Description

Hormel (HRL) - SHORT

5/20/2016 ($34.86)

Summary

Hormel Foods is a producer of packaged and commodity meats currently trading at 22x consensus 2016 earnings. The company’s packaged meat margins have recently benefited from a rapid fall in pork prices, while turkey margins have benefited from high turkey prices in a low corn and soy price environment. As a result, the company is overearning meaningfully. On management’s estimate of normalized margins, HRL is trading at 26x earnings. About 40% of normalized profitability comes from defensible but mostly low-growth franchises like SPAM, canned and frozen meals and Skippy. The remaining 60% of the business consists of commodity or near-commodity meat packing and processing.

While the business has grown organic earnings at ~7% p.a. over the last 5 years, growth was largely a result of favorable commodity tailwinds, which are likely to reverse. The company has consistently earned high returns on tangible capital (18%+ ROTC over the last 10 years), but incremental returns are likely to be low – management invests FCF into high-priced M&A. There is virtually no takeout risk since HRL is controlled by the Hormel Foundation, which wishes to maintain the independence of the company. While HRL has zero net debt, additional leverage used for a share buyback or dividend would not be meaningfully accretive at current prices since the equity yield and the after-tax cost of debt are similar.

Shorting the stock is an attractive risk/reward with limited upside.  

Businesses / Industry

The company operates in 5 segments:

Refrigerated Foods (35% of EBIT):

The segment sells fresh and packaged pork-based meat products to retail and food-service customers, including fresh meat, cold-cuts, by-products, bacon, and pepperoni. The company raises or contracts to raise hogs with independent farmers, then processes and markets the meat. About ~70% of sales are “value-added” meat that has been processed in some way, while 30% of sales are “fresh” meat or by-products. HRL is exposed in varying degrees to 3 different margins that move somewhat independently: the production margin (the price of hogs less the corn, soy and other cost to raise them), the packing margin (the price of meat cuts and byproduct less the cost of hogs), and the value-added processing margin (the price of processed products less the cost of commodity meat and trimmings).

HRL is a small hog producer (~1% US market share) but the fourth largest pork packer, with ~9% share. The packing industry has recently consolidated down to 4 large players with a combined ~70% share. The business has historically been very poor, and recent industry capacity additions suggest that consolidation hasn’t affected behavior in the industry.  

Hormel has leading market share in pepperoni and organic/no-antibiotic deli meats, as a result of the acquisition of Applegate Farms. While Applegate Farms may turn out to be a valuable franchise, the other businesses are largely undifferentiated. The largest competitors in processed meats are Kraft (Oscar Mayer), Tyson (Sara Lee and other brands) and Smithfield.

In a normal environment, the “value-added” portion of the business contributes ~80% of segment earnings. 2014 was an exception, as the porcine virus epidemic in 2014 drove production profitability to 6x normal levels. While the boon in production profits contributed to segment earnings ~20% above normal in 2014, the ensuing unprecedented price decline in 2015 proved to be an ever bigger blessing for the much larger packing and value-add processing portions of the business: the pork packing and processing businesses are much like gas stations and refiners – prices adjust quickly when input costs rise, but decline slowly when they recede (see graph below). Profitability is highest in a declining commodity price environment. The unprecedented price declines in 2015 have led to unprecedented profitability in 2015 and early 2016, especially in the value-added packaged meat businesses, which contribute the bulk of segment earnings. 

While margins have expanded over time, the very favorable recent margins will likely revert to normalized levels.  Competitors are adding capacity in all areas of the business.  

The Refrigerated foods segment has grown at a 5% CAGR since 2000. However, excluding acquisitions, volume growth has been negative. Price/ton increased at a 4% CAGR from ‘00-’14, in-line with commodity hog prices, which suggests that the businesses do not have pricing power.

Jenny-O Turkey Store (26% of EBIT):

The Jenny-O segment (JOT) raises, processes, markets and sells whole, cutout, ground and processed turkey. JOT sells mostly ground turkey, as well as whole birds and deli meats. The industry is integrated like the broiler industry – processors furnish “poults” (turkey chicks) and feed to independent farmers who grow out turkeys which are taken back to be processed. JOT, Butterball and Cargill together have ~50% market share, while the rest of the industry is fragmented.

