Hormel Foods: A Wait And See Approach For This Dividend King (NYSE:HRL)

Investment Thesis

Looking at where Hormel Foods Corporation (NYSE:HRL) is now and considering where I believe it will be in the next few years, I believe the company is a hold. The company, while performing better than some of its competitors, has seen continued margin declines over the past five to ten years, which has negatively impacted the bottom line and caused its payout ratio to steadily increase. With that in mind, and considering the current valuation, the company doesn’t appear to offer much upside, and therefore I assign a hold rating.

Introduction

As I continue my investing journey, my mind is set on achieving financial freedom in some form. With that in mind, I continue to look towards a strategy that involves carefully chosen investments in businesses that are straightforward and are high quality.

In doing so, I have found myself diving into a number of food producers who generally offer a strong and stable dividend. I recently covered Conagra Brands (CAG) given that the stock price had been struggling over the past year, moving down around 20%, which I believe presented an opportunity for investors. Thanks to the opportunity I believe CAG presented, I have found myself looking into HRL to determine whether another similar opportunity exists.

Company Profile

Hormel Foods is an American food company with more than forty brands such as Spam, Dinty Moore and Skippy which are available in over 80 countries. The company generally produces and markets a number of meat and food products in the retail, foodservice, and deli sectors. Hormel’s business model focuses on leveraging its brand strength to maintain a strong market position and innovating products to meet changing consumer preferences.

Like some of its peers, Hormel has seen a notable decline over the past year, dropping more than 10% and is far below its all-time high of $51.79 from April 2022, thanks in part to the slowdown in economic growth and insufficient consumer demand most food giants have reported in the last few years. Despite the price action, Hormel has reported better than expected business performance which, I believe, could be an encouraging sign to investors that the share price could continue to turn around to reflect this improved profitability, and I am hopeful that we will see this turn around begin this year.

Dividend Discussion

As I mentioned, dividends are an important part of my investment strategy, as they’re a way of me receiving a reliable source of income, and they also serve as a good indicator of a company’s financial health. All of this is important for someone like me, who is generally a risk-adverse investor.

Hormel is a great dividend provider; the company has established itself as a dividend king, having raised their cash dividends for 58 consecutive years, including this year. In the past decade, Hormel has achieved a 10-year compound annual growth rate (CAGR) of approximately 9.3% for their dividend. Currently, the dividend is at $1.11 offering a 3.1% dividend yield given on the stock price of $35.27. This yield is better than the average dividend yield of the S&P500 of 1.35%.

Hormel’s payout ratio is at 75.7% suggesting to me that the company can comfortably pay out their current dividend and encourage me that they will likely continue to increase their dividends in the future. I think it’s important to note however that the company has seen their payout ratio rise from the mid-thirties to where it is now, not a great sign in my opinion. Comparing HRL’s dividend to some of its competitors such as Conagra and Tyson Foods (TSN), based on their current prices, Hormel has a worse dividend yield, albeit only marginally in the case of TSN, while its payout ratio is similar to CAG’s and much better than the payout ratio for TSN.

Financial Discussion

Hormel’s overall financial performance over the past decade has been somewhat slow, in my opinion. The top line for HRL has been steadily growing over the past 10 years, with some minor drops along the way. In the most recent decade, revenue has grown from $9.26 billion in 2015 to $12.14 billion in the last 12 months (LTM), corresponding to a compound annual growth rate (CAGR) of 3.05%. As for the profitability metrics of Hormel, earnings per share (EPS) growth have also been growing slowly. In the last 10 years, the company has grown EPS from $1.27 in 2015 to $1.45 (LTM) which is approximately 1.5% CAGR over this period. Hormel’s EPS reached a high of $1.86 in 2018 and has been in somewhat of a downtrend since, along with its operating margins which peaked at 13.5% in 2017 and are now 8.7%, which raise a concern for me that the company is struggling to manage operating costs, and it only seems to be getting worse.

Over to the company’s balance sheet now, which appears to be in a solid position in my opinion. In terms of debt, the company has a large amount, although generally lower than many of its competitors. As of the (LTM), Hormel’s total debt is at $3.31 billion, compared to a cash and cash equivalents balance of $963 million and a free cash flow (FCF) yield of $967 million. To me, this debt level is relatively healthy as it suggests the company can pay of most of its debts within 3 to 3.5 years based on current FCF levels, which is much better than many of its competitors and I believe may give Hormel and advantage in the future as they do not need to dedicate as much financial resources to paying down debt and instead management can focus on reinvesting back into the business or returning value to shareholders. Hormel Foods also has a solid current ratio of 1.49 suggesting to me that they can comfortably pay off all upcoming debt repayments.

