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On December 27th, 2006, I shorted Hershey (NYSE:HSY) at $50.60 per share. This is the first stock that I have decided to short, mainly driven by the following:
  • Canada plant shutdown with a material product recall
  • Lowered guidance twice in the last 6 months
  • Poor financial trends with increasing debt position to buyback shares
  • Lowering advertising budget from 4.0% in 2002 to an estimated 2.5% in 2006
  • Future risk of goodwill/intangible impairments with any additional decreases in revenue
  • Company Background

    The Hershey Company engages in the manufacture, distribution and sale of confectionery, snack, refreshment, and grocery products in the United States and internationally. It principally offers confectionery and snack products in the form of bar goods, bagged items, and boxed items; refreshment products in the form of gum and mints; and grocery products 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. It also offers chocolate products in Brazil under the brand name 'HERSHEY'S'. The company was founded by Milton S. Hershey in 1894. The Hershey Company is based in Hershey, Pennsylvania.

    5 Year Financial Trends

    Nothing exciting when looking at the 5 year financial trends chart for HSY. The revenue line is growing at a rate of 3.7% from 2002-2006 and net income is growing at 7.4% within the same period. The recent guidance from the company is pegging top line growth at ~2.4%. Core business is declining partially offset by the new product launches. Hershey has been experiencing some gross profit erosion due to product mix and raw materials increases. The management has been able to offset these expenses with reductions in the SG&A areas of the business, potentially cutting too much of the advertising expenses.

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    Stock performance

    Investing $10,000 in HSY at the end of 2001 would be worth approximately $16,400 today [as of 12.26.2006]. This represents a 10.4% annual rate of return, 2.4x higher than the S&P 500 benchmark of 4.3%. The stock has captured the majority of the gains in 2003 and 2004, with marginal declines from 2005 through Dec 2006.

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    Value scorecard

    My value scorecard highlights the balance sheet concerns that are supporting my short decision:

  • Increasing debt position over the last 5 years from $880 Million or 64% of book value in 2002 to $2.3 Billion or 275% of book value as of Q3 2006. $190 Million or 15% of the $1.3 Billion in long-term debt is due in 2007.
  • The current market cap of $11.7 Billion is approximately 12.6 multiple from the book value of $830.3 Million as of Q3 2006.
  • The current ratio has been steadily decreasing over the last 5 years from 2.3x in 2002 to 1.0x in Q3 2006
  • Goodwill and Intangibles assets account for 76% of the book value. If sales performance declines, there is a potential exposure of additional asset impairment charges.
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    Growth Potential

    When deriving a price target for HSY, using a straight P/E multiple calculation might not truly reflect some of the liquidity risks that are currently in the stock. HSY has been increasing debt to buyback shares to improve the reported EPS results. For my price target, I am using the discounted cash flow method, resulting in an enterprise value of $9.5 Billion or $40.94 per share. Here are my assumptions:

    Revenue annual growth of 3.5% to $5.7 Billion in 2010 (consistent with management long-term rates and analyst consensus)

  • Free Cash Flow as a % to Revenue of 15%. HSY has averaged approximately 9.4% from 2002-2006.
  • Weighted Average Cost of Capital of 10%
  • Terminal Growth Rate of 4%
  • Q3 2006 Net Debt of $2.2 Billion
  • Understanding that my price objective is based on a few assumptions, I have provided a two-way sensitivity analysis on FCF % to sales vs. terminal growth rate to provide some additional safety.

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    Disclosure: Author is short Hershey (HSY) stock

    Source: Hershey Leaves a Bad Taste For Shareholders