HRL - An Overvalued Dividend King

Not all investors seek excitement and volatility from their investments and look to Hormel Foods Corporation (HRL) for its low volatility, stability, and dependability. Although HRL is a high-quality company, the current issue as I see it is that HRL is an overvalued Dividend King.

A Dividend King is a US public company with a history of dividend increases of at least 50 consecutive years. HRL meets this criterion in that it has increased its dividend for 55 consecutive years. Furthermore, HRL:

  • has paid a regular quarterly dividend without interruption since becoming a public company in 1928; and
  • has distributed its 371st consecutive quarterly dividend on May 17, 2021.

A Dividend King does not typically experience significant capital appreciation in the short term. The rationale for investing in such a company, however, is not primarily for capital appreciation but rather the consistency of increasing dividend distributions. As a result, a Dividend King is more suited for an investor seeking a dependable stream of increasing dividend income.

Previous HRL articles can be accessed from the Archives section of this site; my most recent article was posted on December 26, 2020.

With HRL having:

  • recently stated that it anticipates a June 2021 closing of the Planters acquisition from the Kraft Heinz Company (KHC); and
  • reported Q2 2021 results on May 20, 2021

I now take this opportunity to revisit HRL.

Business Overview

HRL, founded in 1891, started as a processor of meat and food products. It is primarily engaged in the production of a variety of meat and food products and the marketing of those products throughout the US and internationally.

Over the years, it has transformed into a company with a diverse portfolio of products spanning the retail, deli, foodservice and international channels. Furthermore, it has expanded beyond meat protein. This has opened new areas for growth, while further diversifying the business away from the fluctuations associated with commodity meat businesses.

On the international front, HRL markets its products through its wholly-owned subsidiary - Hormel Foods International Corporation (HFIC) in strategic foreign locations such as Australia, Brazil, Canada, China, Japan, and the Philippines. HFIC also has a 40% minority position in The Purefoods-Hormel Company, Inc. in the Philippines.

HRL consists of 4 reporting segments:

  • Grocery Products;
  • Refrigerated Foods;
  • Jennie-O Turkey Store; and
  • International & Other.

At HRL's October 2019 Investor Day, management outlined key milestones on the company's evolution as a global branded food company.

A comprehensive overview of the company and the risks that may adversely affect the company are found in Part 1 of the FY2020 10-K.

Planters Acquisition

On February 11, 2021, HRL announced its intent to acquire the Planters, NUT-rition, Planters Cheez Balls and Corn Nuts brands from KHC. The $2.79B adjusted purchase price consists of $3.35B  less a ~$0.56B tax benefit. This equates to 12.5 times 2020 EBITDA.

The portfolio is well-balanced and is not dependent on any single product or category which makes this an attractive acquisition. Planters is known primarily for its line of peanut products ranging from large-size canisters to small handheld to-go pouches. Peanuts, however, represent only 29% of sales. The remaining portion of the business is:

  • cashews at 29% of sales;
  • mixed nuts at 24%; and
  • all others including corn nuts at 18%.

Total sales for all 4 acquired brands were just over $1B in 2020. This is the largest acquisition in HRL's history and is an important milestone in the company's evolution as a global branded food company.

This acquisition is to be accretive in FY2022 to the extent of $0.17 - $0.20/share. Dilution of ~$0.02 - $0.07/share in FY2021 is expected due to transaction costs, integration costs, and purchase accounting adjustments.

This acquisition is in keeping with management's objective to responsibly leverage HRL's balance sheet.

Financing will be from with cash on hand and a combination of long-term and short-term debt with a focus on retaining HRL's strong investment-grade rating. The plan is also to deleverage during the first 18 - 24 months following the closing of this acquisition.

Q2 and YTD2021 Results

On May 20, 2021, HRL released Q2 and YTD2021 results.

HRL's balanced business model has proven to be a winning formula as the company delivered record sales in Q2 and the first half of FY2021. A key driver is a rebound in HRL's foodservice business.

E-commerce sales have grown double-digits in the past quarter and HRL is gaining share in important categories.

HRL has also improved its distribution network. In the past year, it has opened a new Grocery Products distribution center and a Refrigerated distribution center serving the West Coast. These strategic investments will:

  • reduce overall freight miles and costs;
  • improve customer service levels;
  • support growth for value-added businesses; and
  • reduce greenhouse emissions.

Operating income declined slightly as raw material and feed prices have rapidly increased throughout Q2. Pricing actions have been taken in many categories but in volatile market conditions, pricing will lag the markets.

Free Cash Flow (FCF)

Looking at the Condensed Consolidated Statement of Cash Flows (page 12 of 12) we see HRL generated ~$0.361B of Net Cash from Operating Activities and incurred CAPEX of ~$0.086 for FCF of ~$0.275B in the first half of FY2021.

From a historical perspective, HRL generated 394, 385, 531, 588, 848, 784, 813, 852, 629, and 761 (millions of $) of FCF in FY2011 - FY2020.

CAPEX in Q2 2021 was $45 million versus $80 million in Q2 2020. HRL's FY2021 CAPEX target is $0.26B. Large projects include a pepperoni capacity expansion in Nebraska, projects to support the growth of branded products, and Project Orion.

Project Orion was started in Q1 2019. It is a strategic initiative that will streamline and transform how HRL operates as a global-branded food company. Before launching this project, HRL was running multiple and independent on-premise support systems. The goal with Project Orion is to create a unified Oracle cloud-based platform. The supply chain and HR teams will benefit from integrated systems with new capabilities. Finance will benefit from the transition of the on-premise Oracle financial system to the Oracle cloud-based platform including the use of robotic process automation. Essentially, systems will be simplified and modernized to give HRL teams the actionable and timely data needed to drive deeper analytics and gain insight into the business.