Looking at more recent events, like their latest quarterly earnings, Hormel has seen growth in revenue of 1% for the first quarter compared to the previous year while operating income and margins continued to fall. I believe, while disappointing given the lack of growth, it’s important to consider that many of Hormel’s competitors are experiencing similar difficulties, and it appears that the company is faring slightly better given that they are guiding for revenue increases of 1 to 3% and flat to low single digit EPS growth at a time where companies like Conagra are guiding declines across the board.

On the dividend front, the quarterly dividend grew at 3.00% to an annual rate of $1.13, maintaining their excellent track record, albeit at a slower growth rate than before. For me looking ahead, the key to Hormel’s success is managing their costs, especially given that their payout ratio has soared in recent years. While not necessarily a concern now, if this trend continues, we may be in a position in a few years where their payout ratio becomes a concern given that I don’t expect revenues to grow more than mid-to-low single digits.

Rising Expenses Continue to Impact the Bottom Line

While Hormel seems to be faring better than its competitors recently, guiding for growth during a time where others are not, the company’s quickly growing expenses relative to its revenue growth, especially given that it doesn’t appear to be a one-off event but rather a trend that has persisted for the best part of a decade. In the last 5 years, Hormel’s cost of revenue and operating expenses have grown at 5.9% and 5.2% CAGR respectively, while revenue grew at just 5.0% CAGR. Whilst it doesn’t appear to be a substantial difference, over a long period of time this difference is exasperated, and we start to see increasing impacts on the bottom line, which, I believe, is where we are at now. Couple the increasing fixed costs with the increasing interest expenses on debt thanks to higher interest rates, and I believe it quickly becomes apparent why the profitability of the business is down.

The reason I bring this up is because I believe that returns for investors will not be great until the company manages to bring expense growth to a level at or below the revenue growth rate. Additionally, this trend appears to a problem somewhat unique to Hormel. If we look at the graph below, we can see that while it normal to experience fluctuations in margins, outside of Tyson Foods, Hormel is the only business that has experienced a structural downturn in margins that has not begun to turn it around. This downtrend in margins has resulted in some of its competitors, surpassing HRL in terms of net income margin. To add to this, I don’t expect this year to be any different given that we’re expected to see growing revenue whilst EPS is expected to be flat to in line with revenue growth, which means another year of suppressed margins in my opinion. I believe that this will be something that Hormel has to deal with over the comings years and something I imagine the company will resolve once we enter a more stable environment where commodity prices normalize and some of their latest initiatives have been fully implemented, both of which have been a factor in growing costs.

Valuation

As I discussed previously, I believe Hormel has a solid dividend growth track record over the past 10 years and so long as they can control expenses, something which, I believe, is a multi-year task. On the valuation front, Hormel currently has a valuation grade of C-, suggesting it’s around fair value, which is similar to the sentiment held by Wall Street, which has assigned a hold rating for Hormel. At its current price of $35.27 Hormel’s price to earnings (PE) ratio appears to be slightly lower than its 5-year average (PE) ratio, which to me reaffirms the idea that the company is right around fair value.

I have used a discounted dividend model (DDM) to come up with a more accurate valuation of Hormel. A DDM estimates a stock’s price by discounting predicted dividends to their present value. For the model, I have used a weighted average cost of capital (WACC) of 6.6. The WACC I have chosen for this model is roughly in line with other estimates. For the dividend growth rate over the coming year, I selected a growth rate of 2.73% which aligns with the expected dividend growth rate outlined by management and analysts. Using the DDM, I have estimated an intrinsic value of $29.20 which is below the current price, suggesting that there isn’t much opportunity for this stock at the current price. I think that HRL is therefore a hold and a company I will re-evaluate further down the line.

Risks to Consider

I think the biggest risk to consider for Hormel Foods is their cost management. As I discussed above, they have been experiencing year-on-year declines in margins over the past decade, which has been impacting the company’s profitability. The risk is that management fail to deal with this concern, and we are left with ever-growing costs that outpace sales growth. In this scenario, I believe it wouldn’t be too long until we are in a scenario where HRL’s payout ratio is approaching 100% and alarm bells start to ring surrounding the company’s dividend and its status as a dividend king, which I expect would send the stock price down considerably. While I believe this scenario is unlikely, I definitely believe it’s worth considering for investors when looking into HRL.

Takeaway

What I take away from Hormel Foods is that while the company has been performing well relative to some competitors, the company finds itself in a situation where expenses are rising faster than sales and have been doing so for many years. While its status as a dividend king is attractive to a dividend investor like me, the yield and poor profitability growth, combined with valuations and my DDM suggesting that the company is fairly valued to somewhat overvalued, incline me to assign a hold rating for HRL stock at the current price.