Like A Bad Can Of SPAM

By Chad Henage - July 10, 2012 | Tickers: CAG, HRL, KRFT | 0 Comments

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You might not expect a lot from the company that makes SPAM, I know at first that was my impression. After all, when the Monty Python cast devotes an entire sketch to making fun of SPAM, it's not usually good for the company behind the brand. However, if I said we are talking about Hormel Foods (NYSE: HRL) your opinion might change. Hormel has a good reputation for high quality food. When you add in some of the company's other brands like Jennie-O and Dinty Moore, your impression might improve further. One thing you might not know about Hormel is, the company is a dividend aristocrat. Imagine that, this seemingly boring company has increased its dividend for over 25 years in a row. While dividend aristocrats are usually highly regarded, it seems this company is being afforded a valuation that isn't quite warranted.

On a relative basis, Hormel is a small fry compared to some of their competition. In fact, if you look at the company versus two of their main competitors ConAgra (NYSE: CAG) and Kraft (NASDAQ: KRFT), the comparison isn't very fair. With ConAgra sporting an over $10 billion market cap, and Kraft approaching a $69 billion market cap, at less than $8 billion, Hormel might seem at a disadvantage. What I've learned in many years of studying the market though, is don't assume anything. Let's see how Hormel actually compares to these two companies to see if the company's smaller size is really a disadvantage.

Looking at the numbers, while it seems clear that size matters when it comes to gross margin, Hormel seems relatively well positioned in the other categories. One big difference between Hormel and these two competitors is their level of long-term debt. This conservative fiscal policy could be what has allowed Hormel to achieve dividend aristocrat status, while the other two have not. Speaking of the dividend, can the company continue its streak?

The key to finding out if a company can continue paying its current dividend is, looking at the company's free cash flow payout ratio. Over the last three years, Hormel's payout ratio has risen from 23% to over 35% today. While the rise in this ratio is something to keep an eye on, a 35% payout ratio is still very low. In particular, Hormel's payout ratio looks pretty good compared to Kraft at 74% last year, and ConAgra at 42%. With the dividend well covered the next question is, what about dividend growth?

This is the measure I was most surprised by with Hormel. From 2003 to 2007 the average dividend increase was about 9%. The last five years have seen a big jump in the average dividend increase to over 15%. In fact, three of the last five years the company has increased the dividend by at least 17%. This is huge growth if it continues, and will change the company's yield significantly.

Unfortunately for investors, this type of dividend growth cannot continue. With analysts calling for future earnings increases of about 9%, maintaining over 15% dividend growth would cause problems. In the last three years, the company's operating cash flow growth has trailed net income growth. If this continues, it seems reasonable that the dividend will more closely follow cash flow growth. With cash flow growth probably coming in at around 7%, increases of 7% to 9% would seem to make sense. The company's relatively low payout ratio would allow for these increases for a while before the ratio would be a problem. With a yield of about 2%, Hormel won't win a prize for the most attractive stock in the market, and at nearly 16 times earnings with forward growth expected at 9%, the stock seems a little rich for my taste. Investors looking to buy shares should probably wait for a pullback to capture a higher yield and a better entry point. There are some positive numbers working for Hormel, but buying the stock at a forward PEG of 1.78 seems too expensive. I like the company, and I was admittedly impressed by their dividend growth, but paying too much for a stock is like eating a bad can of SPAM. You might not notice anything right away, but you'll pay for it later.

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