Value Investors Club / Hormel Foods Corp. (HRL)

Description

INVESTMENT SUMMARY: Hormel Foods (HRL) is a high quality company with a long track record for

consistent growth and increasing shareholder value. The company is in a strong competitive position

due to its diversified product mix, high market shares in niche categories, vertical integration, and focus

on operating efficiency. With a history of strong free cash flow and low debt, management has allocated

capital effectively through internal growth investments, value enhancing acquisitions, and consistent

dividend increases over time.

COMPANY DESCRIPTION: Hormel, founded in 1891, is a branded food company primarily selling meat-

based products. Hormel has its legacy portfolio based around core pork products, and it later added

turkey in 1986. Over time, the company has become one of the few meat companies to successfully

transition into the packaged food business with many lines of value added products in the fresh, canned,

and packaged segments. The company’s core business model begins with its hog and turkey raising

operations from which it sells both commodity meat-based products and branded value-added

products, with the latter being the majority. HRL has been investing in acquisitions and new product

development in order to further broaden its portfolio into new categories (multi-cultural, health and

wellness, on-the-go, and international) that offer higher long term growth. Today HRL has a balanced

portfolio with 5 operating segments (Grocery Products, Refrigerated Foods, Jennie-O Turkey Store

(JOTS), Specialty Foods, and International & Other) that serve the retail, food services, and fresh end

markets. HRL still has its headquarters and largest plant location in the small town of Austin, MN.

Employee turnover at the company is very low with average tenure at 26 years. The company offers its

employees an attractive profit sharing package.

INVESTMENT CASE:

HRL’s leading brand recognition, strong distribution relationships, and large portfolio of value-added

products in niche categories create a durable competitive advantage. A key aspect of the HRL

investment case is its longstanding number 1 or 2 positions inover 30 brands across many categories.

These brands come from legacy products, acquisitions, and new product innovation, and they have

significant market share leads over its nearest competitors. Unlike its meat peers, Tyson and Smithfield

Foods, HRL has a much larger share of its portfolio in value-added products as opposed to commodity

meats. Value-added products, which have higher margins, utilize core pork and turkey meats in

combination with other food ingredients, sauces, or packaging. For example, legacy items include pre-

marinated but uncooked pork and newer items include salami and cheese party trays, Spam Snacks, and

Turkey Breast Sticks. In addition to the strong brand and large portfolio of value-added products, HRL

has longstanding distribution relationships across multiple channels providing it with good pricing power

at retailers and food service providers, especially compared to private label competitors. Additionally

unlike its packaged good peers, ConAgra, General Mills, and Campbell Soup, HRL competes in many

niche categories that have room to grow in the market and are not in overly competitive segments with

high penetration rates, i.e. confectionary snacks, soup, cereal, and beverages. HRL has increased its

market share penetration over time due to its innovative product development platform and

acquisitions. In the mid-1990’s, 13% of average American households consumed a Hormel product every

two weeks, and that penetration rate has increased to 30% today. Penetration rates continue to

improve, and management believes plenty of opportunity is left to increase its share of consumer meals

in the remaining 70% of households. Over the last five years, total distribution of items in a retail store

has grown at an 8% CAGR. In other words, a U.S. grocery store in 2010 would have had 160 Hormel

items, and in 2014 this would have equated to 210 items.

HRL’sproduct innovation platform and vertically integrated meat-value chain drive superior long term

returns, growth, and lower costs. The combination of HRL’s legacy portfolio, newly acquired brands

from acquisitions, and new product development capabilities provide HRL with an innovation platform

to drive long term growth and extract superior value from its growth investments. HRL creates new

value-added products by leveraging its acquisitions or legacy portfolio and cross-sells these items into

new end markets and distribution channels. The company strategically targets developing value-added

products that offer better margins in higher growth categories such as turkey, international, multi-

cultural, on-the-go, and nutritious. For example, HRL essentially acquired a peanut butter in a jar

company in Skippy. However, it leveraged its product development team to expand the brand into new

categories through new flavors and packaging twists, and also leveraged its distribution relationships by

pushing Skippy into new international markets. Since the acquisition, HRL has released Skippy Singles

and Bites as on-the-go products with more new product categories expected soon. Additionally, HRL is

leveraging its core product portfolio and number one international brand in SPAM, to develop and

promote new multi-cultural products back in the U.S., e.g. SPAM tacos for a Mexican flavor and SPAM