JOT’s largest business is ground turkey. JOT and Cargill together have almost 70% share of the segment, which has dampened competition. Although Butterball is expanding in ground turkey and others could enter, in the near term, JOT segment margins are more likely to revert because of the commodity price environment than because of a change in the competitive environment.

Like all meat prices, turkey prices have increased steadily since 2000. While rising meat prices were initially driven by higher corn and soy prices, beef price increases accelerated in 2010 and continued increasing even though corn and soy prices declined starting in 2013. The idiosyncratic beef price increases were driven by several years of drought along with a spike in corn prices, which contributed to a meaningful culling of the herd starting in 2008. Ranchers began to rebuild the herd in earnest in 2013 when corn prices cracked, which increased rancher profitability. Rebuilding the herd made the beef shortage worse, because farmers kept cows for reproduction rather than sending them to be slaughtered. Other meats enjoyed increased demand from substitution as well as a pricing umbrella from beef. The retail price of turkey has been ~40% of the price of beef fairly consistently over time. For JOT, this meant ground turkey prices stayed high while input costs decreased.

JOT has enjoyed a number of very good years due to higher turkey prices and lower input costs. Highly Pathogenic Avian Influenza (“HPAI”) hit the turkey flock during the summer 2015, leading to a spike in prices. Several HRL facilities were affected, however, which dampened the potential bonanza.

Turkey prices are correcting from the HPAI driven spike as the flock is repopulated. Prices should fall further as beef prices fall. Beef production turned the corner in 2015, and wholesale prices have responded meaningfully. Retail prices have just begun to follow, and these lower prices should weaken demand for ground turkey, and lead to pricing pressure.

Like the Refrigerated Foods segment, the JOT segment has grown primarily because of commodity price inflation. From ’02-’14, JOT revenue grew 5.5% while turkey prices increased 5%. Margins have been similarly flattered by the commodity prices (high turkey prices / low corn & soy prices). Management has raised their estimate of normalized margins in the segment to 15.5%, but that estimate could be too high in a declining beef price environment.  

Grocery Products (21%):

The segment sells shelf-stable processed products. The main legacy products are SPAM and canned meats. The segment also includes Skippy Peanut Butter, the company’s MegaMex JV (Wholly Guacamole, salsa, tortillas), and frozen microwave meals. The segment has been approximately flat over the last 5 years on both price and volume. While low growth, the segment clearly has a number of valuable (and counter-cyclical) franchises. Margins have been fairly steady.

Specialty Products (10%):

Specialty Products consists of a variety of businesses, including MuscleMilk protein drink (recently acquired from TSG), food additives and contract manufacturing. Muscle Milk is the leader in ready-to-drink protein. Overall, the segment should grow modestly (~2-4%), which is contingent on continued growth at MuscleMilk.

International & Other (8%):

Hormel separate sales abroad, which consist primarily of SPAM and Skippy. SPAM is popular in the pacific islands, as a result of the historical US Army presence (US Army rations had SPAM). The segment should also grow modestly (~2-4%).

Management & Capital Allocation

Management is acquisitive. They look for targets that are growth and margin accretive with a lower emphasis on price. Their hurdle is an 8% return.

HRL is controlled by The Hormel Foundation. The foundation doesn’t want management to dilute them below a 40% ownership stake (currently at 48%), so the company is unlikely to issue high-priced equity. They also can’t buy back many shares because the IRS limits the foundation’s ownership to 50%. While the company has zero net debt, additional leverage used to repurchase shares or pay a dividend would not be meaningfully accretive at current prices since the equity yield and the after-tax cost of debt are similar.

Valuation

HRL is trading at 26x management’s estimate of normalized earnings. The company is not growing volumes and seems unlikely to continue enjoying the commodity driven pricing growth of the last ~12 years.

Summary

Hormel trades like a stable, high-growth and high-quality business in an environment which has put a premium on predictable earnings. In reality, about 60% of HRL consists of commodity businesses that have enjoyed unsustainable growth tailwinds from rising meat prices over the ~12 years, while the remainder consists of low growth but stable franchises. Margins have expanded recently because of a rapid fall in pork prices (good for the value-added margin which drives the Refrigerated Foods segment) and high beef and turkey prices in a low corn and soy price environment (good for margins at JOT). HRL is trading at a high multiple of peak earnings. Shorting the stock is a compelling risk/reward with limited downside.

Catalyst

• Margin reversion
• Capacity increases in pork and turkey processing
• An increase in corn and soy prices