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Hershey Co. (NYSE:HSY)

Q3 2007 Earnings Call

October 18, 2007 8:30 am ET

Executives

Mark Pogharian – IR

Richard Lenny – Chairman, CEO

Bert Alfonso - CFO

David West - COO

Analysts

Robert Moskow - Credit Suisse

Jonathan Feeney - Wachovia Securities

David Palmer - UBS

Vincent Andrews - Morgan Stanley

Christine McCracken - ClevelandResearch

Eric Katzman - Deutsche Bank

Terry Bivens - Bear Stearns

Eric Serotta - Merrill Lynch

Steven Kron - Goldman Sachs

David Driscoll - Citi

Alexia Howard - SanfordBernstein

James Amoroso - Helvea

Andrew Lazar - Lehman Brothers

Pablo Zuanic – JP Morgan

Operator

I would like to welcome everyone to the Hershey Companythird quarter 2007 results conference call. (Operator Instructions) Mr.Pogharian, you may begin your conference.

Mark Pogharian

Thank you, Phyllis and good morning, ladies and gentlemen.Welcome to the Hershey Company's third quarter conference call. Richard Lenny,Chairman and CEO; David West, President; Bert Alfonso, Senior Vice Presidentand CFO; and I will represent Hershey on this morning's call.

We welcome those of you listening via the webcast.

Let me remind everyone listening that today's conferencecall may contain statements which are forward-looking. These statements arebased on current expectations, which are subject to risk and uncertainty.Actual results may vary materially from those contained in the forward-lookingstatements, because of factors such as those listed in this morning's pressrelease and in our 10-K for 2006 filed with the SEC. If you have not seen thepress release, a copy is posted on our corporate website www.Hersheys.com inthe Investor Relations section.

Included in the press release are consolidated balance sheetand summary of consolidated statements of income prepared in accordance withGAAP, as well as our pro forma summary of consolidated statements of income,quantitatively reconciled to GAAP. As we've said in the press release, the companyuses these non-GAAP measures as key metrics for evaluating performanceinternally.

These non-GAAP measures are not intended to replace thepresentation of financial results in accordance with GAAP. Rather, the companybelieves the presentation of earnings excluding certain items providesadditional information to investors to facilitate the comparison of past andpresent operations.

We will discuss our third quarter results of 2007 and 2006excluding net pretax charges associated with our previously announced businessrealignment initiative to advance the company's value-enhancing strategy. Theseare net pretax charges of $151.9 million in the third quarter of 2007 and $1.1 million in the third quarter of2006. Our discussion of year-to-date results and any future projections willalso exclude the impact of net charges related to these business realignmentinitiatives.

With that, let me turn the call over to Richard Lenny.

Richard Lenny

Thanks, Mark. The third quarter, while below expectations intotal, did experience good progress in key aspects of our business, mostnotably a strong improvement in our chocolate business. Through a combinationof increased investment and improved retail execution, retail takeaway onHershey's core chocolate business increased by 6%, led by our top four brands,which had a combined gain of 8%. Additional improvements in trend were achievedin convenience stores and loose bars. This performance drove a 3.5% increase intotal retail takeaway with improvement across all classes of trade.

However, category innovation within dark chocolate andrefreshment, as well as strong competitive activity, curtailed thisperformance. Market share in reported channels decreased by 1.1 points withhalf of this decline in refreshment. Net sales off 1% were impacted by areduction in inventory levels within certain customers and classes of trade andthe fall off in previously introduced new items. Lower sales and the impact ofhigher commodity costs, primarily dairy, resulted in diluted earnings per sharefrom operations of $0.68.

Importantly, good progress was made on Hershey's strategicpriorities of disciplined global expansion and the supply chain transformation.Both of these initiatives will enable Hershey to more broadly participate inglobal category growth and ensure that margins expand sufficiently to invest inour brands and selling capabilities, regardless of the market.

As we move into the fourth quarter, we do anticipate furthergains in the marketplace behind selected new items, a significant step-up inconsumer and customer support, and a double-digit increase in retail coverage.However, the competitive activity and inventory tightening levels experiencedduring the third quarter will persist through year end.

Therefore, full-year net sales are expected to decline byabout 1%, with 2007 diluted earnings per share from operations to be within the$2.08 to $2.12 range. Bert will provide the details of the third quarter andyear-to-date performance; Dave will then discuss major growth plans for thebalance of 2007 and early 2008.

