The Hershey Company

The Hershey Company

/ (HSY-NYSE) / $37.63

Note: FLASH REPORT; more details to come; changes are highlighted. Except where noted, and highlighted, no other sections of this report have been updated.

Reason for Report: FLASH UPDATE: HSY, Ferrero mulling joint Cadbury bid

Prev. Ed.: October 28, 2009; 3Q09 Earnings update

Flash Update

On November 17, 2009, media reports said Hershey Co. is in talks with privately held Italian confectionery company Ferrero International SpA to launch a joint bid for Cadbury PLC. British confectioner Cadbury has already rejected a $16.7 billion hostile takeover bid from Kraft Foods (KFT), calling the offer “derisory.” However, the reports said talks between Hershey and the Italian chocolate maker were in a very preliminary stage and it remained unclear if an offer would be made.

A more expanded account of analyst opinions will follow in the next update of HSY.

Portfolio Manager Executive Summary [NOTE: Only highlighted material has been changed]

The Hershey Company (HSY or the Company) is the leading producer of confectionery products in the US, with a domestic market share of approximately 28%. Hershey is well known for chocolate products (Hershey’s, Reese’s, and Kisses), where the Company enjoys a domestic market share of approximately 45%.

While most companies in the packaged food universe are using productivity improvement initiatives and pricing to mitigate the impact of the high input costs, Hershey is on a different track. The Company appears set to increase its market spending, increase expenses for its newly-established C-store salesforce, and enhance its investment for international growth.

In an effort to increase its potential for profitable growth, management embarked on many company-wide programs to divest low-margin brands and implement numerous supply chain cost-reduction initiatives. A major growth driver for Hershey’s has also been the continual expansion of its portfolio of branded products, both through internal development and acquisitions.

The following is a summarized form of diverse brokerage viewpoints:

Neutral or equivalent outlook (8/15 firms or 53.0%): Target prices range from $37.00-$42.00. The firms with a neutral outlook note that the favorable channel mix, dominant market share, right strategic actions by management, and additional cost reductions through the divestiture of low-margin brands, rationalizing of SKUs, and continuing with the 3-year Global Supply Chain transformation plan, are some of the positives for HSY. In addition, HSY is increasingly better positioned, as its products are inexpensive, impulse oriented, largely US based, and not subject to private label competition. However, these firms believe that poor execution, heightened competition, unfavorable foreign currency exchange rates, increased pension expense, near-term deceleration in the Company’s sales, lower-than-expected contribution from new products, cost inflation, and the need for increases in consumer spending, will pressure HSY’s performance in the foreseeable future. All the firms based their valuation on forward EPS estimates, except one firm, which used EV/EBITDA analysis for valuation.

Negative or equivalent outlook (6/15 firms or 40.0%): Target prices range from $32.00–$38.00. The firms remain cautious on the stock based on the following factors: i) Margins are back at previously unsustainable levels and input cost inflation (cocoa, dairy, sugar, etc.) is likely to accelerate in the coming quarters; ii) Competition from Mars is likely to get more difficult; iii) The stock is trading at a premium compared with its peer group, which is not justified, iv) Volumes are expected to decline going forward particularly as it relates to its seasonal business and v) Promotional spending risk remains around Halloween, Valentine’s Day and Easter seasons. In addition, the firms believe that Hershey is investing heavily in its business in marketing terms and in growth capabilities (U.S. and International) and this will continue to weigh on profitability. The firms used P/E or DCF analysis to derive the target price.

Buy or equivalent outlook (1/15 firms or 7.0%): Target price provided by one firm is $49.00. The bullish firm remains encouraged by Hershey’s strong topline growth momentum and believes that the management team, led by David West, will execute solidly on the Company’s growth strategy with the three-year Global Supply Chain transformation plan. The firm believes that going forward HSY is experiencing significant margin improvement and continues to reinvest a portion of its improvement back into marketing. The firm believes that despite the current headwinds created by a difficult input cost environment, Hershey should continue to generate solid cash flow and EPS growth in the high, single-digit range over the long term, given its leading position in the steady U.S. chocolate market. The firm expects near-term sales growth to be driven by new products and growth of core brands in non-traditional distribution channels. The firm based the valuation on P/E analysis.

October 26, 2009

Recent Events [NOTE: Only highlighted material has been changed]

On October 22, 2009, HSY announced its 3Q09 financial results. Highlights are as follows:

· Net revenues decreased to $1,484.1 million in 3Q09 from $1,489.6 million in 3Q08.

·  Adjusted EBIT increased 15.3% to $290.6 million in 3Q09 from $251 million in 3Q08.

