Many of my recent dividend articles focused on European stocks as that has been the subject of most of my dividend stock purchases since Summer of 2015. I typically buy one stock a month, using fresh cash and my dividends to gradually build up my dividend portfolio.
This time I'm taking a look at a US stock as I recently initiated a position in Hershey (NYSE:HSY). Before the release of the most recent earnings report, Hershey drifted lower and lower, making the stock hard to ignore as I found this to be a good entry point to initiate a position as a long-term holding.
I like stuffing my portfolio with companies like Hershey for a variety of reasons. The business model is easy to understand, Hershey has a lot of brand power and a decent moat, its chocolate bars and candies will likely still be in high demand decades from now, and the company could potentially be run by fools without suffering all too greatly. Plus, owning a tiny piece of a chocolate factory just feels good.
Image source: Hershey
122 years of chocolate making
The Hershey Company was founded in Lancaster, Pennsylvania, in 1894 by confectioner Milton S. Hershey. The original Hershey Chocolate Company was a wholly owned subsidiary of Milton Hershey's Lancaster Caramel Company, it manufactured chocolate coatings for the parent company's caramel candy, as well as chocolate and cocoa products for baking.
Several years later Hershey allegedly said, "Caramels are just a fad, but chocolate is a permanent thing," and sold his caramel business for $1 million to focus exclusively on chocolate.
Hershey sold milk chocolate in bars, wafers and other shapes, and came up with a new production process to make chocolate available for the masses. As sales took off, Hershey build a new factory and came up with innovative products, including the firm's famous Kisses.
The Hershey Chocolate Company went public in 1927, and over the coming decades, it acquired a wide variety of other companies and assets, including cross-town partner H.B. Reese Candy Company, Nabisco's mint and gum business, premium chocolate brand Scharffen Berger, Brookside, and Krave Jerky. Additionally, it also purchased the US rights to manufacture and market popular chocolate candy like KitKat (now owned by Nestlé (OTCPK:NSRGY)) and Cadbury (part of Mondelez (NASDAQ:MDLZ)). For several decades, Hershey even had pasta businesses but this group was divested in 1999.
Today, Hershey is the largest maker of chocolate in North America, it sells over 80 brands and sells products in around 70 countries.
Image source: Hershey
Mostly limited to North America, global expansion ongoing but troubled
While Hershey is ubiquitous in the US, it's fairly unknown in most parts of the world. The company pulled in sales of $7.39 billion in 2015, but just 12.4 percent of this was generated outside the US - and at much lower margins. That's quite low as international revenues account for about one-third of S&P 500 sales, and much more than that for companies like Coca Cola (NYSE:KO).
Contrary to big rivals like Mars and Mondelez, Hershey really neglected the international market. I live in Europe and can confirm that Hershey's products are virtually non-existent here as the company has no distribution in Europe. Perhaps the company missed a big opportunity here, as Hershey used to have some brand recognition in many parts of the world after the second world war.
Hershey manufactured chocolate ration bars for the US Army and supplied over three billion bars to servicemen. Soldiers handed out many Hershey bars to civilians, who received it as a gift or traded other items for it. In the history books, you can find stories about Der Schokoladenflieger (the Chocolate Flier), the most well-known symbol of the Berlin Airlift. This plane dropped Hershey bars and other candy over Berlin during the Berlin Blockade.
According to the stories, Hershey's chocolate bars were very desirable item for hungry kids and adults. They tasted pretty awful, though, as the army ration bars were manufactured to quite specific requirements, it was not intended to be candy but served as a sort of foul-tasting energy bar.
The ration bars had several requirements; they needed to weigh about four ounces, be high in food energy value, and have a melting point of 120 degrees Fahrenheit. The most peculiar requirement for Hershey was that the Army required a chocolate bar that did not taste good, so soldiers wouldn't be tempted to eat it except in an emergency. The end result was a block of hard chocolate that didn't really taste that well.
