Hershey Hurts in Move Away from Core Chocolate

Hershey (HSY) is the largest U.S. maker of chocolate and non-chocolate confectionery products. It has very well known brands such as Hershey’s Kisses, Reese’s, KitKat, Twizzlers, Jolly Ranchers, Ice Breakers, Bubble Yum, etc. The company generated approximately $0.56M in net income on $5B in sales this past year.

Hershey’s stock price though has been in a funk and is down approximately 23% since its peak in mid-2005 and closed today at $50.81. Hershey recently reported another weak quarter missing earnings estimates the second time in a row and reporting about 1% decline in sales. The company is facing challenges to include increased competition, weakness in its core brands, a poorly executed transition to “new product platforms,” and a weak international presence.

The company has three main competitors within the U.S., Cadbury Schweppes PLC (CSG), Nestle SA (NSRGY), which trades as ADRs, and Mars, which is privately held. All three companies have larger market capitalizations and greater total sales than Hershey. A number of other competitors overlap with Hershey in certain market segments but do not compete in all areas. Although the total number of competitors is small, competition is fierce as all the companies spend heavily on marketing and advertising, developing line extensions and special edition products.

Hershey’s brand troubles stem from moving away from its core chocolate and non-chocolate confectionery products to “new growth platforms.” Hershey historically grew incrementally though line extensions and special edition products. Recently, though, the company is trying to expand its brands to Dark and Premium Chocolate, Refreshment (gum and mints), Substantial Snacks (cookies, brownies, nuts, and trail mix), and Health & Wellness (organics and small serving sizes). In doing so, however, Hershey reduced its advertising and marketing spending on its core products, which negatively affected sales and earnings growth.

The company’s balance sheet is also weaker, with increasing short and long-term debt. At the end of last quarter the company had approximately $3.7B in total debt, an increase of $1.4B from the end of 2003. Since the company normally carries less than $100M in cash on its balance sheet, some of the increase in debt was likely due to the purchase of the premium chocolate brands Scharffen Berger, Joseph Schmidt, and Dagoba Organic. Some of the debt, though, seems to be going towards share repurchases. This, however, is not abnormal, as Hershey has used debt in the past to purchase shares from the Milton Hershey Trust.

To return to its historical steady growth Hershey will first have to invest more in its core brands. Chocolates and other confectionery products are mostly an impulse purchase, meaning the product must be in the mind of the purchaser. A reduction in advertising will logically lead to lower sales. Second, Hershey must execute the development of its new “product platforms” better. The company seems to have started several growth initiatives simultaneously and is unable to focus adequately on any single one. Third, the company will need to expand internationally through acquisitions or joint ventures such as the recent one with Lotte in China, South Korea, and Japan.

Hershey is undervalued when compared to historical valuation metrics. For example, the dividend yield is currently 2.1% a level not seen since the mid 90’s. The trailing price-to-earnings [PE] ratio is 21.7 while the forward PE ratio is 18.3. Again, these are approaching values seen in the mid 90’s. Although Hershey may be undervalued, I believe that the stock price will continue to weaken in the near term. The company simply went away from what it did best and is having trouble finding traction in its new business strategy. Ultimately it may take a management change to properly refocus Hershey and increase the stock price.

Disclosure: The author does not have a position in any stocks discussed at the time of writing.

HSY 1-yr chart