010426 Hormel a Stock With Some Meat on It

TheStreet.com - What will it take for weary investors to turn their jaded eyes toward food stocks? Even now, with the empire of tech in smoking ruins around us, and economic signals all but screaming for investors to get defensive, food companies tend to get overlooked -- and that's especially true for the little-recognized folks who traffic in processed meat, the trusty mainstay of the American dinner table. Case in point: Hormel, a leader in turkey and pork processing, with product lines such as Spam, Dinty Moore stew and Jennie-O turkeys.

Hormel has a lot going for it these days -- so much that some investors view the stock not just as a defensive play, but as a turnaround story. As food companies go, this member of the wiener glitterati is one of the stronger bets. It's expected to grow earnings this year around 11%, with continuing double- digit growth for several years out.

The bottom line: once known primarily as a meatpacker, Hormel's branched out into more profitable branded consumer products. It's even ventured into slightly more upscale American food, with a small sideline in supplying ethnic food products to names like Chi-Chi's and House of Tsang sauces. Another plus: Despite gaining 27% over the last year, the stock still looks cheap on a historical basis. Spam notwithstanding, the Gomer Pyle pedigree is looking more and more like a relic of the past.

There's one sizable short-term worry, though. If foot-and-mouth disease -- a highly contagious ailment affecting hogs and cattle that's become a big problem in England and has spread to other European nations -- were to reach the U.S., it could put a big dent in Hormel's business. According to the company, about 80% of its products contain pork. Even if the disease never materializes in the U.S., the company could be hurt by increasing consumer wariness about meat from animals susceptible to the disease.

Also, a labor dispute resulting in a three-week work stoppage at a Hormel plant had just been resolved at press time. Though the strike may have an effect on second-quarter earnings, its impact isn't expected to spill into the second half.

The Case for Hormel

In the long term, of course, we're not talking about the stuff of revolution. Hormel runs a pretty mundane business, even by food company standards. By the transitive property of monotony, if processing meat is duller than packaging cereal, which in turn is more boring than sending tiny fireworks of light shooting through wires, then meat processing is a lot more humdrum than building out technology. Not surprisingly, the prospects for growth over time in processing meat are a lot more earthbound, too.

Hormel's revenue probably will grow at a fairly unexciting 6% to 8% annually over the next few years, predicts William Frels, a portfolio manger who's owned the stock for close to a decade in the Mairs & Power Balanced fund.

Other analysts are more optimistic, though: George Dahlman, an analyst at U.S. Bancorp Piper Jaffray , predicts the company will see sales growth of 8% to 10% over the next few years.

But even if sales gains won't be huge, earnings growth looks solid. "It's an improving profitability story," says Frels, who believes earnings will grow in the 10%-to-12% range over the next few years.

Those gains will come as a result of a long-term corporate realignment toward higher-profitability businesses. Over the last few years, Hormel has been gradually shifting away from its old focus on meatpacking and moving into food processing. Hormel used to make most of its money by slaughtering hogs and selling the products, like bacon and sausage, to supermarkets without much additional processing (Spam, which boasts a 60-year lineage, was a notable exception to the rule). Now Hormel makes greater profits by slaughtering and then processing animals into easy-to-prepare, packaged meats sold in supermarkets or through wholesale channels.

The company estimates that it draws about 60% of its revenues from Hormel- branded products, and it eventually wants to push that number even higher, to around 80%. (The remaining 40% of its revenues comes from commodity sales of slaughtered, unprocessed hogs).

"Hormel sticks out as a company that has done an extraordinarily good job of creating growth," says Eric Hull, portfolio manager of Jurika & Voyles Value and Growth fund. As it's moved more of its production from commodity-oriented to branded products, he adds, "sales growth has accelerated nicely, margins have improved and returns have improved."

Because it still relies on the commodity side for a decent chunk of its revenues, Hormel lags a little behind some of its competitors in terms of its profit margins, but it also has more room for upside. "As a percentage of sales, I'd say margins are a little bit lower than other completely branded companies, but they're making excellent progress in that area," says U.S. Bancorp's Dahlman.

Plus, the company's stabilized some of the inherent volatility on the commodity side by starting to buy hogs on long-term contracts, instead of in the short-term market. "They've dampened significantly the cyclicality of their raw material price swings, and made returns much more stable," says Hull.

In a move that further diversifies its business mix, Hormel recently bulked up its existing turkey-processing business (already the biggest in the world) with the $334 million cash acquisition of a major U.S. turkey company, The Turkey Store . Dahlman estimates the resulting Jennie-O Foods Turkey Store , which would combine Hormel's existing turkey business with The Turkey Store's, will have annual revenues of close to $1 billion, contributing nearly 25% of Hormel Foods' total revenues.

Other Moves

Besides making selective acquisitions, the company's funneled some of its cash flow toward buying back stock. It's in the final stages of a 10-million share, two-year buyback, with only 1 million shares to go.

And the stock still looks cheap. According to Thomson Financial/Baseline , the stock's P/E is 16.1, below the historical median of 20.4. Viewed another way, it's trading at around 14.3 times its forward 12-month estimated earnings, according to U.S. Bancorp Piper Jaffray. That's 23% below the forward P/E of the S&P food group of 18.6.

Hormel trades at a discount, yet it boasts a much better growth profile than its competitors, says Hull. "I think Hormel suffers from an association that many on the Street have with its past, when it was primarily commodity-oriented. Most people looked and said, 'Well, as the price of hogs goes, their stock goes in the opposite direction.' That's not correct anymore."

The stock lagged for much of the growth-oriented 90s, beset by concerns about its sensitivity to commodities. With an annualized return of 8.07%, for the 10-year period through the first quarter of 2001, it trailed the S&P 500 by 6.3 percentage points. But for the more recent three-year period, it bested the S&P, with an average return of 5.8% a year.

And for the last year, it's up close to 30%.

Says Dan Thelen, fund manager at Loomis Sayles Small Cap Value, "I think as time goes on, Hormel will be valued less and less as a commodity company, and more and more as a processed foods company."

Whether you like the turnaround prospects or are drawn by the idea of a defensive play, the stock offers a level of earnings stability that's in short supply these days. Sure, with Hormel you may never get a big happy spike on your price chart. It's safe to assume demand isn't going to shoot up; consumers aren't going to start breaking down doors to get their fix of Dinty Moore. But - - barring a U.S. outbreak of foot-and-mouth disease -- there probably won't be a huge demand dropoff for Hormel products, either. And going into a recession, there are plenty of worse things to own than food stocks.

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