2023-10-12 17:16:04 ET
Summary
- Hormel Foods' valuation has defied logic, with high multiples despite extremely poor growth.
- The company announced a strategic plan to accelerate investments and deliver $250 million in operating income growth.
- The focus on significant investment in 2024 has led to a selloff, but other news may be more relevant.
- We go over the numbers and tell you why we give this an upgrade.
Hormel Foods Corporation ( HRL ) was always a special case. Bears knew that the victory on valuation was inevitable, but the battle was likely to be long drawn out. After all, the company had the undying support of the dividend growth investor. That category of investor will prize dividend growth rates over all else, including valuation, and assume that the key to retirement is getting a simple equation right. This equation in many circles is "yield+ growth of yield > 12%." With HRL you got it in spades (or SPAM we should say).
So the obvious side effect was this.
The chart goes from October 2013 until March 2022. 30X earnings? 21X EV to EBITDA? Outside them literally selling SPAM, there was no remote association to technology or Internet here. Valuation defied logic.
Analyst Day
HRL had an analyst presentation today (Oct. 12) . One of HRL's first slides in the presentation was the one showing identical operating income over six years. This too gets us to our original problem of why investors had gone stark mad to pay those multiples.
But that was not the issue. HRL was announcing a strategic plan to accelerate investments and deliver an operating income growth of $250 million over the longer run.
This was going to require some nifty work to get there.
The four key focus areas mentioned were:
1) Improving personnel capabilities and improving processes.
2) Modernizing and improving the company's technology infrastructure.
3) Improving supply chain efficiency.
4) Portfolio management, which in this case refers to their product portfolio. Here the company plans to focus on offerings with stronger margins and perhaps prune away those with low margins.
Interestingly enough, the likely culprit for today's selloff was the focus on 2024 for significant investment/capex. This increase is going to come on top of a very large increase over the 2017-2022 timeframe. Again, these are not our words, but simply what the company talked about.
So lots of spending in 2024, though the exact numbers were not mentioned.
Benjamin Theurer
Ben Theurer from Barclays. Just combined question. So obviously, that will require some capex, and you've talked about the investment in that, and we've seen over the last couple of years, more like a run rate, call it, $250 million, $280 million. What's like kind of the magnitude you have to elevate capex to in '24 and maybe '25 to get to the matrix target? And how are you going to balance that with what now is, of your earnings per share, a very high dividend payout in order to keep that dividend balance growth maintained given the capex needs?
James Snee
Yes. So we'll obviously give you some better visibility here in a few weeks. But I would say the one thing to consider, Ben, is when I talked about that ramp-up in capex, a big part of that was the capex that we have invested for value-added capacity for our ability to grow the business. And I mean we'll continue to make those investments. But we've already made along the way some pretty significant investments, and we now have that capacity to support the business.
The maintenance piece of the capex, that's going to be in every year's number. How much we have to spend on the value-added piece or the growth piece, because we've got the capacity based on the investments that we've made, it may not have to be one on top of another on top of another on top of another because we are in a really good place with our value-added capex investments.
Source: TIKR
We think at least a $50 million expansion here seems likely to be the low-end. 2024 will likely show little for those investments based on the discussion. 2025 will be the year when we will start to see the value of those investments and 2026 is going to be the pivotal moment.
So let's contextualize that. Below you have the operating income shown from the HRL Q3 ending in July 2023 (year-end is October). You can see the remarkable drop-off in operating income for this year whether you are running the third quarter or the whole nine yards.
HRL 10-Q
So with a $1.1 billion to $1.3 billion run rate, $250 million is a solid change of about 20%-25% over whatever HRL sees as their base run rate. But that change is not over and above the expectations. The current estimate for earnings per share, which is a more levered multiplier on operating income, is for solid growth across the next three years. In fact, earnings per share were expected to grow by 45% over this timeframe.
HRL has low financial leverage and is one of the lowest amongst consumer staples names.
While that is a good thing for access to capital markets, it's not necessarily great for how earnings per share will improve. HRL has low leverage from rising operating income, especially during a time of rising interest rates. In other words, everything that the company appears to be promising today was likely built into analyst forecasts. In fact, it may be disappointing to some on the free cash flow calculations as capex run rates will move up substantially for some time.
Verdict
In case you bought the stock in the $50's for the dividend growth, fear not. There will be dividend growth again.
Benjamin Theurer
How's that going to be balanced with the dividend growth? What should we expect there?
Jacinth Smiley
I would expect that we would continue - if I can sit here today and say that, that we're in a position to continue to increase the dividends next year. There is no doubt in our minds. So no concern there at all.
And as Jim said, with not having to invest in the capacity that we've already put in for capital you think about that trade-out that then potentially offset this additional investment in transformation and modernization.
Source: TIKR
Of course, that's of little solace today as HRL wipes out 14 quarters of worth of dividends from the stock price. Our outlook is less moved by this efficiency measure and more moved by the other news of the day.
That will sting, and it remains to be seen how HRL's announced measures will rise to the margin compression coming from the other direction.
But all good things here for the bears come to an end. Our take back when the stock near $50 was that it was a laughable bubble guaranteeing negative returns as far as the eye can see.
At the end of the day, it's a valuation call, but we have a very high degree of certainty here because Hormel is in the 99th percentile across every valuation. Sure, you can compare Hormel to a 10-year Treasury note or even Bitcoin and say "Hormel is better". But that is the fastest way to the poor house. We expect negative 10-year returns and even a 50% drop from here would hardly be unexpected to us.
Source: A Mini Spam Bubble
With the stock now down 32% since then, you have to know when not to press your bets. Sure, there's room on EV to EBITDA (easily can go to 12X) and price to sales (minimum 1.2X in our view) for bears to asset domination with 5.5% risk-free rates.
And the labor contract probably emboldens some in the bear camp. But the stock has taken the froth off. It's trading now 20% below its 200-day moving average and has suffered the largest single-day price drop in 15 years. The whole consumer staples sector has been cleaned with Clorox ( CLX ). Twice over.
It's in the face of such an epic climax that we see it fit to change our view. We're upgrading this to a Hold/Neutral and believe that those dividend growth investors are being given a better entry point today, even though future growth will be far lower.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
For further details see:
Hormel: Analyst Day Spooks The Bulls... As We Opportunistically Upgrade