Bert Alfonso

Thank you, Rick, and good morning, everyone. Consolidatednet sales in the third quarter of $1.4 billion came in 1.2% below the prioryear. Diluted EPS from operations of $0.68 declined 13%, primarily due tohigher commodity costs, increased consumer investment spending, and unfavorablemix due to lower shipments to select distributors.

Net sales for the quarter, excluding the benefit of theGodrej acquisition, were down 2.7%. This reflected a combined net decline involumes and negative price realization of around 3 points.

The pricing action announced in the U.S.in April had little impact in the quarter, as we protected previously agreed topromotional price points. Additionally, trade promotion increased in thequarter behind successful coupon offers that generated trial of select newitems, notably Cacao Reserve and Ice Breakers.

The decline in volume reflects gains in our internationaland artisan businesses, which were more than offset by the decline in the U.S.While retail takeaway increased in the quarter, shipments decreased to selectdistributors, as velocity at retail did not keep pace with historical patterns.Furthermore, due to deteriorating credit markets, distributors have beenfocused on improving working capitals.

Turning now to marketplace performance, Hershey's retail takeawayin the quarter was ahead of shipments. Consumer takeaway for the 12 weeks endedSeptember 9, 2007 inchannels that account for over 80% of our retail businesses was up 3.5%. As areminder, these channels include food, drug, mass, Wal-Mart and conveniencestores.

Note that we continue to execute well in other non-measuredchannels such as dollar stores and importantly, Wal-Mart. In the FDMxC classesof trade, retail takeaway was up 0.5%, while we lost 1.1 share points in thelatest 12 weeks; it was a 40 basis point sequential improvement.

Our core chocolate franchises, Hershey's, Reese's, andKisses, were up in the quarter, driven by programming behind Reese's Elvis LimitedEdition, the Kisses 100th anniversary promotion and Cacao Reserve trial drivingcoupons. Increased investment spending on the core drove takeaway, which was up11% on these brands in FDMxCW channels.

The Reese’s Elvis Limited Edition and related programmingdid lead to an increase in quality merchandising in the quarter. This wasprimarily responsible for the positive C-store take away, up 0.5%, a 20 basispoint sequential improvement in total market share. Total C-store share was off1.1 points, about half of the decline accounted for by refreshments. In the twofour-week periods, Hershey Chocolate takeaway in the C-store channel has keptpace with the category, with share about flat.

Turning now to gross margins, during the third quarter grossmargin was down 220 basis points, primarily due to higher commodity costs.Specifically, dairy costs were up markedly and have remained at a high level.While dairy costs are higher, they are tracking relatively in line with ourmidyear assessment. We continue to believe that dairy will somewhat subside inthe fourth quarter.

In the third quarter, the total commodity cost negativeimpact on gross margins was about 280 basis points. While annual productivityinitiatives are on track and will exceed the prior year, these savings are morethan offset by higher input costs and unfavorable mix due to lower single-serveshipment softness. Net obsolescence costs were at normal rates in the quart andthey were favorable year-over-year.

The Godrej India business and Lotte manufacturing jointventure are operating effectively, and they did not have a material impact ongross margin or EBIT in the third quarter.

EBIT margin for the quarter was down 280 basis points, asselling, marketing and administrative costs increased about 3% versus the prioryear. Lower G&A incentives and consumer promotions were more than offset byhigher advertising and selling expense, including added retail coverage thatbegan in Q3 and will benefit 2008.

Advertising was up 8% in Q3 and was significantly increasedin Q4 by more than 25%, as we increased brand support during the upcomingHalloween and holiday periods. Consumer promotion decline in the quarter, asthese funds were shifted to coupon spend to drive trial. As a result, they areaccounted for as trade promotion versus marketing expense. Total brand spendingin the quarter -- advertising, consumer promotion, and the coupon portion oftrade promotion -- was up 7% versus prior year.

Moving down the P&L, interest expense increased, comingin at $33 million versus $32 million in last year's third quarter, reflectinghigher short-term borrowings to fund the JV investments, $150 million of the$250 million repurchase program initiated earlier in the year. Borrowing costswere mitigated by improved working capital, which I will touch on later.