After the war, Hershey conquered the US market but failed to capitalize on the brand power the American soldiers had build across Europe. Perhaps this was a historical mistake, nowadays it would be very hard to break into the European market due to high competition. And there's also the issue of the sour taste, Hershey's chocolate is sort of an acquired taste (and smell). Europeans who didn't grow up on Hershey's candy are unlikely to crave it because it tastes significantly different than most European-made chocolate.
Image source: Hershey
Perhaps this is why Hershey is predominantly focusing its international effort on markets like China, Mexico and Brazil, via a series of joint ventures and acquisitions.
In 2014, Hershey bought a 80 percent stake in Shanghai Golden Monkey, a Chinese confectionery and snack brand company, to broaden its footprint in China. It spent $394 million on this purchase, but not even a year later Hershey took a $280.8 million goodwill impairment charge as Golden Monkey's net sales and profitability were far lower than initial expectations, and the supply chain not as good as anticipated.
Hershey remains optimistic about the potential of the Chinese market and plans to acquire the remaining 20 percent stake of Golden Monkey later this quarter. Once this is done, Hershey can get to work on integrating the company and optimize it for top line growth.
In the United States, Hershey is going through slow sales growth, but overall, it continues to do well. It's the leader in many of its target markets. In the total confectionery market, Hershey has a market share of 31.3 percent, a close match with the 29.1 percent of privately-held Mars, and much higher than the 5.4 percent held by Mondelez, the third largest company in the US confectionery market.
Hersey is even stronger in the chocolate market, it owns 44.4 percent of this market, versus 28.9 percent for Mars and 9.5 percent for Lindt (OTCPK:LDSVF). In the US, it is also the second largest company in the non-chocolate candy market (15.0 percent market share), the third largest in the gum market (5.3 percent market share) and the largest breath freshener mint maker (40.6 percent market share).
Image source: Hershey
The controlling interest of the Hershey Trust Company
Hershey has a dual-class stock structure, the common shares you can buy on the stock exchange carry one vote for each share, while the Class B stock gives right to 10 votes per share.
There are over 156 million common Hershey shares and 60.62 million Class B shares so the B class holds three-fourths of the voting power. Virtually all B class shares plus a sizeable amount of common shares are held by the Hershey Trust Company so private investors have no real power in this company. In return, the common shares get a 10 percent higher dividend than the B class shares.
The Hershey Trust Company is the trustee for the Milton Hershey School, a private school Milton Hershey and his wife created in 1909. The Milton Hershey School provides cost-free, high-quality education to over 2,000 students in pre-kindergarten through 12th grade. Originally, it was a school for orphan boys, but nowadays the focus is on children from disadvantaged families. Thanks to the continued success of Hershey and its non-stop stream of dividends, it is the richest grade school in the world.
Over a decade ago, the Trust considered selling its stake to diversify, but the auction got halted as the Trust faced a public outcry as well as stiff resistance from the Pennsylvania attorney general. The main takeaway here is that a potential takeover of Hershey is not as straightforward as with other companies, if not highly unlikely.
Image source: Milton Hershey School
Hershey's dividend policy
In terms of cash flow priorities, Hershey's first goal is to invest to grow its business, both organically and via M&A. Dividends come second and share buybacks come third.
Hershey has a target payout ratio of about 50 percent, and although the historical dividend track record is excellent, I was unable to find a written commitment to a progressive dividend policy. It is not a Dividend Aristocrat because it froze its dividend in 2009, it currently has six consecutive years of dividend growth. Before 2009's dividend freeze, Hershey was a Dividend Aristocrat with 33 years of consecutive dividend increases.
Dividends are paid quarterly, the payments hit your account around the middle of March, June, September and December. In recent years, Hershey increased its dividend in July or August, but if we look at the historical data there's not really a fixed paradigm.
At the moment, Hershey is trading at a dividend yield of 2.62 percent, above its historical average.
