Playing Both Sides

A few weeks ago, the Fed finally acknowledged the dual mandate at Jackson Hole and signaled what we have been anticipating for months: the start of an easing cycle.

We have long argued that the Fed has been over 100 basis points too restrictive, and the data continues to confirm that view. Last week’s ugly jobs report, followed by the largest downward revisions on record at nearly one million, and a soft PPI print seem to have locked in a rate cut for next week. The only question is whether it will be 25 or 50 basis points.

(Click on image to enlarge)

And as we enter this easing cycle, investors are already tripping over themselves to add exposure exactly where you’d expect. Rate-sensitives, housing, discretionary, and small caps are all starting to get a bid and see flows return after being left for dead for much of this cycle. We entered the year pounding the table on that exact playbook, albeit at much lower prices, and have since been handsomely rewarded. Whether it’s VF Corp, Canada Goose, housing names like SWK, GNRC, and QXO, or cyclical autos such as AAP and CPS, all are just leaving the station with a long runway ahead.

(Click on image to enlarge)

However, what has been completely overlooked in this scramble, and where we continue to see generational opportunities, is the defensive side of the market. Staples, healthcare, and energy have all been left for dead. While investors seem to be crowding to one side of the boat, we continue to believe this is not an all-or-nothing market. This is a regime where both trades can work, and with the rubber band stretched so far against these defensive areas, reversion to the mean becomes inevitable.

A key driver of this view is the fact that dividend yield remains cheap and neglected, a trend we expect to reverse quickly as the Fed enters this easing cycle. Once rate cuts begin, the ~$7.4 trillion sitting on the sidelines earning 4% risk-free will be forced to find yield elsewhere. When that happens, these sleepy, boring dividend payers will be in high demand, triggering a rotation that brings defensives back into vogue, and we’ll be more than happy to help investors get exposure.

(Click on image to enlarge)

Two of the names that we believe are well-positioned to benefit from this rotation, and the focus of this week’s article, are Hormel and Diageo.

Hormel (HRL) Update

Hormel just reported its fastest top-line growth in nearly three years, +6% YoY, as the protein craze continues to show no signs of slowing. Unfortunately, a steep and unexpected rise in commodity costs caught HRL offsides, erasing much of that benefit and putting earnings under pressure. Par for the course this earnings season, the market overreacted, sending shares down ~13%. We were in the market buying as many shares as we could, and for those who sold us shares in the hole, we thank you for your service.

(Click on image to enlarge)

At the end of the day, Hormel has been compounding wealth since 1891. To think this is the first time it has faced rising input costs over 130 years is laughable. As it has done many times before, HRL will work through a handful of quarters of margin volatility while passing through costs. Zoom out, and this will be nothing more than a blip on the radar. On top of that, you have a proven CEO, Jeff Ettinger, back at the helm to right the ship through October 2026, with plenty of time to work his magic and position the new CEO to step in as a hero. In the meantime, we’ll continue to add shares where we can, collect the 4.5% dividend yield, and watch this “sleepy” name recover.

(Click on image to enlarge)

Q3 Earnings Breakdown

10 Key Points

1) Organic net sales rose 6% YoY to $3.03 billion, accelerating for the third straight quarter and sharply above Q2’s 1% growth. Growth was driven by volume (+3%), pricing (+2%), and positive performance across all three segments.

2) Adjusted operating margins fell ~80 bps YoY to 8.4% as a steep run-up in commodity inflation completely eroded benefits from strong top-line growth. Beef costs remain near all-time highs, pork bellies are up ~30%, and wholesale pork up ~10%, driving a 400 bps increase in raw material cost inflation in Q3 alone. Management is implementing targeted pricing actions and evaluating additional measures, with profit recovery expected to lag into next year as cost pressures persist in Q4 and price hikes only partially benefit the upcoming quarter. However, this is not the first time Hormel has faced high commodity prices in its 130+ year operating history. They have a track record of successfully passing on costs in the past, and we expect this time will be no different.

3) The Transform and Modernize initiative remains on track, delivering results in line with management’s expectations, with ~90 projects contributing measurable value and earnings. Management continues to expect incremental benefits for FY2025 of $100–$150M and is currently tracking toward the high end of the range.

4) The Retail segment delivered 5% volume growth, 5% net sales growth, and segment profits of -4%. Top-line strength was broad-based, with 5 of 6 brands posting YoY growth. Jennie-O was a standout, up 13% YoY, continuing to outpace the broader category and gain market share on top of its #1 position. SPAM also delivered another quarter of YoY volume and net sales growth. Segment profitability was pressured by input costs, with management expecting profits to begin to recover in 2026 as pricing actions take effect.

5) The Foodservice segment delivered 2% organic volume growth, 7% organic net sales growth, and segment profits down 1% YoY. Hormel outpaced the broader industry despite ongoing pressure, including declining restaurant traffic and soft higher-margin convenience store visits. Premium pepperoni was a standout, posting over 20% volume growth. Management expects the pass-through nature of costs in the Foodservice portfolio to drive a faster recovery of profitability, which is key as the segment typically commands a mid-teens operating margin versus high single digits at Retail.

6) The International segment delivered 8% volume growth, 6% net sales growth, but segment profitability fell 13% YoY. Top-line strength was driven by a “thriving” Chinese market and positive export results, led by the global SPAM brand. Profitability was primarily impacted by ongoing competitive pressures in Brazil.

7) Planters, acquired by Hormel in 2021 for $3.35B, continues its turnaround, achieving higher YoY growth in distribution, household penetration, and turning dollar sales positive by quarter-end. With capacity now in place to meet demand, management expects continued sales momentum. On the bottom line, profit recovery is lagging expectations, though Q3 profit did grow, albeit more slowly than top-line gains.

