Hormel (HRL) Stock: Hit The Fade And Look To Buy Below $25

In our last update for Hormel Foods Corporation (NYSE:HRL), we suggested that the bears were pushing deep into oversold territory and risks for a countertrend move were high. We expected a bounce, one that should reset sentiment and prepare the stock for the next big move lower. Specifically, we said:

Markets seldom move in a straight line though the last 15 weeks in the SPY seem to suggest otherwise. HRL’s drop has been rather extreme for a consumer staples company and while there are headwinds, the sentiment looks extremely one-sided. Relative to its 200 day moving average, HRL was only lower on a handful of occasions. The setup looks good for a bounce that clears away the excess pessimism.

Source: “Peak Pessimism, Buy For A Trade And Then Hit The Fade.”

That worked well, and HRL outperformed the S&P 500 (SP500) by over 20% in two and half months.

We now give you three reasons why you need to refocus on the longer-term story and exit the profitable play.

1) Lofty Valuation

Even if you believe the estimates out there, HRL is trading far too expensive for an era of 5% interest rates. At 22X earnings for this year, you have to be a real believer in SPAM. As the picture below shows, even those earnings are actually contracting from the year prior.

Not only are these contracting, but remain well below levels since in many previous years. The chart below shows the trailing four-quarter figures and gives a sense of how bad the deterioration has been.

The maximum you want to pay for a business like this is about 15X earnings. In case you think that is too pessimistic, here are three examples of consumer staples stocks which have done a better job than HRL, all trading under what we just suggested.

15X the $1.60 gets you to $24.00. 15X the 2025 estimate of a $1.69 gets you $25.35. We don’t think the earnings estimates are overly optimistic here, so we won’t deduct points for that. But the valuation path remains firmly lower.

2) Oversold Conditions Relieved

In our last coverage, we had pointed to the 200-day moving and the fact that HRL was 20% below it, as a key reason to dial back the bearishness.

We are now grazing that 200-day moving average once more, and this is the point where we expect the dominant trend to reassert itself.

3) Dividend Growth Story Likely To Slow Down Considerably

HRL put on a brave face and hiked its dividend once for 2024.

The payout ratio is now likely to be around 70%-75% (depending on how you calculate it). This is likely to be at or above the comfort zone for management. The bulk of the dividend growth story was driven by an expanding payout ratio. This ratio went from 25% to 75% over the 13 years.

Needless to say, nobody is stupid enough to believe that we can go from 75% to 225% over the last 13 years. This expanding payout ratio impact has been most notable since 2016. During this time, earnings have been flat (yes, over 8 years) and dividends have approximately doubled. From this point on, the dividend is likely to grow by 3% at best, and a freeze is not out of the question.

Verdict

HRL has used up all its key cards. The Planters acquisition is in the bag, and earnings look worse than they were before that. The balance sheet, which was the best in the business, has now moved to just slightly above average.

One other way to visualize this is to see the debt in relation to sales.

S&P (which downgraded Hormel in 2023 from A to A-) is still optimistic that the company can hold under 2.0X debt to EBITDA.

Leverage will remain modestly elevated in fiscal 2024. Hormel’s EBITDA (S&P Global Ratings-adjusted) declined about 10% in fiscal 2023 (ended Oct. 29) due to a combination of factors, including commodity turkey market volatility, rising consumer price elasticity, weakness in China, and fixed-cost under-absorption. As a result of the profit decline and the company’s $400 million investment in Garudafood in December 2022, leverage has been sustained in the high-1.0x area over the past year (compared with 1.5x at the end of fiscal 2022). Although first-quarter fiscal 2024 performance exceeded our expectations, supported by stronger-than-expected volumes and lower logistics expenses, we expect profitability will remain pressured in fiscal 2024 due to still-weak commodity turkey prices, increased brand investment, and costs associated with the company’s transformation and modernization program. As a result, we now expect leverage will be sustained at about 1.8x in fiscal 2024 (compared with our previous expectation that the company would deleverage to about 1.5x). Nevertheless, we continue to believe Hormel will generate good free operating cash flow (FOCF) that will exceed shareholder returns and support deleveraging over the long term.

Source: S&P

This lack of cushion also means those payout bumps are going to require a microscope to see.

You could argue for a premium multiple for HRL in the past because it used so little debt in the 2012-2021 era relative to Conagra Brands, Inc. (CAG), Campbell Soup Company (CPB), and The Kraft Heinz Company (KHC). That has changed. While it still uses less debt, the relative advantage here is crumbling. Despite that smaller advantage, HRL still trades 5 multiples wide on forward EV to EBITDA. That is insanely high and offers big risks to the downside.

We would look lower for this one over the next 12 months, especially as investors come to grips again with “higher for longer.”

As we close off here, one possibility holds that HRL could surprise on the upside, at least over the next 3-6 months before the wheels come off. In our experience, major market tops tend to form with defensive sectors like utilities and staples leading the charge. The positioning in staples, in particular, is also conducive for a bounce.

This could prolong the transition down to fair value a little bit longer. We would still avoid Hormel Foods Corporation stock, and if we get $37-$39, we would look to establish a short position.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult a professional who knows their objectives and constraints.