Hormel's Outlook Disappoints

 Hormel Foods (HRL) reported a solid fourth quarter, and we expect to modestly increase our $41 fair value estimate, largely as a result of the time value of money. Management expects to exceed its long-term goals of 5% sales and 10% earnings growth in fiscal 2015, but it disappointed investors with forecast earnings of $2.45-$2.55 per share, roughly in line with our forecasts. Echoing our concerns, management cautioned investors that record turkey and pork commodity prices may ease.

We have assigned Hormel a narrow Morningstar Economic Moat Rating and are positive on its long-term prospects, but believe the valuation is stretched. We are impressed by Hormel's success in the value-added turkey market and expect it will benefit from long-term secular growth as consumers look for healthier options, but the recent performance (with Jennie-O Turkey sales up 11% and margins up 440 basis points to 18.7%) could also be partially attributed to near-term factors that may prove to be fleeting, with low grain costs and supply still catching up. Additionally, while management deserves praise for its strong capital-allocation record, we think it will be difficult to identify accretive external opportunities, given the elevated multiples of consumer packaged goods firms.

Fourth-quarter revenue increased 9.5% to $2.54 billion, with segment operating profits up 9% to $269 million. Driven by PEDV supply shortages, elevated pork prices drove robust refrigerated results, with sales up 9.4% and flat margins at an elevated 7.2%, but also contributed to soft grocery results, with sales down 3.4% and margins falling 270 basis points to 12.4%. We believe the total impact was a net benefit, and high pork commodity costs should ease as farmers learn to handle the virus. The international segment also benefited from increased pork exports and the growth of the China business, with sales up 13%, while specialty foods generated 30% top-line growth with the acquisition of CytoSport.

Innovation Breeds Success
Hormel has developed a large portfolio of value-added protein brands (mostly meat-centric) that has carved it a narrow economic moat. Many of Hormel's brands can charge meaningfully higher prices over private-label competitors while still maintaining leading shares in their respective categories. Hormel has earned excess returns even during periods of challenging input cost volatility, and we think the firm can sustain returns on invested capital approaching 20%.

Hormel's executive team has developed a strong record of brand innovation, and we expect it will continue to identify attractive new opportunities. We are particularly optimistic regarding management's initiatives to create new convenient on-the-go protein meals (such as Rev Wraps), expand product categories with health-conscious brands like Jennie-O, and increase Hormel's scope in underpenetrated distribution channels internationally and domestically (through convenience stores, for instance). Still, Hormel generates much of its profits from mature categories with limited organic growth prospects, so we believe management will need acquisitions if it is to reach its long-term targets of 5% sales and 10% earnings growth (which compare with our forecasts of 4% and 6%, respectively, excluding future unannounced acquisitions).

Hormel has spent more than 30% of its cumulative free cash flow over the past eight years on acquisitions and has improved overall returns during this period, with average ROICs including goodwill above 14%. We believe management is adept and can add value at acquired firms; we expect Hormel will reinvigorate growth at Skippy, for instance, by identifying low-hanging investment opportunities that its former owner neglected. Still, while we are impressed by management's execution, we are wary of blindly assuming that Hormel's unannounced acquisitions will generate excess returns and close the shortfall. Consumer packaged goods acquirers have bid up transaction multiples as a result of cheap financing, so it will be difficult for Hormel to identify opportunities that meet its return threshold, especially since the firm has rarely strayed from its net cash position.

Meat Makes the Moat
Hormel's large collection of value-added protein brands form a strong intangible asset advantage. Several of these brands command significant pricing power and assist Hormel in generating excess economic profits even during periods of unfavorable demand (due to economic conditions) or input cost volatility (due to crop prices and increased demand for commodities in emerging markets). Hormel has reported average returns on invested capital of over 19% during the past five years (15% including goodwill), and we project that it can sustain ROICs (excluding goodwill) above 20% over the next 10-year period, generating returns far exceeding our cost of capital estimate.

Hormel competes in a host of categories, including luncheon meat (Spam) microwavable meals (Hormel Compleats), peanut butter (Skippy, the second-largest domestic brand), and Mexican-centric foods (through joint venture MegaMex). We believe the firm's most attractive brands are in small niche categories--luncheon meat and chili, for example--in which Hormel commands a sizable share lead and faces less private-label competition because of the category's small size. Additionally, several of Hormel's brands, like Spam and Skippy, have gained traction internationally, where the products may be viewed as higher end and benefit from greater pricing power.

