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Hormel: Hearty Meals, but Indigestive Stock

Richard Saintvilus

NEW YORK ( TheStreet) -- There's not much a company can do when the Street has fallen in love with its stock. While some management teams will look for opportunities to play down expectations, there are companies, like Hormel , that revel in the challenge, especially when they know their growth prospects are actually better than perceived.

But I believe Hormel's stock, which has posted year-to-date gains of close to 50%, is expensive. I'm saying this even though I know that the company has a long history of margin expansion and above-average growth. Not to mention, when it comes to strong returns on capital, Hormel has compared favorably to other well-established brands, like Nestle and Kraft Foods , which I happen to like.

But the Street has come to expect this level of performance. And the way I see it, several of these metrics are already presumed in Hormel's current valuation, which carries a P/E of 24. Although that is still three points below the industry average, Hormel nonetheless trades at a multiple that is two points higher than Mondelez . This is even though Mondelez posts better gross margin and operating margin.

Essentially, new investors would be paying up for stock that has already outperformed not only the entire sector, but its own historical average. I'm not suggesting that a selloff is imminent. That the company was able to deliver fourth-quarter adjusted earnings per share of 58 cents, which was up 18.4% year over year, was indeed impressive.

I won't deny that the 7% year-over-year revenue growth, was a pleasant surprise -- especially given the dire state the entire food and beverage sector, which has been marred by poor volumes and weak prices. But as has been the case for other food rivals/peers like ConAgra , very little of Hormel's 7% growth was of the "organic variety," which measures a company's operational performances by excluding events such as mergers and acquisitions.

To that end, Hormel's January acquisition of the Skippy peanut butter brand "buttered up" the results. In fairness, this has been the growth method of the entire sector, which is still in a period of consolidation. From Campbell Soup Co. to Pepsico , acquisitions have fueled the top line. The difference is, expectations for those companies are -- I believe -- more reasonable.

The Street is placing strong bets on Hormel for 2014, which assumes that the company can overcome several operating obstacles. Not the least of which is that Hormel just posted a decline in operating profit in the specialty foods segment, due to the loss of a large contract from a major customer. Management must figure out a way to offset that loss and get specialty foods back on track.

The other thing is, although company executives have spoken optimistically about margin improvement due to lower grain and turkey commodity prices, it's not clear if these sorts of benefits will be realized. Nor can we assume the extent that lower commodity prices will boost margins. Obviously, it will have some positive effects.

Nevertheless, this goes back to my original point that any positive effect from an operational perspective is already assumed in the stock price. Last but not least, I believe the Street is discounting the offsetting effects of high beef input costs, which has been an issue for most of the year. And to say nothing about the uncertainty that surrounds hog supplies, where animal activists have investigated/charged former Hormel suppliers with animal cruelty.

To Hormel's credit, however, management has taken swift and corrective action upon acquiring knowledge of these claims, including the development of what it calls a Quality Management System that details animal procurement and processing procedures.

So despite the bad publicity, I was impressed with the manner in which Hormel was able to demonstrate that this is still a great company with strong business prospects. But as I've said, smart investors already know this and already own the stock. And I don't see any scenario where buying this stock around $45 a share makes sense for new investors. But Hormel at under $40 would be very appetizing.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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