Musubi for a Hawaiian/Asian flavor. Also, HRL’s large-scaled and vertically-integrated meat-value chain

provides it with cost advantages in its core pork and turkey-based operations compared to its meat-

based competitors. Management’s history of successful new product innovation, strategic execution,

long term growth, and utilization of assets has resulted in improving margins and strong returns on

capital. ROIC is higher than its meat-processing and CPG peers of 9% and 11.25%, respectively.

HRL has a long history of growing free cash flow, strong balance sheet, effective capital allocation, and

record dividend increases. HRL consistently generates high levels of free cash and returns well in excess

of cost of capital over the course of a cycle. Free cash flow margins over the last 10 years have averaged

5% with recent improvement from the 3-5% range before 2008 to the 4-7% range after 2008. FCF has

grown 30% from $453M in 2009 to $588M in 2014. The company’s high level of free cash flow

generation allows it to internally-finance its capital requirements, aside from larger acquisitions, while

also increasing its dividend. Debt, at only 6% of total capital, has historically been very low and used to

finance large acquisitions. Over time management has allocated capital effectively in ways to enhance

its competitive advantage by investing in growth, through supporting brands, new product

development, or acquisitions, and byreturningcash toshareholders, throughdividend increases and

opportunistic share repurchases. Between 2009 and 2014, management allocated approximately $700M

to organic growth investments, $1.1B in acquisitions, $850M in dividends, and $475M in share

repurchases. ROIC has increased from 11.5% in 1997, to 14.2% in 2009, and to 16.25% in 2014. ROIC has

averaged 16.5% the last 5 years, well in excess of its weighted average cost of capital at 7.7%.

Maximizing shareholder value through increasing dividend payments continues to be a priority of

management going forward. HRL has increased its dividend 49 years in a row, putting it in the top 10

ranks for U.S. companies in terms of length of dividend increases. The company increased its dividend by

18% in 2014 and is on track to increase it by 25% in 2015. Over the last 5 years, the dividend has grown

at a 19% CAGR, faster than the EPS CAGR of 12%. The current dividend yield is 1.7% or $1/share.

Management has stated that it is targeting a dividend yield that is closer in line with the CPG peer

median of 2.6%, which leaves the opportunity for future increases. With a payout ratio of 38%, the

company has of capacity for further increases.

LONG TERM GROWTH DRIVERS:

(1) Long term consumer shift towards turkey. As part of the company’s healthier food initiative, the

Jennie-O Turkey Store (JOTS) brand provides HRL with its most significant growth opportunity.

Widespread demand for turkey is seeing a secular rise, particularly amongst Millennials, as the healthier

food option with better flavors replaces other traditional cow and pork-based substitute products.

Turkey is penetrating and replacing many traditional product areas such as bacon, burgers, sausage, and

tacos. As the largest branded turkey vendor, HRL is seeing significant rising demand as it promotes its

“fresh” turkey campaigns, continues to develop new value-added products, and improves penetration

and distribution at non-retail grocery stores, such as fresh deli’s, school cafeterias, hospitals, nursing

homes, and other food services – all of which offer a large and under-penetrated opportunity. HRL has

increased its advertising, particularly targeting Millennials through digital channels, to support the

turkey initiative which has resulted in an increase in overall brand awareness from 77% in 2009 to 90%

in 2014. Household penetration is only at 24% for the general population and at 28% for Millennials,

leaving room for further penetration especially given HRL’s leading brand and strong competitive

positioning. The JOTS franchise has grown at a 6% CAGR from $1.2B in 2009 to $1.7B in 2014, including

the best performance from its Lean Ground Turkey franchise that is growing over 20% per year. Ground

turkey as a share of the overall ground meat market worth $8B per year, has increased from 9.6% in

2009 to 12.6% in 2014. Value-added turkey products are estimated to make up 70-80% of JOTS sales.