Hershey dividend history
While Hershey has a very long dividend track record, most of the dividend data is not readily accessible. The company's website does not go back beyond 1997, but the best data I could get my hands on dates back to 1977, which is enough to get a grip the firm's long-term earnings power. All figures below were adjusted for the stock splits of 1983, 1986, 1996 and 2004.
As mentioned above, the dividend track record of Hershey is very good, the only blemish is the dividend freeze from 2009. It seems the company just wanted to be prudent, its non-GAAP EPS dipped from $1.93 in 2007 to $1.76 in 2008, but hit $2.23 in 2009. At the same time, Hershey also went through a three-year supply chain transformation that cost around $630 million.
Since 1977, distributions have increased from $0.0475 to $2.236, which corresponds to a compound annual growth rate of 10.67 percent! The 10-year growth rate is an equally impressive 9.17 percent and the 5-year growth rate stands at 11.80 percent. Given the continued high dividend growth, the 2009 dividend freeze is easily forgiven.
Below is a chart with all quarterly dividend payouts since 1977. As I mentioned above, the dividend increase usually coincides with the third-quarter earnings report, but it's not an ironclad rule as the company has frequently deviated from this pattern.
You can also see that the dividend freeze during the financial crisis was quite long; Hershey stuck to a quarterly dividend of $0.2975 for ten consecutive quarters. Also worth mentioning is that Hershey declared a special dividend in 1990; I excluded this from the charts because it was a one-off extra dividend.
|1990||0.048750||0.048750||0.05625 + 0.0375*||0.056250||0.247500||*special dividend|
Dividend payout ratio history
Hershey has a dividend payout ratio target of 50 percent. The actual dividend payout ratio for 2015 was 54.3 percent so perhaps this indicates this year's dividend increase won't be significant unless growth picks up significantly. At this level, the dividend is very secure and it's also well covered by free cash flow.
The dividend payout ratio has steadily increased over the last quarter century, from 38.7 percent in 1990 to a peak of 63.3 percent in 2008. If the company maintained a payout ratio of 38.7 percent like in 1990, its compound annual dividend growth rate would have been 8.44 percent instead of the actual 9.92 percent.
Here's a chart showing the total annual dividend payouts, as well as the dividend growth rate and payout ratio.
|Year||Dividend||YoY change in percent||Payout ratio in percent||Notes|
|1990||0.2475000*||13.51||38.7||*includes special one-off dividend|
Hershey returns value to the shareholder via dividends and share buybacks. Last week, the Hershey Board of Directors approved an additional $500 million stock repurchase authorization. Over the years, the share buybacks have resulted in a very meaningful decrease in the number of outstanding shares; split-adjusted, the figure has declined from 360.75 million shares in 1987 to 216.79 million shares in 2016, a reduction of 1.80 percent per year!
Several of the largest reductions were achieved via repurchase deals with the Hershey Trust, which occurred in 1995, 1997, 1999 and 2004.
The last 5-10 years Hershey repurchased shares at a slower pace than in the previous decade. Since 2005, the share count declined at an annualized rate of around 0.9 percent as there were no buybacks in 2008-2010 nor 2013.
Recent business performance
Hershey's shares drifted lower throughout 2015 and hit a 52-week low of $82.41 before the fourth-quarter earnings release. The stock has a low beta of 0.26, but this has been of little solace to investors who bought a year ago as Hershey is now trading around 20 percent under its all-time high. Among other things, the stock got punished due to weak sales growth, unfavorable currency rates, lower expectations about future growth, the poor performance of Shanghai Golden Monkey, and fears about a change of taste towards healthier alternatives.
HSY data by YCharts
Hershey announced full-year 2015 adjusted earnings of $4.12, giving it a P/E ratio of 21.57. The forward P/E chart illustrates that most of the overvaluation of Hershey burned off as the stock went through a P/E compression.
