The food processing industry can best be described as a defensive play with stable revenue and earnings. The industries end product is food which end user demand is inelastic irrespective of economic condition. You may see show trading down, say expensive proteins (steak, veal chops etc) for less fare (chicken and pork) yet demand stays roughly the same. With the above definition in mind, earnings growth and predictability should be fairly straight forward which makes the industry a perfect candidate for WACC (Weighted average cost of capital) and DCF (discounted cash flow) analysis. In the article below, I will present my figures for Hershey's (NYSE:HSY), in my opinion the best choice in the industry.
I would like to begin with a brief discussion as to why I choose certain values in my calculations. The risk free rate was imputed as 3% which is still much higher than a 10 year U.S. treasury bond. I am hard pressed to find a higher risk free rate than this in the world today. The low interest rates as any retiree will gladly point out to you are byproducts of the Federal Reserve's attempt to jump start the U.S. economy. For stellar companies such as HSY it has lowered the borrowing costs to very low levels which have enabled them to grow.
I would like to draw your attention to the cost of debt input which is tabulated at 5% currently. HSY longest dated outstanding debt current coupon is 3.55%, which expires in 2027. I would like to draw your attention to just how accommodating the debt market is too well established companies such as HSY. The final number chooses was a WACC of 8% which given HSY stable business model and its significant name recognition is warranted in my opinion.
I would like to draw your attention to the DCF analysis chart listed above. The first number I would like to highlight is the sales growth number. HSY growth rate in sales has averaged 6.5% over the past 10 years and 6% over the past five years. The numbers I used are lower to add a further margin of safety to my projection.
The margin growth rate is also a tad on the conservative side as well. HSY margin has grown over the past five years at a fairly steady clip. In my model, I had zero margin growth in the 2016-2018 time frames. HSY just handed down price hikes due to the rising cost of raw materials which will have a positive impact on margins in 2015. I suspect my margin estimates will be proven too conservative which adds a further margin of safety to my projections.
Based on my calculations, a fair value for HSY is $116.86 a significant discount to its current market price. The conservative investor will look to purchase at a bargain to its implied value, the question is how much of a bargain. In my opinion a 20-25% discount to its model price implies a purchase price of 87.65 to 93.48. Naturally, the lower the price the more advantageous of an entry point. I entered into a position at $88.20; a price I believe is more than fair for such a wonderful company.
Quite a few will initially scoff at this projection and dismiss it out of hand, stating the famed P/E ratio is too high. The market consistently applies an above average P/E to HSY due to its industry leading metrics such as return on equity and return on total capital. What the market is saying here is you have a high quality, easily predictable company that simply won't go on sale. Just for a point of reference, HSY P/E was 16.9 during the height of the market meltdown in 2009 when every security was getting decimated. A better metric to use is the 10 year P/E average to get a gauge if the company is currently expensive or a relative bargain. In HSY case, the ten year average is 21.36, when applied to next year's earnings estimate it nets out a price of 97.18 which is slightly higher than the top end of the range using the DCF analysis.
In conclusion, HSY offers quite a compelling value proposition for the dividend growth investor. HSY has a virtually unassailable business position which allows for a rather predictable earnings and dividend growth. I view HSY as a forever holding and plan on simply sitting back and allowing the dividend to compound. I would like to offer special thank you to Matt Hogan with Levered Returns for giving me access to the wonderful charts you see in the article. I would also like to thank the reader for taking the time to read the article and I await your comments.
Disclosure: The author is long HSY.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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