In the 210 days since I wrote my cautious piece about Hormel Foods Corporation (HRL), the shares are up about 11.3%, against the S&P 500 which is basically flat over the same time period. Much has happened at the firm, obviously, so I thought I’d check in on the name to see if it’s time to buy. I’ll try to answer that question by looking at the financial history here, and by looking at the stock as a thing distinct from the underlying business. In addition, I recommended a short put in lieu of shares last time, and so I thought I’d check in on how that trade did also. I don’t want to spoil the surprise, but the short put trade worked out quite well and presents further evidence of the risk reducing, return enhancing capacity of these things.
For those who, understandably, lack patience for my writing, I’ll jump right to the point. I think this is an excellent business, with an illustrious history of dividend increases. Management, obviously, treats shareholders very well. The problem is that this isn’t a well-kept secret, and the shares reflect that fact. I think an investor’s return is largely a function of the price paid for a given security and the price here is a bit rich at the moment. For that reason, I must recommend that investors eschew the shares at these prices. That said, there is (another) great short put trade that I go through in the paragraphs below.
In many ways, the financial performance at Hormel Foods has been very good. In spite of the fact that the top line has grown at a CAGR of less than 0.5% over the past five years, net earnings have grown at a CAGR of about 7.4%. This has allowed the company to fuel dividend increases at a CAGR of about 10.9%. Finally, I like the fact that the company has cleaned up the capital structure massively since 2015, with long-term debt declining at a CAGR of about 24% since then.
All seems quite good until we compare the first 26 weeks of 2020 with the same period a year ago. In spite of a slight (2.1%) uptick in revenue, net income dropped by over 10%. When this happens, I like to look at the source of the underperformance. If earnings decline happens because of a one-off event that’s one thing. That’s not what happened in this case, though.
Specifically, COGS and SG&A increased by 3% and 7%, respectively. In my view, there’s no reason to consider this to be an aberration, so it may be worthwhile considering these new figures to be the new normal. Although the firm is still solidly profitable, this trend is, obviously, troublesome for shareholders. The next task involves working out whether or not investors should be nervous about the dividend at this point.
When I review the sustainability of a dividend, I look at the size and timing of future cash flow obligations and compare them to current and likely future resources. Obviously, the greater the latter relative to the former, the better. In my ongoing campaign to make your life as easy and stress-free as possible, dear reader, I’ve compiled a list of the size and timing of future cash outflows and have presented that table to you below. There are two points I should make up front. First, the company has about $57 million in debt and that’s due in semi-annual portions through to April 2021. I don’t know the exact size of each portion, but I’ve divided the total in half. This may be slightly inaccurate if more is paid in one year relative to the next. Second, on page 25 of the latest 10-K, the company suggested that CAPEX this year will be about $360 million. Since I have no visibility beyond this year, I’ve used the average CAPEX over the past five years for 2021 and beyond. I’ll remind you, dear reader, that the point of this exercise isn’t to come up with a mathematically precise number for each year. The point here is to work out what year will be the most onerous for the company and to work out the relative scale of obligations and resources.
Source: Latest 10-K
Against these obligations, the company, currently, has about $623 million in cash. In addition, the company has a $400 million unsecured revolving line of credit that has no drawn balance at the moment. This all suggests to me that the 54-year streak of dividend increases is not in danger as the company has more than enough cash to fund the dividend here for the foreseeable future. I’d be happy to buy these shares at the right price.
Source: Company filings
“At the right price” are some of the most important words in investing in my estimation. If an investor overpays for a given asset, at some point, their returns will be muted. If the investor can pay a much lower price for that asset, their returns will, obviously, be much greater. The more an investor pays for a stream of future cash flows, the lower will be their subsequent returns. For that reason, I want to try to make sure that I never overpay for a stock.
I judge whether or not I’m being asked to overpay in a host of ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value, like earnings, free cash flow, and the like. In particular, I want to see shares that are trading at a discount relative to both their own history and the overall market.
In my previous missive, I made much of (yammered on about?) the fact that Hormel stock price was trading at a relatively rich valuation, and I fretted that the shares would underperform. We see from the following chart that the valuation is now even more stretched than before. I don’t believe that history necessarily repeats, but I think it definitely rhymes. Note that the last time the shares traded at these valuations in late 2015, early 2016, the shares went on to underperform for a few years. I consider the risk of that dynamic playing out again to be particularly high at the moment.
Since this stock is trading near the high range of its historical valuation, I can’t recommend buying the shares at this point.
Just because I consider the shares to be too expensive, doesn’t mean that I wouldn’t buy the shares at a lower price. I’d be very happy to own this company at the right price and thankfully, the options market provides a way to generate premia while locking in the obligation to buy at a great price. As a reminder to those few of you who forgot, in my previous article on this company, I recommended selling put options in lieu of share ownership. Specifically, I suggested that investors would do well if they sold January 2021 put with a strike of $35. These were bid-asked at the time at $.70-$1.10 and are currently priced at $.25-$.40, suggesting that trade worked out fairly well. I like to repeat success, so I’m going to recommend another short put trade.
I particularly like the March put with a strike of $35. These are currently bid-asked at $.40-$.60. If the investor simply takes the bid here and is subsequently exercised, they’ll be obliged to buy the shares at a price about 30% below the current market price. If the shares remain above $35 over the next eight months, the investor simply pockets the premia, which is not a bad thing. This is why I consider this to be a “win-win” trade. The investor does well in my estimation no matter what happens to the stock price.
My regular readers know what to expect at this point, but for those of you just joining us, allow me to splash cold water all over the notion of a “win-win” trade by writing about risk. The world is such that we must choose between a host of imperfect trade-offs. No matter what some progressive politicians may try to tell you, there is no such thing as a “risk-free” path, and short puts are no different in this regard. We do our best to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. The risk-reward of stock ownership is obvious to readers on this forum.
I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money, and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.
Puts are distinct from stocks in that some put writers don’t want to actually buy the stock – they simply want to collect premia. Such investors care more about maximizing their income and will, therefore, be less discriminating about which stock they sell puts on. These people don’t want to own the underlying security. I like my sleep far too much to play short puts in this way. I’m only willing to sell puts on companies I’m willing to buy at prices I’m willing to pay. For that reason, being exercised isn’t the hardship for me that it might be for many other put writers. My advice is that if you are considering this strategy yourself, you would be wise to only ever write puts on companies you’d be happy to own.
In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day.
I’ll conclude this rather long screed about risk by indulging my tendency toward tedious repetition. I’ll use the trade I’m currently recommending as an example. An investor can choose to buy Hormel Foods today at a price of ~$49.00. Alternatively, they can generate a credit for their accounts immediately by selling put options that oblige them – under the worst possible circumstance – to buy the shares at a net price about 33% below today’s level. Buying the same asset at such a discount is the definition of lower risk, in my estimation.
I think Hormel Foods is a fine business, and I think the dividend is well protected at this point. In fact, I think management will be well able to extend the history of dividend increases into the future. As is frequently the case, the problem here is with the stock. I think investors are paying too much for the shares at the moment, and if history is any guide at all, the shares are about to enter a period of underperformance. Because I don’t want to buy the shares at the current price doesn’t mean I don’t think there’s value here, obviously. I’d be very happy to buy this stock, but only at a price that correlates to great long-term returns. Thankfully, the options market provides an opportunity to generate some return immediately for taking on the obligation to buy this dividend aristocrat at a great price. So, for people so inclined, I recommend the above options trade. For other investors, I strongly suggest standing on the sidelines until price falls to match value.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I’ll be selling 10 of the puts described in this article.