8) Management continues to prioritize the company’s dividend aristocrat status, returning $159M to shareholders this quarter through dividend payments, bringing total dividends to $474M through Q3. This marks 59 consecutive years of dividend increases and the 388th consecutive quarterly dividend, with a 5-year dividend growth CAGR of 5%.

9) Capex for the quarter totaled $72M, or ~2.4% of net sales, up from $65M last year. The largest investments remain focused on expanding capacity and optimizing the manufacturing footprint, with management forecasting full-year capex of ~$300M.

10) Management revised full-year guidance, narrowing net sales to $12.1–$12.2B (from $12.0–$12.2B), implying 2–3% organic net sales growth. Due to steep commodity cost increases, adjusted operating income is now expected at $1.05–$1.07B (prior $1.18–$1.25B), with adjusted EPS midpoint reduced to $1.44 from $1.63. Most importantly, management reiterated that the long-term algorithm remains intact: 2–3% organic net sales growth and 5–7% operating income growth.

Morningstar Analyst Note

Earnings Call Highlights

Diageo (DEO) Update

Moving along to Diageo, this is yet another straw hat in the winter setup. Shares have been cut in half as if consumers will never drink again. We’re more than happy to take the other side of that trade.

While consumers may be “moderating,” the real trend is clear: they are drinking less but drinking better. No company is better positioned to capitalize on this long-term premiumization trend than Diageo. Diageo is a classic story of cyclical downturns playing out within a long-term secular uptrend, and we expect this cycle to be no different.

The #1 thing we look for in a turnaround is free cash flow recovering and that is already well underway, with management targeting $3 billion in FCF for the coming year. In the meantime, as management waits for the inevitable cycle to turn, they continue to focus on what they can control, cutting costs and positioning the company for the next leg of growth. Zoom out a few years, and Diageo will be leaner, stronger, and benefiting from margin tailwinds tied to premiumization. It will be growing at a mid-single-digit clip and trading above $200. Tomorrow’s newspaper, today. Until then, we’ll sit on our hands, collect our 4% dividend, and wait.

Q4 Earnings Breakdown

10 Key Points

1) Organic net sales rose 1.7%, ahead of street consensus of 1.4%, driven by 0.9% volume growth and 0.8% price/mix growth. Management noted that the tariff-driven pull-forward behind last quarter’s 5.9% YoY growth has largely cycled through, with inventory levels now normalized.

2) Diageo gained or maintained share in 65% of total net sales across measured markets, including the U.S., and delivered organic growth in 4 of 5 regions. Sales rose 1.5% in North America, 9.2% in Latin America & Caribbean, 0.3% in Europe, and 10.5% in Africa, while Asia Pacific declined 3.2% on weaker China and travel retail.

3) Guinness remained a standout during the quarter, delivering 13% organic net sales growth and gaining share in its top three markets (Great Britain, Ireland, U.S.). Guinness 0.0 continues to expand, driving 40% growth in Diageo’s non-alcoholic portfolio, where the company leads the market at 4x the size of its nearest competitor. Don Julio was another highlight, up 38% organically and gaining share in 90%+ of measured markets.

4) Management raised its cost savings target under the Accelerate Program to $625M (from $500M) over three years. ~50% of savings are expected to flow through to the bottom line, supporting mid-single-digit organic operating profit growth for FY2026 and sustaining a ~29% sector-leading EBIT margin, with the remainder reinvested for growth.

5) Diageo generated $2.75B in free cash flow for the year, up $139M YoY. Improving cash flow remains a top priority for management, with guidance for at least $3B annually starting in 2026, which includes one-time Accelerate program costs, with upside potential as the business recovers. At current prices, this implies a FCF yield of at least 5%.

6) Cleaning up the balance sheet remains a top priority, with DEO ending the quarter with $21.9B in net debt and a 3.4x net leverage ratio, in line with prior guidance of 3.3–3.5x. Management remains on track to hit its 2.5–3x net debt/EBITDA target by FY2028 at the latest.

7) ~75% of Diageo’s business is unaffected by U.S. tariffs, with most products exempt under USMCA. Management expects a ~$200M annualized operating profit hit but aims to mitigate ~50% in year one BEFORE broader tariff-specific pricing actions.

8) Management expects capex of $1.2–1.3B for the upcoming year, down from $1.5B in FY2025, as they continue to focus on improving ROIC and higher-growth opportunities. Over the next three years, capex is projected to decline to a mid-single-digit % of net sales, versus 7.7% in FY2025.

9) Diageo has a track record of active portfolio management and remains committed to pursuing disposals of non-core assets. However, despite earlier rumors, management has no plans to sell Guinness or its stake in Moët Hennessy at this time.

10) For FY2026, management expects organic net sales growth near FY2025 levels (1.7%), with slightly negative H1 and accelerating H2, which would imply organic sales growth in the 4% range. They anticipate a return to positive operating leverage as cost savings kick in, driving mid-single-digit organic profit growth, which includes the current impact of tariffs.

Morningstar Analyst Note

Earnings Call Highlights

General Market

The CNN “Fear and Greed Index” ticked down to 51 this week from 60 last week. You can learn how this indicator is calculated and how it works here: (Video Explanation)

The NAAIM (National Association of Active Investment Managers Index) (Video Explanation) ticked down to 81.58% this week from 92.94% equity exposure last week.

(Click on image to enlarge)

---

More By This Author:

“The Capitulation Rally” Stock Market (And Sentiment Results)
“Fed Opens The Floodgate” Stock Market (And Sentiment Results)…
“Crafting A Comeback” Stock Market (And Sentiment Results)