(2) New product innovation and improving mix drives higher long term margins. New product

development, particularly in value-added products, is a key part of HRL’s growth strategy. The company

has a long history of successfully developing and bringing to market new product categories that go on

to have leading market share. Notable new product lines that have been created from legacy products

include Natural Choice (all-natural fresh lunch meat) and REV (healthier on-the-go snack and meal

replacements), and new products spurred out of recent acquisitions include Wholly Guacamole Mini’s,

Skippy Singles, and Muscle Milk Pro-Series. New products have added $1 billion worth of sales between

2000 and 2007, and $2billion between 2007 and 2012, and managementis now targeting an additional

$3 billion in sales from new products by 2016. As a $10 billion company, approximately 30% of sales will

be contributed by products that were new to the market within the last 15 years, which is impressive for

a company in the meat and food processing industry. Sales from new products have risen from 24% of

total sales in 2010 to 26/27% in 2014. Over the long run, margins should continue to improve due to a

better mix with higher contribution from newer and faster growing value-add products.

(3) Current and future acquisitions to drive long term growth. M&A is an important component to HRL’s

current and future growth. Over the past 5 years, acquisitions contributed 3% out of the 7% in total

revenue growth. In 2014, the Skippy and CytoSport (Muscle Milk) acquisitions contributed $189MM or

2% of total revenue of $9.3B. HRL targets leading brand companies with a number one or two market

share position that will provide it with exposure to higher growth categories such as multi-cultural

(Wholly Guacomole), nutritious (Muscle Milk and Applegate), “on-the-go” (Muscle Milk), and

international (Skippy). Management historically has expanded margins from acquired companies by

leveraging HRL’ supply chain operations or realizing cost synergies through common back offices for fully

integrated targets. As mentioned previously, HRL also extracts excess value from its acquisitions because

of its product innovation platform and broad distribution channels for launching value-added products

into new adjacent markets, e.g. HRL created the fast growing Wholly Guacamole Mini’s to expand a

multi-cultural flavored product into the on-the-go market. Management has a long track record of

displaying good price discipline to not overpay and for integrating acquisitions smoothly, and I expect

them to continue to do so. Over the last four years, HRL has made the following four major acquisitions:

Applegate Industries for $775 million in July 2015, CytoSport Holdings in August 2014, maker of MUSCLE

MILK, for $450 million, Skippy Peanut Butter for $700 million in 2013, and Fresherized Food, makers of

Wholly Guacamole, for over $200 million in August 2011 through the MegaMex joint venture. (See

Acquisitions Strategy section for further details).

(4) International expansion to China/Asia. China and broader Asia provide HRL with significant growth

opportunities in its international segment. Especially popular abroad are its SPAM brand, fresh pork

business, and Skippy that all have flavor twists to accommodate local preferences. Having been in China

for over 50 years, the company has a strong presence and distribution relationships in the retail and

food service markets with a good portfolio balance between frozen, chilled, and shelf stable items. As a

result, HRL has similar platform and product development capabilities abroad in China as it has

domestically. The company has recently stepped up its level of investment in China by adding a 3rd

plant (fall 2016) in order to support growth, particularly in the canned luncheon meat space which offers a

huge market opportunity. This will be a refrigerated food plant to produce pepperoni, bacon, ham,

SPAM, and other refrigerated meats for the retail and food services channels. International sales have

grown at an 18% CAGR from $225M in 2009 to $530M in 2014, and operating profit has grown at a 25%

CAGR from $30M in 2009 to $85M in 2014. With faster expected growth and higher levels of investment

than HRL’s other reporting segments, the international segment has financial goals of 10% and 15% for

revenue and operating profit growth over the long term, compared to overall targets of 5% and 10%,

respectively. Long term margins for the international segment should also improve as revenue in China

grows and the third operating plant comes on-line.