The tax rate for Q3 was 36.5%, slightly higher than theprior year. For the full year, we estimate that the tax rate will be 36%.Please note that on a quarterly and year-to-date basis, the reported tax rateis lower than the pro forma, due to the higher tax rate applicable to thesupply chain realignment charges.

The weighted average shares outstanding on a diluted basisfor the quarter were 230.4 million versus 237.7 million versus last year's 2006third quarter, leading to an EPS of $0.68 per share diluted from operations,down 13% versus year-ago.

Now, a quick recap of the year-to-date pro forma results.Net sales were flat or down, about 1%, excluding the Godrej Hershey JVacquisition in India.EBIT from operations declined 10%, with EBIT margin down 200 basis points to 18%from 20%. SM& A, while lower by $5.6 million, was roughly in line withyear-ago as a percent of net sales. Higher advertising and selling expenseswere offset by tight cost control and lower incentive compensation expense.

Gross margin at 36.1% year-to-date versus 38.3% last yearwas primarily due to increased input costs. Normal productivity, thoseexclusive of the global supply chain, are on track and running ahead of lastyear. This has helped offset higher commodity and volume mix challenges.Earnings per share diluted from operations declined 9.4% to $1.54 per share.

Turning now to the balance sheet, at the end of the thirdquarter, net trading capital decreased versus the end of last year's thirdquarter, resulting in an improvement of $142 million. Accounts receivabledecreased $42 million and remains extremely current and of high quality.Inventories were lower by $11 million compared to the third quarter last yearand accounts payable increased by $88 million.

The improvement in working capital reflects 2007 planningprograms to improve our sales and operations planning process and to manage ourdays payables.

In terms of other specific cash flow items, during thequarter, capital additions including software were $45 million. Year-to-datecapital spending is $128 million. For 2007, capital additions are targeted tobe within the $200 million to $210 million range. This is below the initialestimate of $250 million to $300 million due to the timing of projects relatedto the global supply chain transformation.

Depreciation and amortization were $84 million in thequarter. This includes accelerated depreciation related to the global supplychain transformation of $33 million. Operating depreciation and amortizationwere about $50 million in the quarter and should be in the $200 million to $210million range for the full year.

We paid dividends during the second quarter of $66 millionand we spent $50 million for 1.1 million shares in our share repurchase programduring the third quarter. This leaves $100 million outstanding on the currentauthorization that the board approved in December 2006.

Shares acquired through our repurchase programs are held astreasury shares. In addition, during the quarter, we purchased $1.5 million ofour common stock shares in the open market to replace shares in connection withemployees exercising stock options. Our goal is to repurchase all such shares.

Finally, we made a $20 million equity payment related to thepurchase and installation of manufacturing equipment into the Lotte jointventure in China.This brings our total investment in this venture to approximately $38 million.Our manufacturing joint venture in Chinais on track and producing product, specifically we're manufacturing Kisses,Nuggets, and chocolate bars in anticipation of demand related to the holidayseason. We have also began discussions with Lotte about distribution andselling of Hershey products in South Koreaand Japan.We'll have more to share with you on these prospects in the future.

The Godrej-Hershey joint venture in Indiais progressing as planned. We are leveraging our confectionary R&Dexpertise and go-to-market capabilities as we focus on business growth andprofitability. Our investment in manufacturing is on schedule and more thanadequate to support the upcoming launch of the Hershey branded products in India.

Now, for an update on the global supply chain transformationannounced back earlier this year in February. During the quarter, totalbusiness realignment charges of $152 million pretax were recorded. This reducedearnings per share by $0.41 for the quarter. We recorded $38 million in cost ofsales consisting of accelerated depreciation and inventory reductions. The $2.4million recorded SM&A reflects program management costs.

The $112 million on the restructuring line in the P&Lincludes $104 million related to employee costs, and $8 million in assetwrite-offs and contract terminations. On a year-to-date basis, pretax expensesrelated to this program totaled $317 million, or $0.85 per share diluted on areported basis.

For 2007, our initial estimates are to report GAAP chargesof about $270 million to $300 million, or $0.75 to $0.84 per share diluted.However, we are running ahead of schedule and now expect that we will recognize$380 million to $400 million in 2007 project costs or $1.03 to $1.08 per sharediluted.

