EUR 850.00 For Business Accounts Only

Morningstar | Narrow-Moat Hormel Expects Further Cost Pressure; Shares Modestly Overvalued

We do not expect to make a material change to our $36 fair value estimate for narrow-moat Hormel after a fiscal second quarter that was largely as expected, with 0.6% revenue growth (0.9% for the first half), compared with our 1.1% full-year estimate excluding Cytosport, and a 12.6% adjusted operating margin (12.8% for the first half), not far off our 13.2% full-year estimate. Despite their moderate sell-off, the shares appear rich to us, trading at a high-single-digit premium to our fair value estimate.

Hormel reduced fiscal 2019 revenue guidance by 2% to $9.5 billion-$10 billion, largely due to the Cytosport divestiture. Its also lowered 2019 EPS guidance by 3% to $1.71-$1.85 to account for the divestiture, margin compression from higher pork prices, and higher planned marketing investments in the turkey business. Our model, calling for $9.6 billion in adjusted revenue and $1.85 in EPS in 2019, accounts for the divestiture and higher pork prices, although we expect to adjust for additional marketing investments. However, we think these expenditures will be largely offset by the benefits from higher demand for turkey resulting from China’s African swine fever outbreak. We are therefore comfortable with our earnings estimate falling at the high end of guidance, as management has opted to exclude this benefit, a reflection of its conservatism, in our opinion.

After two salmonella-related recalls for Jennie-O ground turkey, Hormel has lost shelf space and announced plans for higher investment in promotion and advertising to regain that space. It is confident in its ability to do so, as the category has not performed as well without the leading brand. While the higher spending will pressure revenue and margins, we expect the global protein shortage will result in higher volume and prices for turkey, as the chicken market is already seeing improved demand and the pork shortage is enormous in magnitude, accounting for a 5% shortfall in global protein supply.

We applaud Hormel’s efforts over the past few years to exit commodity-related protein businesses in favor of branded products; in fact, the firm’s strong brands are the driver of our narrow moat rating. However, in times such as these, when protein prices are rapidly moving higher, margins on branded fare tend to contract due to a lag in price increases. Hormel is proactively working with customers to put price increases in place to mitigate the inflation; we think this, along with cost savings, will result in annual operating margins largely in line with last year’s low-double-digit level.

During the quarter, Hormel closed on the $465 million sale of the Cytosport business to Pepsi and used the proceeds to pay down debt, reducing net debt/adjusted EBITDA to a negative level, in line with our expectation. Hormel maintains a very strong balance sheet and has the capacity to fund acquisitions if it finds attractive opportunities. On the call, management said it is looking at several different opportunities. Hormel has been a disciplined acquirer (one of the drivers of our Exemplary stewardship rating), and we expect it will maintain this record. We would not be surprised to see the firm make additional investments in its food-service or international businesses, strategic areas of focus.