STRATEGIC OVERVIEW: HRL invests in acquisitions and its core platform of pork and turkey-based

products in order to expand its new value-added offerings into additional niche andhigher growth

categories. While a significant share of the company’s sales and profits come from more commodity-

based products and competitive segments of the market, this legacy portfolio, which caters towards

older audiences, creates the core foundation and platform for HRL to innovate newer products, which

are targeted at younger generations. Management is focused on expanding margins in the Refrigerated

and Grocery segments, and growing the top line in JOTS, International, and Specialty. Management has

also focused its efforts on increasing the value-added portfolio’s contribution to the overall mix.

New product innovation strategy. New product development focuses on value-added products that

introduce new flavors, convenience, packaging combinations, and creative food options in order to stay

relevant with consumer preferences. For example, bacon comes in a wide array of flavors, and

pepperoni is available fresh or pre-packaged. HRL develops new product categories organically as well as

from acquisitions and follows a methodical consumer research and sound strategic execution process.

Innovation in the food industry occurs over very long periods of time, unlike the health care or

technology fields. Management strives to have its product portfolio strike a balance between having

enough dependable mainstays and new items to drive growth.

As U.S. preferences gradually shift towards eating away from home, HRL has expanded its line of on-the-

go products, for example Muscle Milk to-go’s, Pepperoni Stix, REV items, Wholly Guacamole Minis, and

SKIPPY Singles. HRL’s product team created REV, a combination of meat and cheese wrapped in

flatbread, for on-the-go and health conscious consumers. REV comes in over 15 varieties for breakfast,

lunch, and snacks and has at least 15 grams of protein in each. The new product has performed well in

its first year with sales of $55 million and growth in the double digits. More recently, as preferences

have emphasized healthier and more nutritious products, HRL re-launched its Natural Choice product

line in 2015, which is now a $100M business and has grown at a 9% CAGR over the past 5 years.

On the multicultural front, HRL entered the category in the late 1980s by offering a wide array of ethnic

food items in the U.S, licensing the Chi-Chi's restaurant chain name, and starting a joint venture with

Grupo Herdez out of Mexico. Up until the end of the 2000’s, HRL’s domestic portfolio still had been very

American centric and not particularly multicultural. More recently, the company has emphasized

Mexican food, and in 2010 it formed MegaMex, which was a combination of various businesses that

included Herdez, Grupo Kuo, Embasa, and La Victoria. MegMex began as a $200 million business in 2010

and has grown to $600 million in 2014.

Acquisition strategy. HRL typically targets companies in the $200-800 million range that will add

accretion to the company’s existing margin structure. Acquisition targets of this size are very

manageable from a financial perspective, i.e. not having to add significant debt or issue equity, and are

capable of being incorporated into HRL’s overall portfolio. Management runs the company from a

financially conservatively perspective, but they have made it clear that they would be willing to take on

several billion dollars in debt for the right kind of transformative deal for the company. HRL can take on

up to $3B in additional debt while still maintaining its investment grade rating.

Applegate ($775M, 30x P/E, July 2015): Applegate is a leading natural and organic branded meat

company with over 150 products. Over Applegate’s 30 year history, the company has been known

for raising its animals humanely and without antibiotics. The company has a number one share in 6

categories including natural and organic sliced deli meats, hotdogs, bacon, dinner sausage, frozen

breaded chicken, and frozen breakfast sausage. Approximately half of Applegate’s sales are

generated at specialty retailers (natural and organic) where HRL does not have strong presence

(HRL’s presence is in non-specialty grocery stores). About 70% of Applegate’s products are natural

and 30% are organic, including turkey, pork, chicken, and beef. HRL is expected to expand

Applegate’s organic offerings into new product categories. Applegate’s natural products are at a

higher price point due mostly to being anti-biotic free compared to HRL’s natural line which mostly

features just no-artificial ingredients. The company has a robust supply chain with strategic

relationships with over 1,800 farmers and co-pack manufacturers that act as trusted partners for the

natural and organic categories. Applegate is expected to generate sales of $340M in 2015, add $0.07

to $0.08 in EPS in 2016 (neutral to EPS in 2015), and comes with a tax cash flow benefit of $165M.