· Adjusted net income was $168.5 million or $0.73 per diluted share in 3Q09 versus $145.8 million or $0.64 per diluted share in 3Q08.

Overview [NOTE: Only highlighted material has been changed]

The Hershey Company (HSY or the Company) manufactures chocolate and non-chocolate confectionery and grocery products. It principally offers confectionery and snacks sold in the form of bar goods, bagged items, and boxed items; refreshment products sold in the form of gum and mints; and grocery products sold in the form of baking ingredients, chocolate drink mixes, peanut butter, and beverages. The Company sells its products primarily to wholesale distributors, chain grocery stores, mass merchandisers, chain drug stores, vending companies, wholesale clubs, convenience stores, and concessionaires through sales representatives, food brokers, and retail sales merchandisers in the United States, Canada, Mexico, and Brazil. In addition, the Company imports and/or markets selected confectionery products in the Philippines, Japan, and South Korea; and markets confectionery products in approximately 60 countries. The Hershey Company is headquartered in Hershey, Pennsylvania.

The Milton Hershey School Trust controls approximately 78.0% of The Hershey Company's voting shares and is the largest shareholder of HSY.

The firms have identified the following issues as critical for evaluating the investment merits of HSY:

Key Positive Arguments / Key Negative Arguments
Largest Manufacturer: HSY is the largest North American manufacturer of quality chocolate and sugar confectionery products. / Execution Risk: HSY’s entry into the cookies sector puts the Company squarely up against some powerhouse competitors. Hence, its success is by no means assured.
New Product Introductions: HSY’s ability to continue with its innovation plan and introduce new products holds the key to its long-term growth. / Commodity Food Costs: Commodity costs across all food categories have risen substantially over the past year.
International Opportunity: Management is expanding into the international markets, focusing on Mexico, Brazil, Canada, and Asia. / Hershey Trust: The Hershey Trust controls 78% of the voting power at Hershey, thus the Trust’s interests might be in conflict with those of other shareholders. For example, the Trust may prefer diversification to increased dividends.
Expanding Margins: Numerous initiatives involve expanding margins, such as divesting low margin brands, rationalizing SKUs, and implementing numerous supply chain cost-reduction initiatives. / Mature Industry, Less-than-Healthy Product Line: The secular growth rate of the food business is slowing. Some wonder if the confectionery business can outpace the industry, given the trends toward healthier eating habits.
Strong Financial Position: The Company maintains a sound financial position and has a strong cash flow. Strong cash flow allows management to return value to shareholders in the form of share repurchases and dividends. / Competitive Pressures: The Company is facing incremental competition, due to the challenging consumer marketplace and particularly from the acquisition of Wrigley by the privately-held Mars Inc.
Limited Growth: HSY’s growth could be limited by its too much dependence on its domestic market.
Currency Risk: HSY is exposed to currency risk as the Company invests in international markets,

HSY’s website is: http://www.hersheys.com.

Note: HSY’s fiscal year ends on December 31.

October 26, 2009

Revenue [NOTE: Only highlighted material has been changed]

The Company reported 3Q09 sales of $1,484.1 million versus $1,489.6 million in 3Q08, down 0.4% y/y, as 10%-11% higher prices was offset by lower volume, the discontinuation of Starbucks and Cacao Reserve, and the unfavorable foreign currency exchange rates. According to the Zacks Digest, in 3Q09, sales decreased 0.4% to $1,484.0 million from $1,489.8 million in 3Q08.

U.S. retail takeaway, in channels that account for over 80% of retail business (i.e., food, drugs, mass, convenience, and Wal-Mart) was up 4.8% y/y in 3Q09. The improvement in HSY’s retail takeaways is largely driven by 1) the mainstream, core brands (e.g., Reese’s, Hershey’s, Kit-Kat, and Twizzlers) as sales trends in the premium, gifting, and novelties segments remains lackluster; 2) strong sales growth in non-measured channels, including Wal-Mart as non-measured sales likely increased at 6%-7% relative to 2.7% growth in retail takeaways in the measured channels; and 3) material increase in advertizing.

HSY’s Convenience store (c- stores) results were particularly strong with retail takeaway up 5.8% y/y compared with category growth of 3.8%, which resulted in a market share gain of 0.5% y/y. Specifically, HSY posted strong retail sales growth of 7.3% in chocolate and 9.3% in non-chocolate segments in c-stores owing to price realization, increased distribution of king size bars, and strong in-store selling and merchandising. HSY’s refreshment takeaways in the c-store channel remain weak.

HSY’s US market share in measured channels remained flat during the quarter and improved 0.3% y/y in the first nine months of FY09, due to market share gains in core chocolate and confectionary sugar.

