these shares beyond my comfort zone.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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