Going forward, management expects sales to grow in the low double digits.

CytoSport Holding ($450M, 15x EV/EBITDA, Aug. 2014): CytoSport Holdings, makers of Muscle Milk,

appealed to HRL for its massive global potential along with opportunities to address a younger

audience that favors on-the-go products and a more protein-based and health conscious balance in

the company’s Specialty segment. Muscle Milk should be the key growth driver within the Specialty

Foods group as HRL expands the brand into new categories and distribution channels. Muscle Milk

comes in ready-to-drink, powdered products, and bars, and HRL is already developing an improved

bar for the Muscle Milk brand. The overall category is growing in the low-teens within the U.S. and

at a much higher rate internationally; Muscle Milk is growing faster than the overall category.

Approximately 40% of Muscle Milk’s sales are in the U.S. food, drug and mass channel, which is one

of the strongest markets for HRL’s sales force leaving the potential for strong distribution gains.

While Muscle Milk already had $25 million in global sales at the time of acquisition, the previous

family ownership was looking for a buyer to help it aggressively expand internationally and enhance

its presence in other categories, i.e. on-the-go, meal replacements, and healthy lifestyle. Prior to the

acquisition, the Specialty Foods segment featured mostly unbranded powdered and ready-to-drink

protein products through the Century Foods operations. The Muscle Milk acquisition steers the

company back towards its branded messaging for its family of products. The CytoSport acquisition is

expected to add $0.05 in EPS in 2015, and over the long run, sales growth is expected to be

materially higher than the company’s 5% overall growth goal.

Skippy ($700M, 1.9x EV/Sales, 2013): HRL acquired the U.S. portion of Skippy in January 2013 and

the China portion in December 2013. Skippy was an attractive target primarily for its international

business, including the number one peanut butter brand and a plant in China, and secondarily for its

appeal to domestic non-meat protein-conscious consumers. HRL acquired essentially a peanut

butter in a jar line but is leveraging its product development team to expand the brand into several

new flavors and on-the-go product innovations. The company has already launched Skippy Singles

and Bites with more new products expected in the upcoming months. Skippy is a much less mature

product outside of the U.S. with $100 million worth of international sales, and should thus drive

solid double digit growth rates for the international unit as it enters new international markets such

as Colombia, Panama, Brazil, and Spain. Skippy has also picked up distribution gains in the U.S.

where the brand had not received the optimal amount of advertising attention and shelf-space at

retailers. Domestically, the peanut butter category has grown at a 6% CAGR in dollars and 2.5%

CAGR in units over the past 5 years, which is robust for a mature product category. Over the past

year and a half, the Skippy acquisition has provided HRL with strong growth and profit contribution

to the Grocery Products and International divisions.

Wholly Guacamole ($200M, 2011): With the number 1 market share in the U.S. for guacamole at

42% in 2014, Wholly Guacamole offers HRL with substantial growth opportunities in the

international, nutritious foods, on-the-go, and multi-cultural categories. It has global distribution

reach in countries including Canada, Japan, Australia, South Korea, Israel, Chile, and the United

Kingdom, and is rapidly spreading to more markets around the world. Based off of its Mexican-core,

HRL is spreading Wholly Guacamole’s application to new categories, such as prepared avocados on

sandwiches, natural and organic offerings, on-the-go guacamole spreads, and many others. The

Wholly Guacamole Minis are growing at a 60% to 70% annual rate, making it the fastest growing

component within the line. HRL acquired Wholly Guacamole through its 50% stake in the MegaMex

joint venture.