FY2021 Guidance

FY2021 sales guidance is $10.2B - $10.8B. Adjusted diluted EPS guidance of $1.70 - $1.82 does not include the estimated impact of the pending acquisition of the Planters snacks nuts business.

Management has a very positive outlook on the food service business and is increasingly confident that K-12 schools and colleges and universities will open and operate more traditionally in the Fall of 2021. This should benefit both Refrigerated Foods and Jennie-O Turkey Store.

Elevated demand in the retail, deli and international channels continues and further benefit from pricing actions is expected.

The rapid increases in key input costs across HRL's businesses are likely to persist for the remainder of 2021.

Operations were heavily impacted by plant shutdowns, supply shortages and lower production throughput caused by the effects of the pandemic in the back half of FY2020. This ultimately led to lower levels of inventory, which negatively affected Q3 and Q4 results. Through the strategic actions taken to improve all facets of HRL's operations and based on a record first-half performance, management expects to benefit from more normalized operations in the back half of FY2021.

Credit Ratings

Moody's currently rates HRL's senior unsecured domestic currency debt A1. This is the top tier of the upper-medium grade category.

The A rating assigned by S&P Global with a negative outlook is one notch lower than that assigned by Moody's and is the middle tier of the upper-medium grade category.

Both ratings define HRL as having a STRONG capacity to meet its financial commitments. However, it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

Both ratings are investment grade and are acceptable for my purposes.

Dividend, Dividend Yield, and Share Repurchases

HRL's dividend and stock split history on the website only dates back to 1989.

As noted earlier in this article, however, HRL's dividend track record is far more extensive than this.

The dividend yield is currently ~2% based on a ~$49.36 share price.

When HRL announced on February 11th its intent to acquire Planters, management indicated dividend growth has been and will remain a top long-term priority. However, share repurchases will have a lower priority as HRL deleverages its debt; HRL is targeting to achieve 1.5 times leverage by 2023 and to retain a significant capacity for additional leverage for future investments.

In fact, we see from the Condensed Consolidated Statement of Cash Flows that HRL has repurchased less than $10 million of issued and outstanding shares in the first 2 quarters of the current fiscal year. Of the $10 million spent in the first 2 quarters of the current fiscal year, less than $1 million was deployed in Q2. By way of comparison, HRL spent just under $12.4 million in share repurchases in the first 2 quarters of FY2020.

We also see that HRL's average number of issued and outstanding shares in FY2011 - 2020 has not changed that much: 544, 538, 540, 540, 541, 542, 539, 544, 545, and 547 (millions of shares rounded).

Valuation

At the time of my December 26, 2020 article, HRL had reported $1.66 in diluted EPS for FY2020. With shares trading at $47.17, the PE was ~28.

HRL's mean FY2021 adjusted diluted EPS guidance from multiple analysts was $1.77. Using the current $47.17 share price, the forward adjusted diluted PE was ~26.5.

We now see that HRL has generated $0.82 in diluted EPS for the first half of FY2021. In addition, management's adjusted diluted EPS guidance for the year is $1.70 - $1.82 and guidance from 13 brokers is a mean of $1.74 and a $1.66 - $1.87 range. Management expects the Planters acquisition to be dilutive to the extent of ~$0.02 - $0.07/share in FY2021 but let's give HRL the benefit of the doubt that dilution will only be $0.02/share. On this basis, adjusted diluted EPS guidance following the Planters acquisition is $1.68 - $1.80.

Shares are trading at $49.36 so the forward adjusted diluted PE range for FY2021 is ~27.4 - ~29.4.

Management has not provided adjusted diluted EPS guidance for FY2022 but based on input from 13 brokers I see a mean of $1.88 and a range of $1.75 - $2.12. Management has indicated the Planters acquisition is to be accretive in FY2022 to the extent of $0.17 - $0.20/share. If I add $0.20 to the FY2022 broker estimates I get a mean of $2.08 and a range of $1.95 - $2.22.

Using the current $49.36 share price, the forward adjusted diluted PE range for FY2022 is ~22.2 - ~25.3.

By way of comparison, we see HRL's PE levels for FY2010 - 2020 are 17.55, 16.83, 16.78, 23.16, 23.36, 31.13, 21.23, 23.18, 22.95, 25.06, and 28.08.

I am somewhat hesitant to base an investment decision on FY2022 earnings estimates from brokers, especially when there is a $0.37/share variance between the low and high estimates.

Hormel - An Overvalued Dividend King - Final Thoughts

I initiated a position on June 16, 2017, through one of the 'Core' accounts within the FFJ Portfolio. At the time, HRL had reported $1.64 in diluted EPS for FY2016. Adjusted diluted EPS estimates for FY2017 based on input from 13 brokers was $1.65 in FY2017 and $1.71 in FY2018 and shares were trading at $33.95. This resulted in HRL's forward adjusted diluted PE being ~21 and ~20 in FY2017 and FY2018, respectively.

Higher growth companies typically attract a higher valuation. HRL, however, is not a high-growth company. As much as HRL is a high-quality company and is a component of the Dividend King group of companies, I am reluctant to acquire additional shares at the current valuation.

In my opinion, an adjusted diluted PE in the low 20s (eg. ~22) is a more reasonable valuation. On this basis, a reasonable price at which to acquire HRL shares would be ~$40 or less.

Stay safe. Stay focused.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long HRL.

Disclaimer: I do not know your individual circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your own research and due diligence. Consult your financial advisor about your specific situation.