I rated Hormel Foods (NYSE:HRL) a hold in February due to its valuation. This call was correct, with the stock dropping 26% on a total return basis compared to the S&P 500 (SP500) return of 7.7%. I suggested that investors sitting on substantial gains consider selling covered calls at a $47 strike price to generate extra income. I also mentioned that the call may have a low probability of being assigned given its monthly return history, so the investors may end up holding on to their stock. That’s how the scenario turned out for investors: the investors kept the call premium and the stock. I continued to rate it a hold in August; since then, the stock has dropped 19%. Although I continue to rate it a hold since the stock looks overvalued based on the PE ratio, in terms of EV/EBITDA, the stock is moving, albeit slowly, towards an attractive valuation of 11x forward EV/EBITDA multiple. Hormel Foods is still a hold, but a cash-secured put strategy with strike prices at or below $29 can yield a good income and provide an opportunity to acquire a good dividend income grower at a reasonable valuation and dividend yield.
I typically do not place a sell rating on good dividend stocks. It is challenging for retail investors to time their buys and sells. One would have to spend an extraordinary amount of time monitoring stocks and figuring out the right time to book profits. Suppose one has a day job other than stock trading. In that case, it may be best to buy and hold, especially if one has invested in a favorable valuation and the dividend yield has grown substantially. But, if a stock, even a dividend-yielding one, has grown above 5% of the portfolio, it may be okay to take some profits. The 5% threshold may be arbitrary, and each investor has to decide for themselves the level at which they would consider trimming their holding in a single stock.
Return of volume growth
One of my complaints about the company’s revenue growth in 2022 was the lack of volume growth. Most of the growth was driven by price increases, which is unsustainable. The company’s Retail segment volumes were up 1%, Food Service volumes up 2%, and International Segment volumes up 10% in the third quarter. But, the company’s revenues were lower overall, and this streak of lower revenues is now in its fourth quarter. Since only one more quarter is left in the fiscal year, the company forecasts a 4% revenue decline for the year.
The consensus EPS estimates from analysts of $1.63 for 2023 would be a 10% decline over the previous year. The company’s margins have not recovered to their average over the past decade. Over the past three quarters, the gross margins were below 17% compared to its quarterly average of 17.6% since April 2020 and an annual average of 18.9% since 2013 (Exhibits 1 & 2). The quarterly operating margins average of 8.3% since April 2020 are well below their long-term annual average of 11.2%. The company has put together a plan to reduce costs and increase productivity. But, it may take a while for these efforts. Inflation, although fading lately, could still rear its ugly head and undo much margin improvement in the consumer staples sector over the past year.
The company is normalizing its inventory costs
Inventory has leveled off but is still high compared to its long-run annual average. The company has average 50 days of inventory over the past decade but now carried well above that level (Exhibit 3). It is heartening to see that the quarterly inventory is no longer increasing at a double-digit pace. This stabilization in the inventory costs helped it improve its operating cash flows. The operating cash flow margins, which had dipped below 7% in Q1 and Q2, improved to 10.7% in Q3 (Exhibit 4). The improvement in its operating cash flows has aided its free cash flows. Free cash flow margins in Q3 were 8% compared to its quarterly average of 8% since April 2020. The annual average free cash flow margins have been 7.5% since 2013.
The dividend yield is not high enough for this rate environment
The biggest reason to own Hormel is the dividend yield, and in this rate environment, the stock has to, at the very least, yield closer to 4%. Now that Hormel has dropped substantially and may be nearing a fair valuation with an attractive dividend yield of 3.5% or above, investors should consider a two-pronged strategy to buy it. The first strategy is to consider buying small tranches as the stock nears $30 or below, and the second is to sell cash-secured puts. The December 15, $29 strike puts last traded at $0.20, yielding just 0.68% (Exhibit 5). This is a low premium, but if interest rates, which have been trending lower over the past couple of weeks, go higher, that may cause more selling pressure on the consumer staples sector. If this happens, Hormel’s dividend yield could increase as its price drops, and the puts may be more richly valued, allowing investors to sell puts that yield reasonable premiums. It may be best for investors to wait closer to a 1% yield for selling calls or puts. At $29, the stock would yield close to 3.8%.
Improving margins helps cash flows
The company has a lot of cash left over after its capex and dividend payments. The improvement in its cash flows has benefitted it. The company’s debt/EBITDA ratio is 2.2x, a manageable level of debt, and it has $600 million in cash on its balance sheet. The substantial cash position can be a strength for the company, given that the interest rate earned on it would help offset some of the interest payments it has to make. The company has spent $32 million on share repurchases, issuing shares worth $144 since October 2020 (Exhibit 6). It is no wonder the share count has not changed. The company gets a poor rating for its share buybacks.
The stock trades at a forward GAAP PE of 19.9x, higher than the sector median of 17x but lower than its five-year average of 25x. But, the past valuation is a poor guide since interest rates were much lower than now. The higher interest rates offered by the U.S. Treasuries offer stiff competition to dividend-paying stocks. The yields for dividend stocks will have to rise much further, and one way to accomplish this is for these stocks to command a lower valuation. The stock trades at a forward EV/EBITDA multiple of 13.6x, higher than the sector median of 10.6x.
An EV/EBITDA multiple closer to 11x would be a much more reasonable valuation for a company with good annual dividend growth of 5.7% over the past three years and 7.9% over the past five years. A 5% annual dividend growth can be good for investors to grow their income and likely get ahead of inflation. A discounted cash flow model puts the per-share equity value at $28.12, not far from my buy price lower than $30. This model assumes a growth rate of 3%, a free cash flow margin of 7.5%, its average over the past decade, and a discount rate of 8%. This model provides a point estimate for Hormel’s value.
Hormel Foods is a good dividend income stock that may get closer to a fair valuation after spending much time overvalued. Investors should wait for a pullback closer to $30 or below and a dividend yield of 3.7% or higher. Investors may buy in small tranches and sell cash-secured puts to generate income and acquire shares at a much more favorable valuation if the price drops. I continue to rate Hormel Foods a hold.