International sales declined 1% y/y in 3Q09 but remained positive on constant currency basis as 1) sales increased double digits in Brazil; 2) confectionary sales increased modestly in Canada and India; and 3) beverage sales declined in Mexico and India.

Outlook

Based on the year-to-date price/volume elasticity trends and brand-building and marketplace initiatives for the remainder of FY09, the Company expects 2009 net sales to grow within 3% and 5% long-term objective. This sales growth reflects expectations for a more modest pricing benefit in 4Q09 due to a compressed Halloween season (owing to the late Labor Day) and shift in a large portion of Valentine’s Day and Easter shipments from December to January. Over the balance of FY09, HSY is accelerating domestic and international investments in consumer capabilities, customer insights and category management techniques that will benefit the Company over the long term.

For FY10, management assumes that the economic environment for consumers in the U.S. and international markets will continue to be challenging. Hence, the Company will continue to focus on and make appropriate investments in core brands and expects 2010 net sales growth to be within 3 to 5% of its long-term objective.

One firm (Stifel Nicolaus) estimates sales growth of over 4% in FY10, which is in line with the Company's guidance range of 3%-5% sales growth for FY10 with over 1% benefit from improved FX rates.

Another firm (Barclays Capital) expects sales growth of 2.5% in 4Q09, based on a stronger 4% organic growth, which resulted from significant pricing (+8%) that will likely be somewhat offset by volume declines (-4%). It also expects that sales growth will be curbed by ongoing brand rationalization (-2%), though favorable currency translation should provide a modest (+0.5%) offset. It believes HSY has considerable flexibility to increase trade spend to ease consumers into higher promotional price points, drive a sequential improvement in volumes, and ensure strong takeaway for its key Halloween period – though a significant increase in promotional activity would curb some of the pricing gains that HSY is likely to see.

Provided below is a summary of revenue as compiled by Zacks Digest:

Revenue ($M) / 3Q08A / 2008A / 2Q09A / 3Q09A / 4Q09E / 2009E / 1Q10E / 2010E
Total Revenue / $1,489.8 / $5,132.9 / $1,171.0 / $1,484.0 / $1,422.7 ↑ / $5,314.3 ↓ / $1,279.8 / $5,512.8 ↓
Digest High / $1,490.0 / $5,133.0 / $1,171.2 / $1,484.1 / $1,472.0 ↑ / $5,364.0 ↓ / $1,289.0 / $5,594.0 ↑
Digest Low / $1,489.6 / $5,132.8 / $1,171.0 / $1,484.0 / $1,395.0 ↑ / $5,287.0↓ / $1,270.6 / $5,383.0↓
YoY Growth / 6.5% / 3.8% / 6.0% / -0.4% / 3.3% / 3.5% / 3.5% / 3.7%
Sequential Growth / 34.8% / -5.3% / 26.7% / -4.1% / -10.0%

Highlights from the revenue table are as follows:

·  For 2009, the estimated revenue ranges from $5,287.0 million to $5,364.0 million with an average of $5,314.3 million (↓ from the previous estimate of $5,363.6 million).

·  For 2010, estimated revenue ranges from $5,383.0 million to $5,594.0 million with an average of $5,512.8 million (↓ from the previous estimate of $5,572.2 million).

Please refer to the Zacks Research Digest spreadsheet on HSY for detailed sales breakdown and future estimates.

Margins [NOTE: Only highlighted material has been changed]

According to the Company, gross margin improved by 480 bps y/y to 39.8% in 3Q09, due to the better price realization, supply chain efficiencies, productivity gains and lower dairy cost, which more than offset approximately 175 basis points of input cost inflation (e.g., raw materials, packaging, and energy) and higher employee benefit costs. HSY’s gross margin improved for the fourth consecutive quarter and increased to the highest level in more than four years. According to the Zacks Digest model, gross profit was $590.1 million in 3Q09, up 13.2% y/y. Gross margin was 39.8% in 3Q09 versus 35.0% in 3Q08.

According to the Company, operating profit was $190.6 million in 3Q09, up 16.0% y/y. HSY’s operating margin expanded by 280 bps y/y to 19.6% in 3Q09. The operating margin improved largely due to pricing benefits, cost savings resulting from the Supply Chain Transformation Program, and productivity gain, which more than offset higher commodity and employee-related costs, including pension expense and 50.0% y/y increase in advertising expense. According, to the Zacks Digest model, operating profit was $290.9 million in 3Q09, up 15.9% y/y. Operating margin was 19.6% in 3Q09 versus 16.8% in 3Q08.