HSY PE Ratio (Forward) data by YCharts
It is not bargain bin cheap at this level, but I think it makes sense here for a long-term holding. At the moment, Hershey is trading at a fairly attractive dividend yield of 2.62 percent, a level not seen since early 2011.
Full-year 2015 revenue declined 0.5 percent to $7.39 billion, primarily due to currency and overseas woes. North American sales rose 1.8 percent year over year to $6.47 billion, whereas International and Other revenue fell 14.1 percent year-over-year to $918.47 million.
Zooming in on the fourth-quarter data, North American sales rose just 0.2 percent, whereas the International sales collapsed 26.8 percent, resulting in a fourth-quarter revenue decline of 5.0 percent. Adjusted earnings per share rose from $3.98 in 2014 to $4.12 in 2015. Reported EPS was a lot lower than the year before due to a $1.28 per share asset impairment charge on the Chinese assets, which results in a much higher P/E being shown by most financial sites.
While the big revenue decline is worrying, there's a very stark difference in profitability between the North American and International sales. Segment income for North America rose 8.2 percent year over year to $2.07 billion and this division operated at a 32.1 percent sector margin, whereas International and Other revenue operated at a $98.07 million loss, versus a tiny $40.0 million profit the year before. Total group margins increased from 45.0 percent in 2014 to 45.8 percent in 2015.
Hershey carries around $1.92 billion in financial debt on its balance sheet, resulting in a high debt-to-equity ratio versus the $1.05 billion in shareholder equity. It does have $346.53 million in cash and cash equivalents, and the debt-to-adjusted EBITDA ratio is very healthy. The last couple of years the debt to adjusted EBITDA followed a range of 1.2 to 1.5, below Hershey's target range of 1.5 to 2.0, so the debt burden is very manageable.
One thing Hershey excels in is delivering continued high return on equity, usually in the mid to high double-digit range. Last year, Hershey achieved a ROE of 48.97 percent, down from 54.85 percent in 2014. A very significant portion of this high ROE is derived from the use of leverage in the company. For comparison, Mondelez delivered a return on equity of just 7.27 percent in 2014. Furthermore, Hershey also delivers impressive return on capital ratios, typically in the 20-25% range.
The healthy balance sheet, the powerful brand name and the strength of the underlying business are all good reasons why investors want to pay a little premium for Hershey's shares.
Image source: Hershey
For 2016, Hershey anticipates constant currency net sales growth of around 3 percent and adjusted earnings per share growth of around 6 percent. The EPS forecast of $4.36 to $4.38 per share is in line with analyst estimates, which call for 2016 EPS of $4.35.
Over the long term, Hershey anticipates it can achieve constant currency net sales growth of 3 to 5 percent. The company recently downgraded its long-term EPS growth rate from a range of 9 to 11 percent to a range of 6 to 8 percent, reflecting the growing pains it is going through.
If the company can achieve these goals, investors can expect many more sweet dividend increases. The global markets remain volatile, though, and it will be interesting to see if Hershey can get its international expansion off the ground. The international division is still very weak but Hershey has high hopes about the fast-growing Chinese market. Previously, Hershey aimed to achieve $2.0 billion in international sales by 2019, but given the Chinese issues that target will be hard to hit.
The next dividend hike will likely be announced when Hershey presents its Q2 2016 results. It's still half a year to go, but I don't think it will be more than a mid single-digit increase this year.
After several years of high valuation, Hershey is once again trading at a level close to fair valuation. The P/E compressed significantly as the company is facing some issues like growing pains in international markets and slowing growth in its home market. It is not cheap at this level, but I think that 20-30 years from now, it will not matter greatly whether you paid $80 or $90 for this high-quality company. Hershey is a great compounding engine that will likely keep rewarding long-term holders for many decades to come.
If you've enjoyed this article about Hershey, please click the "Follow" button and check out some of my previous articles:
How long have you held Hershey shares? Are you considering to add more shares at these levels, or will you be initiating a position soon? Share your thoughts below.
Disclosure: I am/we are long HSY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.