SALES, MARKETING, AND DISTRIBUTION: HRL has a direct sales force assigned by regional territory or to

large accounts. The company has longstanding distribution relationships in the retail and food service

end markets, as well as a strong presence at fresh customers and health care facilities. The food services

sales organization has placed a higher strategic emphasis on targeting healthcare, universities, and

hotels as the sub-segment as a group is projected to have real growth of 2.5% in 2016. HRL uses

independent brokers and distributors and common carriers in international markets.HRL supports its

branded products through advertisements in store, television, print, and digital channels. HRL spends

additional advertising dollars on newer products, such as on Muscle Milk, Wholly Guacamole, and REV,

as well as on legacy and acquired products that may have been neglected marketing dollars, such as the

domestic and international portions for the Skippy brand.

OPERATING SEGMENTS: HRL’s products consist of primarily meat-based products that are sold fresh,

frozen, cured, smoked, cooked, packaged, and canned. HRL has 5 reporting segments: Grocery Products,

Refrigerated Foods, Jennie-O Turkey Store (JOTS), Specialty Foods, and International & Other. The

Grocery Products segment consists of shelf-stable food products sold primarily to the retail market.

MegaMex Foods, a joint venture 50% owned by HRL and 50% by Herdez Del Fuerte of Mexico, is

included in the segment. The Refrigerated Foods segment consists of branded and unbranded pork and

beef products that are sold to the retail, food service, and fresh product customers. 70% of refrigerated

segment is made up of value added products. Recently acquiredApplegateoperates as a standalone

subsidiary in the Refrigerated segment. The JOTS segment consists of branded and unbranded turkey

products that are sold into the retail, food service, and fresh product customers. Value-added turkey

products are estimated to make up 70-80% of JOTS sales. The Specialty Foods segment includes private

label shelf products, nutritional products, sugar, and condiments that are sold to the industrial, retail,

food service, and fresh customers. The Specialty segment provides HRL with diversification from protein

markets, coverage of excess capacity in manufacturing operations, and faster growth. Brands include

the Diamond Crystal Brands (sugar substitutes), CytoSport, Century Foods International, and Hormel

Specialty Products (HSP). CytoSport operates as a stand-alone business. The International segment

manufactures and sells all of HRL’s products internationally.

INDUSTRY BACKGROUND: Demand for HRL’s core pork and turkey products has been stable over time

as shifts in consumer taste occur very slowly and over long periods. Demand for packaged for are

forecasted to grow at a 3% CAGR over the next three years domestically. While consumer food

preferences are slowly shifting towards more nutritious, on-the-go, and multicultural flavors, HRL’s

management team has proven to be effective in responding and anticipating market changes. End

customers of HRL’s products include retail (grocery stores), food service (restaurants, fast food chains,

hotels, hospitals, and conveniences-stores), fresh, and specialty (health clubs and nutrition companies).

The company’s strong brand and large portfolio of value-added products give it good pricing power at

retailers and food service providers as HRL’s products help drive customer foot traffic and sales.

HRL competes with national and regional pork and turkey companies and producers of other meat and

protein sources, including peanut butter. Large meat competitors include Tyson Foods and Smithfield

Foods; grocery product competitors include ConAgra Foods, General Mills, Campbell Soup, and J.M.

Smucker Co.; and turkey competitors include Cargill and Butterball. Both Tyson Foods and Smithfield

foods have their products weighted towards commoditized meats, giving HRL a structural edge in

generating excess economic profits. Tyson also has large chicken and beef businesses, and Smithfield’s

hog/pork raising operations is its biggest business. HRL also competes with private label brands in many

of the more commodity-like categories such as basic meats and packaged food offerings. Because of

HRL’s brand strength, the company has significantly more pricing power than private label competitors.

