Hormel Doing Better Than Most

By Stephen D. Simpson, CFA | May 28, 2012 AAA

These aren't easy times for food companies, as rising input prices push up costs and shoppers rebel against price increases. Hormel Foods (NYSE:HRL) seems to be holding up better than most, though, as the company's expense control and increased focus on processed/packaged goods pays benefits. Hormel looks like one of the best long-term stories in food right now, but the valuation means that investors shouldn't expect outsized capital gains from the shares.

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Decent Revenue and Surprisingly Strong Margins
Hormel did post a modest miss on its top line, but revenue still grew nearly 3% this quarter as price increases outweighed a slight (2%) volume decline. That puts the company between Tyson Foods (NYSE:TSN) and Smithfield (NYSE:SFD) in terms of volume performance, and better than quite a few packaged food companies. Sales grow was strongest in the specialty business (up 12%), which is not surprising given the company's ongoing focus of building this business through acquisitions and product development.

Hormel did well on margins this quarter, helped in large part by the Jennie-O turkey business. Gross margin was flat with last year, while operating income rose nearly 16%. While the refrigerated business saw profits decline 25% on more difficult pork margins, investors should also realize that the year-ago comp was a difficult one. On the positive side, Jennie-O profits jumped more than 50%, while the grocery and specialty businesses logged high single-digit growth.

SEE: A Look At Corporate Profit Margins

At the Right Price, Sara Lee Seems Like a Natural Fit
If the rumors are right, bankers are working overtime trying to drum up interest in Sara Lee's (NYSE:SLE) meats business. Articles from Reuters and the Financial Times have highlighted Smithfield as a targeted buyer, but I would be very surprised if companies like Cargill, Tyson, ConAgra (NYSE:CAG) and Hormel weren't fielding calls from bankers as well.

While there are multiple Brazilian meat/grocery companies that would love to have a point of entry into the U.S. protein and grocery market, Hormel is arguably the best fit of all. Hormel wants to increase its branded/packaged business, and though Sara Lee is not as strong in the center aisles of the grocery store, the sausage, hot dog and breakfast products would fill gaps in Hormel's line-up.

Will Hormel get Sara Lee? Hormel has generally preferred smaller deals and management doesn't like to overpay. Assuming that the bankers are trying to auction Sara Lee and play likely bidders off each other, the price may go past the point where Hormel management can expect a reasonable return.

Evolution, Not Revolution
While Kraft (NYSE:KFT) is splitting its branded grocery business from its snack business and ConAgra and Ralcorp (NYSE:RAH) are migrating more towards generic/private-label foods, Hormel is trying to build up that grocery and branded packaged food business. With the more stable margins offered by shelf-stable packaged foods, that makes imminent sense.

That said, it's not going to happen overnight. This is a company that just gradually gets a little better over time and is committed to a disciplined plan centered on strong returns.

SEE: Evaluating Grocery Store Stocks

The Bottom Line
Hormel has excellent returns on capital, despite the volatility that goes with pork and turkey processing. Those returns have also been coupled with decent mid-single digit cash flow growth over the years, as well as even stronger book value growth. As the company continues to see more and more revenue coming from the center aisles, I expect that trend to continue.

All of that makes Hormel a good company, but today's valuation doesn't make it a great stock. Based on high single-digit free cash flow growth, these shares are around fair value today. Maybe owning a great company at a fair price isn't the worst plan for an investor with a long-term orientation, but it does reduce the margin of error with these shares.

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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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