In Rough Times, Inferior Goods Make Superior Stocks

Hormel & CampbellStudents of Economics 101 will remember the lesson of inferior goods, which are goods whose demand is inversely related to the consumer’s income or purchasing power. The classic example of this phenomenon is Spam, the canned meat product made by Hormel (HRL). You will not find a lot of people who eat Spam for the flavor or the nutrition, people eat Spam because it is a cheap alternative to fresher meat. So, in this economy where people are pinching their pennies in order to get the most value for their money, inferior goods are a growth industry. We have already noticed consumers trading down to Wal-Mart (WMT) for everything from groceries to clothing and dropping the high dollar retailers like Whole Foods (WFMI) and The Gap (GPS). In this post we will discuss two companies that are benefiting from the trading down in food: Hormel and Campbell Soup Co. (CPB).

To begin, let’s look at Campbell Soup, who reported earnings on Monday. The results showed that CPB has grown sales 3%, which followed the summer quarter’s results (normally CPB’s weakest) were up a handsome 13%. Soup sales grew by an impressive 12% in the most recent quarter. Unfortunately, Campbell’s had a very tough time converting those sales into cash earnings because of increased commodity costs related to corn and other basic inputs. Further dampening earnings, Campbell Soup ended up on the wrong side of commodity hedging amounting to a loss of $26 million. The company also was pressured by a strengthening dollar as the company claims between 25 and 30 percent of sales from abroad. Profits slipped 3.7% to $260 million, but on a per share basis the results were actually up slightly to $.71. The company is also in the process of rolling out some new brands of Soups including Select Harvest, which is in direct competition with Progresso Soup from General Mills (GIS). The company has increased advertising budgets to get the word out on Select Harvest and to capitalize on the economic downturn.

Hormel and Campbell Soup Co.Campbells has been largely unscathed in the negative market action of the last year. At this point, CPB is down 11% which is remarkable considering the rest of the market. Furthermore, nearly all of that loss has occurred since Friday when the broad market was headed higher. So, with this kind of inverse price action in relation to the market it is easy to understand why CPB has a beta coefficient of .19. Interestingly, shorting interest has increased in the last few months for Campbells. We at Ockham Research have Campbell Soup rated Fairly Valued as of our last report on 11/22/08, but after the decline in price and mixed yet encouraging quarterly results, we may be inclined to go more positive in the near future.

As for Hormel, makers of Spam, chili and Jennie-O Turkey products, they announced earnings this morning for the fourth quarter and fiscal year. The results contained some similarities to Campbell Soup in that sales were healthy as they grew 12% from $1.66 billion to $1.86 billion. However, the company could not lift profits based on these gains, and earnings slipped 33% from $101.2 million ($.73 per share) to $67.8 million ($.50 per share). Commodity costs were again a major culprit, even though they have fallen from this summer’s record highs, commodities were still far more expensive than in the past. Also, Hormel is feeling the same pain other investors are feeling right now as investments in an executive retirement fund fell sharply.

The company offered guidance for the fiscal year 2009 on the low end of estimates calling for earnings of $2.15-$2.25. The stock is trading down about 3% on the day, but you cannot blame that on Spam. Spam is hardly Hormel’s only product, but the gelatinous mixture of spiced ham and pork invented during the Great Depression is again their most popular. As an article from the New York Times (NYT) proclaims production of Spam is going full tilt. Workers are working plenty of overtime and are only allowed vacation days on Thanksgiving and Christmas Day.

HormelWe have an Undervalued rating on Hormel right now as the company is priced below its historically normal valuation ranges. For example, Hormel in the past has had a price-to-cash flow between 9.55x and 12.92x but currently the stock is trading for just 8.1 times cash flow. Another oft used valuation metrics is price-to-sales which for HRL over the last ten years has normally ranged between .66x and .89x, but it is currently only .56x. The stock would need to appreciate into the mid thirties for these valuation metrics to return to within the normal ranges. So, if you believe that the market and the economy have further to decline, you may want to look at these food stocks as a delicious hedge against further weakness.

About Ockham Research 645 Articles

Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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