Additionally, private label competition is not present in many of HRL’s more attractive brands in niche

categories, such as luncheon meat, chili, and value-added products, due to the smaller category size.

FINANCIALS: With low sensitivity to the economic cycle, HRL has a long track record for consistent

growth with low volatility. HRL has delivered EPS growth in 27 of the last 30 years. The company has

long term financial goals of 5% revenue growth, 10% operating earnings growth, and no more than 1%

growth in labor costs and benefits. Additionally, management has set a $3 billion goal for new product

development by 2016. Over the past five years, the company has surpassed its goals with 7% CAGR in

sales (4% contribution from organic growth and 3% from acquisitions) and 12% CAGR in earnings. Future

financial performance can outperform due to greater realized synergies from acquisitions, faster

consumer adoption of turkey, current commodity environment for meat prices and input costs remain

favorable, and putting the under-levered balance sheet to work on acquisitions. Value drivers. Long

term revenue drivers include: new product innovation, acquisitions, harvesting /production of live hogs

and turkeys, unit volume, company specific pricing actions, and to a lesser extent the level of

advertising. Gross profit drivers include: commodity pork and turkey prices, meat input costs, product

mix (value-added products drive better margins), and pork operating margins. Pork operating (packing)

margins consists of total costs and sales for pork-based products which include international sales of

exotic pork parts, such as ears that can impact margins. SG&A has run at about 7-8% of revenue and is

expected to continue to do so going forward. R&D expenses are expected to continue to run at about an

absolute rate of $29M per year, for under 0.5% of sales. Earnings from affiliates are a very small

percentage of profits and includes contribution from the 50% ownership of the MegaMex J.V.

Margin expansion and cash flow growth: Over the last decade, HRL has expanded operating margins

from the mid-single digits to the low-teens as it increased the value-added product’s share of revenue

and its presence in faster growing and higher margin categories (JOTS, international, multi-cultural, and

nutritious). Also management has focused on running efficiently and making improvements across its

operation and supply chain by closing inefficient plants. FCF margins have improved by approximately

300 bps over the last decade from the 3-5% range before 2008 to the 4-7% range after 2008. Capital

expenditure spending to maintain and growthe business is expected to remainat 1.5-2.0% of total

revenue in the long run.

HRL has approximately $250M in cash and $650M in debt following the July 2015 Applegate acquisition.

It’s debt to equity ratio is still very low at 17%, leaving plenty of room for additional debt capacity for

acquisitions. HRL has an investment grade rating, which management intends to keep over the long run,

of A1 compared to its peers that have an average rating of Baa1.

VALUATION: Shares of HRL trade at 20.9x FY ‘16 consensus EPS, which is above the meat and CPG peer

median of 17.8x, due in part to the company’s low level of debt. On an EV/EBITDA basis, shares of HRL

trade closer in line with CPG peers (11.7x versus 11.5x) but also come with better prospects for a

growing dividend. Shares are trading around fair value on a PE and EBITDA multiple basis. On a free cash

flow yield basis (LTM), HRL shares look more reasonably priced trading at 3.4%, above its 10-year

median of 3.1%. The company’s free cash flow has improved with 5-year average margins rising from 4%

to 6%. Shares could rise as management raises the dividend to be more in line with CPG peers (current

1.7% yield versus 2.5% peer average.

Based on a DCF valuation, fair value of HRL is $61.15. Free cash flow margins and growth have been

consistent over time. I used consensus estimates through FY 2017, and I modeled 6.2% FCF margins

along with 4% growth into perpetuity. The cost of equity is 7.9% is lower than a market portfolio of 9%

due to HRL’s lower financial leverage and less cyclicality.

Based on a two-period dividend discount model, fair value of HRL is $69.56. I model faster dividend

growth of 20% over the next 5 years followed by 5% in perpetuity. This will bring the current dividend of

$1/share and yield of 1.7% closer in line with the CPG peer median of 2.5% by 2020. HRL has room to

increase its dividend with strong free cash and a current payout ratio of 39%, and management has

indicated it wants to be closer in line with the CPG median.