Hormel generates the majority of profits from products in more crowded categories (like microwavable meals), which compete with a greater range of branded close substitutes. Still, these categories are large and present opportunities for innovation, and Hormel has successfully developed a number of products that have gained brand recognition and pricing power. In particular, the Jennie-O Turkey Store division--the only category in which Hormel grows and processes the majority of its livestock internally--has had great success building a branded umbrella platform, which the firm can leverage to roll out an array of value-added turkey products, many of which target a higher-end, more health-conscious consumer. These initiatives have contributed to expanding margins over the past decade, from the midsingle digits to the midteens, and helped transform Hormel into the largest domestic branded turkey vendor.

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Hormel also provides a number of more commodified meat processing products (deli meat, for instance), many of which are in the refrigerated foods category and face greater private-label competition. However, even this portfolio of products is more weighted toward value-added brands than those of more commodified meat processing peers, like Tyson TSN and Smithfield Foods, and has generated more consistent profitability as a result.

We believe Hormel's large portfolio of brands provides the company with significant pricing power and the flexibility to generate excess returns, even if conditions are unfavorable in individual categories. We believe the large portfolio of brands provides the firm with negotiating leverage with retailers, given their brand recognition and ability to drive retail traffic. Moreover, Hormel's comprehensive meat-centric value chain has created a cost advantage, in our view, due to its scale in certain meat categories (mainly turkey and pork) and ability to better leverage its administrative, distribution, and research expenses. Several of Hormel's categories face persistent private-label competition, but we expect the company's overall portfolio will maintain a meaningful pricing spread over private-label offerings for the foreseeable future, which should be sufficient to generate strong economic returns.

That said, we do not believe Hormel deserves a wide economic moat rating, since it still generates a meaningful amount of its profits from commodified meat processing and does not carry many products that have developed international brand recognition. Additionally, while Hormel participates more in the value-added meat categories, it could still be vulnerable if meat input prices continue to rise over the long run as a result of structurally higher crop prices and increasing global demand, which could push consumers toward private-label and other less expensive alternatives.

Commodity Prices Are a Risk
A substantial amount of Hormel's costs, such as corn and soybeans, goes to feeding animals, while peanut costs could also challenge the recently acquired Skippy business. In addition, Hormel incurs fuel costs related to packaging and distributing its products to end consumers. Of the various factors that can influence commodity prices, unfavorable weather conditions can adversely affect crop yields and ultimately result in an increase in corn and soybean feed prices. Increased demand for corn from China and for ethanol-based fuel has also led to higher corn futures prices, and a continuation in the upward trend could adversely affect Hormel's profitability. Over the long run, a sustained increase in prices could push consumers away from Hormel's protein brands and toward less expensive alternatives. Additionally, these trends could reduce Hormel's negotiating leverage with retailers, which could compromise the firm's pricing power and ability to ward off competition from private-label competition. Finally, the acquisitions of Skippy and CytoSport carry risks, as their integration could prove to be a disruption for management, particularly as they represent a foray into entirely new categories for Hormel.

Capital Allocation Has Been Excellent
We believe management has allocated capital effectively over the past several years, and we award Hormel an Exemplary Stewardship Rating. Hormel has maintained a disciplined acquisition strategy and has prudently refrained from overpaying for growth opportunities that do not complement its core innovation capabilities. The firm has effectively reinvested profits in supporting its brand portfolio, which helps to support its moat, and has generated average returns on invested capital (including goodwill) of around 15% over the past seven years, well above those of no-moat processors.

Hormel has historically maintained an extremely conservative capital structure, as it frequently carries net cash on its balance sheet. We believe Hormel's conservative capital structure and capital-allocation policy is at least partially influenced by the Hormel Foundation, consisting of several family trusts (owning more than 43% of Hormel's basic share count) and a charitable foundation (with over 5% of shares).

We believe Hormel's compensation policy places adequate emphasis on performance (about 75%-85% of compensation is performance-based), which involves benchmarking against internal company goals as well as the performance of peers. The company considers earnings per share growth, consolidated and business operating profit and asset returns, relative total shareholder return performance, and stock price growth when setting performance-based compensation plans. Finally, management and shareholder interests are appropriately aligned, in our opinion, as all directors and executive officers own about 3% of the total shares outstanding and are required to hold company stock with a value of 1.5-5 times their five-year average base salary.