Reviewing Perpetual Value's portfolio (the hedge fund I run), I realized I that one of my stocks, Hormel Foods (NYSE:HRL) stands poised to benefit from the rash of low-carbohydrate diets sweeping the nation. Of course, back in August 2003 when I purchased Hormel, I wasn't buying based on a diet fad (frankly, I would not call low-carb eating a diet or a fad, but that's a column for another day).
Keeping it simple
I don't invest based on fads or momentum. That's speculation, not investing. I buy based on relatively straightforward criteria -- strong return on invested capital (ROIC) and free cash flow (FCF). My belief is that if you buy quality stocks, below their intrinsic value, all you need do is sit back and wait. Things become all the more interesting if you get a company that boasts quality financials and some dynamic that recommends it to the momentum/speculation set. I believe Hormel is one such idea that offers investors a unique opportunity.
Hormel, a well-run, conservative company with solid brands, manufactures and markets a variety of consumer branded and non-branded meat and food products. It may not quite enjoy the name recognition of say Gillette (NYSE:G), but its brands include some big names: Hormel, Always Tender, Dinty Moore, Chi-Chi's, Jennie-O and, of course, SPAM -- to name a few.
In fact, 32 Hormel brands are number one or number two in market share. And chances are you buy Hormel products and don't even realize it. Products of interest to low-carb eaters include packages of pre-sliced pepperoni and microwave ready bacon. Both represent high-margin, easy-to-prepare branded products, reflecting a shift away from commoditized, non-branded meat products to high-margin, branded food solutions.
A winning past
Hormel is a company run for shareholders, a refreshing change of pace these days. Over the past two years, with the company suffering from an inventory glut and a lack of pricing power in the protein markets (turkey and pork), management has been candid and forthcoming. I like when management gives it to me with no sugar coating. And yet, despite the trying times, the company continued to perform satisfactorily.
In fiscal year 2003, Hormel generated over $180 million in free cash flow (FCF) (for a FCF-to-sales margin of 4.3%), and an ROIC of 11.3%. That's down from historic norms of 6.5% and 16%, respectively, but hence the opportunity to buy Hormel on sale.
Hormel's balance sheet is also in fine shape with current debt to shareholder equity of 32% and improving. For a stable well-run business like this, anything under 50% is fine with me. In an act of shareholder-friendly corporate governance, the company opted to expense stock options, which a modest impact on EPS.
Finally, consider Hormel's strong dividend history. In 2003, Hormel paid out its 300th consecutive quarterly dividend and increased its dividend for the 37th consecutive year -- a record of which any company would be proud. In this portfolio manager's opinion, Hormel's historical results are downright impressive, and I see no reason why anything would change in the future.
The low-carb twist
And yes, along with great brands and solid financial results, Hormel stands poised to benefit from the low-cab revolution. I understand the craze first hand, having personally changed my eating habits and lost weight, while at the same time lowering my blood pressure. Books have been written on the virtues of eating low carb from the classics like Atkins and Protein Power to the more recent South Beach diet.
While restaurants and food suppliers of all sorts race to bring low-carb foods to market, Hormel's products are mainly protein, the staple of low-carb eating. Following these programs, I noticed that not only did I eat more protein, I bought more prepackaged (branded) protein products. Fortune recently reported that in 2003 sales of bacon were up nearly 17% vs. 2002!
I don't think this trend will reverse anytime soon. After all, the success people are having eating low carb nearly ensures that protein products will continue to sell. So while Hormel might be fighting protein inventory gluts near term, over the next few years, both investors and consumers should be eating the stuff up. If you want a responsible play on the low-carb revolution, it's hard to go to wrong with Hormel.
Shop wisely
Readers of my columns know that I am extremely price sensitive when I buy a stock. I believe in the margin of safety theory, and I believe in quality companies that I can sleep at night knowing I own. I made my initial (and as of yet only) purchase of Hormel in the low $20s and obviously would like to buy more at those levels. Still, you might wonder whether investors are still paying a discount to intrinsic value.
Using some very conservative FCF projections, I calculate that at $25.50, Hormel is trading 20% below its intrinsic value. If I use less conservative, but not aggressive estimates for FCF, I can make the case that Hormel is trading at a 30% discount to intrinsic value. So, while Hormel is not dirt cheap, investors should remember that this is a quality company, with a strong balance sheet and a history of solid free cash flow.
You don't often get a chance to buy such companies at much more of a discount. In view of the broader market valuations, Hormel clearly strikes me as a bargain. If low-carb trends accelerate, as I believe they will, Hormel should make investors happy for some time to come.
Paul N. Jaber, Jr., CFA is the portfolio manager of the Perpetual Value Fund, an intrinsic value hedge fund. The fund's portfolio is highly concentrated with quality companies that should achieve a high return on capital and strong free cash flow. His fund was long Hormel at the time of this article. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Jaber appreciates your feedback at [email protected]. The Motley Fool is investors writing for investors.