MANAGEMENT AND OWNERSHIP: HRL has a strong management team that has a long history of

excellent capital allocation, strategic execution, and operational efficiency. Management has a history

of successful execution with low cost operations, maximum utilization of assets, advantageous

investments in technology, efficient supply chain management, effective sales and marketing, and

diligent consumer research. Jeff Ettinger, Chairman, President, and CEO of Hormel Foods, has been with

Hormel since 1989. He was named President in 2004 and CEO in 2005. Jody Feragen, CFO and EVP, has

been CFO since 2007. Incentives for management compensation are aligned with shareholder interests.

Base salary makes up approximately 15-25% of total compensation with incentive salary accounting for

approximately 75-85% of total compensation. Incentive salary is split approximately equally between

cash and shares but is primarily determined by achieving long term financial targets based on share

price, asset returns, and relative shareholder returns to peers. All directors and executives own

approximately 2-3% of outstanding shares and are required to hold shares of stock worth 1.5-5x their 5-

year average base salary. The Hormel Foundation owns 48% of the company’s outstanding shares,

including a group of family trusts that own 43% and a charitable foundation owning 5%. Foundation

ownership allows management to focus on long term shareholder value as opposed to near term

targets.

RISKS: Lack of or overpaying for acquisitions. HRL relies on M&A to drive long term growth and to fulfill

its strategic objectives by entering new product categories. If M&A opportunities dry up due to a lack of

targets or if the deal environment becomes expensive or overly competitive, then HRL is at risk of

slowing growth or overpaying for companies, ultimately hurting shareholder value.

Margin compression. Over the last 4-6 quarters, HRL has benefited from either lower meat input costs

or favorable meat commodity costs across its various segments. These margin tailwinds are likely to

gradually abate in the near term as excess margins and returns will either self-correct or in a more

adverse scenario, attract the attention of competitors to flood segments of the market.

Animal disease, e.g. Avian influenza. In spring 2015, the Avian influenza outbreak significantly impacted

turkey operations. As a result of the outbreak, HRL had to put down all turkeys in each infected barns.

While insurance and government assistance partially covered the costs for those turkeys affected,

normal JOTS operations were severely disrupted in terms of volume produced and the higher costs of

purchasing turkeys from outside vendors. For FY 2015, HRL is expected to see turkey sales decline by 10-

12% and operating margins reduced by 5% within the JOTS segment. Since HRL has the majority of its

turkeys concentrated at a small number of farms, an outbreak at a single farm has a significant impact to

operations. Although highly unlikely, management has stated they will consider spreading out the

harvesting of turkeys to minimize this risk, even though concentrated harvesting has positive benefits in

normal operating times.

Sudden rise in commodity costs. A large amount of HRL’s costs go into animal feed for its hogs and

turkeys. Any sudden increase in commodity costs for corn or soybeans could hurt near term profitability.

Also, harsh weather conditions could negatively impact crop yields and prices in addition to creating

unfavorable conditions for raising hogs and turkeys.

Competition from both branded and private label companies is intense. HRL may need to increase

future spending on product innovation or marketing support as competition continues to fight for an

increasing share of the consumer’s discretionary wallet.

Customer concentration in each operating segment is high. In 2014, the top 5 customers accounted for

45% of Grocery Products, 35% of Refrigerated Foods, 39% of JOTS, 42% of Specialty Foods, and 26% of

International & Other. Wal-mart accounts for 14% of HRL’s total sales.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Utilizing under-leveraged balance sheet for a large acquisition or multiple smaller deals.

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			2015	2016
Price:	61.39	EPS	2.54	2.76
Shares Out. (in M):	264	P/E	23.6	22.2
Market Cap (in $M):	16,330	P/FCF	31.2	25.4
Net Debt (in $M):	251	EBIT	1,053	1,141
TEV (in $M):	16	TEV/EBIT	15.7	14.5