Can Hormel's Model Shine With The Drought?

By Stephen D. Simpson, CFA | August 24, 2012 AAA

Processed foods may not be healthy for us as consumers, but they certainly don't do the producers any harm. Whether you look at a five, 10 or 15-year chart, the performance of Hormel (NYSE:HRL) simply blows away the likes of Tyson (NYSE:TSN), Smithfield (NYSE:SFD) or Pilgrim's Pride (NYSE:PPC). Sure, some of that can be laid at the feet of superior management, but the reality is that it's much better to be the maker of branded processed foods than a virtual commodity supplier of fresh or frozen protein.

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That said, Hormel doesn't get a free ride - it still takes animal protein to make products like Spam, Dinty Moore and Compleats, and this summer's drought raises the very real specter of higher protein costs down the line. While I expect the company to navigate this well, any disruption or disappointment could be an opportunity to pick up shares in a quality company at a better price.

Third Quarter Pretty Much In-Line
At the top and bottom lines, Hormel didn't really surprise with its earnings, but then this company rarely does. Instead, it looked a lot like the "just do a good job" type of quarter that most Hormel investors have come to expect.

Hormel posted 5% sales growth this quarter on the back of 4% volume growth, and organic growth was about 3% (excluding the acquired revenue from Don Miguel). Grocery, boosted by that deal, was the growth leader at 21%, with organic growth around 3% and volume growth at 2%. Specialty saw an 11% improvement in revenue (volume up 4%), while Jennie-O climbed 7% on 3% volume growth. The company's huge refrigerated business was the laggard, with sales declining slightly on a 1% uptick in volume.

Largely, margins were OK. Gross margin did fall a bit (30 basis points), but operating profits and segment operating profits both increased 17%. In fact, not only did every segment show operating income growth, but all but refrigerated grew by double-digits (and refrigerated did pretty well at 7% given tougher pork margins).

SEE: Understanding The Income Statement

Still a Lot of Unknowns on the Drought
The fierce drought that has wrecked significant swaths of the corn crop is clearly going to have an impact on a host of agricultural and food companies, including ag companies like Archer-Daniels Midland (NYSE:ADM) and protein companies like Tyson and Smithfield. Likewise, it is going to have some impact on Hormel.

There are still a lot of unknowns, though, including how bad the yields will ultimately be. While Hormel buys in the pork it uses, it also hedges forward corn and soybean meal (the two largest commodity components of hog chow) prices on a one to two-year rolling basis. Even still, it's likely that the company is going to have to raise prices to offset higher costs next year - the question, then, is to what extent Hormel can undercut rivals and fresh protein producers by virtue of its stronger brands and processing margins.

Buyout Buzz Isn't Going Away
While the restructuring of Sara Lee into Hillshire Brands (NYSE:HSH) now complete, there's no reason to think that the drone of M&A speculation is going to die down.

SEE: Analyzing An Acquisition Announcement

Once again, though, that doesn't mean that Hormel does the deal. The company has preferred small tuck-in deals, but a deal for Hillshire is going to carry a price tag of over $3 billion and likely more than 50% of Hormel's enterprise value. That's a huge transaction, even if the product synergies make sense. At the same time, it wouldn't be an easy deal for Tyson, Smithfield or any of the major Brazilian players either, so this could be a deal that takes longer to happen than many might otherwise imagine.

The Bottom Line
Not much changes quickly with Hormel; it's been a high-quality packaged food company for a while, and it hasn't been an especially cheap stock for some time either. While I can appreciate the "buy it and forget it" angle on Hormel, I stick to my guns when it comes to valuation and a fair value around $30 doesn't leave much meat on the bone. Consequently, I'm almost hoping that the drought or some other operating mishap knocks the company off stride for a quarter or two, as that might be the only way to get these shares at much of a discount.

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

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