Specifically, the increases result from a greater thananticipated number of impacted employees volunteering for the early retirementpackage. While these employees will be working through the first half of 2008, GAAPrequires that we recognize the expense when the employee commits to aretirement date. This is an accounting change only and does not impact cashflow or the total cost of the global supply chain transformation.

Our estimate of total pre-tax charges and non-recurringproject implementation costs remain in the $525 million to $575 million range,including project management and start-up costs of approximately $50 million.

For the remainder of the year, our plans are on track forthe global supply chain project to deliver $15 million in savings. Theconstruction of the new facility in Monterreyis on track and production is scheduled to begin during the first quarter of2008.

Let me comment now on the rest of 2007 and 2008. During thefourth quarter, our investment in consumer and customer programming will be up markedly.Furthermore, selling expense will increase as the additional sales associatesrequired to enhance retail coverage are now on board. Total retail coveragehours in Q4 will be more than double in grocery and up double-digits inconvenience stores. These efforts will result in sequential improvement inmarketplace performance.

However, the competitive activity has increased and willimpact retail velocity and shipments in select distributors. Therefore, weexpect organic net sales for '07 to be decreasing about 1%. Profitability willbe impacted by unfavorable mix related to lower single serve shipments, higherdairy and commodity costs and increased business investment. As a result, weknow anticipate full-year diluted earnings from operations in the range of$2.08 to $2.12.

In 2008 we remain committed to increasing consumer andcustomer programming. We are currently reviewing plans that will include higherinvestment spend on the core, as well as in our dark and premium platforms.This spending will have a positive impact on market share and we expectsequential improvement throughout the year.

At the same time, our major input costs remain volatile andwill be higher next year. Therefore, we'll provide further details on the company'sfull year 2008 financial objectives in January.

Let me turn it over to Dave now, who will talk about somespecifics about our business.

David West

As Burt highlighted, Q3 results were not up to ourexpectations. While we are not pleased with the company's overall financial andmarket share performance, progress has been made -- albeit more slowly than wehad anticipated. Importantly, Hershey's takeaway improved significantly in thethird quarter. In the food, drug and mass, including Wal-Mart and convenienceuniverse, our takeaway in the 12 weeks ending September 9 was up 3.5%, a 4 pointimprovement over the 12 weeks ending June 17.

Importantly, this reflects an improvement in each of theclasses of trade. This was driven by several key factors, the first being supportbehind our four core chocolate brands -- Reese’s, Hershey's, Kisses and Kit Kat-- which posted an aggregate 8% gain in retail takeaway in Q3. Improvedadvertising support continues to benefit these brands and line extensions suchas Reese's Crispy Crunchy are working.

For the first time this year, quality merchandising was upin the quarter driven by Reese's Elvis, S'mores and Kisses 100th anniversaryactivity. This reflects increased retail resources which were added and focusedon the food class of trade during the quarter and have begun to make an impact.

We also invested more in trade promotion and trial-drivingcoupons to ensure we were competitive in the market on our key brands. We willcontinue this type of support into Q4. All this drove total chocolate takeawayacceleration in Q3, posting its best performance to date as chocolate marketshare sequentially improved by 80 basis points.

While progress was made in the marketplace and in corechocolate in particular, the advances were not reflected in shipments, with netsales down 2.5% excluding the Godrej India JV.

Several factors impacted revenue during the quarter. First,the credit crunch combined with year-to-date sluggish C-store and then takeawayled to inventory destocking at many of our distributors, who chose not tofinance current inventory levels at higher borrowing costs. We also experienceda slight shift in seasonal business during the quarter as back-to-school andholiday reduced year-over-year sales growth by 1%. We also continue to beimpacted by discontinued items and the under performance of certain product launches,such as Take 5 and Kissables, which are still being sold through at retail, butnot being replenished with follow-on shipments at the same levels. We expectthese factors to continue in the fourth quarter and then begin to moderate inQ1 2008.

With respect to total market share, while our core chocolatefranchises did grow nicely, we nonetheless lost share. We were unable to keeppace with the category growth in premium chocolate and refreshment. To put itin perspective, in FDMxCW, we estimate that dark and premium chocolate is a$1.5 billion category. There are two aspects to premium.

The first is the $1.1 billion trade-up segment that includesproducts such as Hershey's Extra Dark and Mars Dove; and a $400 million premiumsegment, with Cacao Reserve and Scharffen Berger, as well as Lindt andGhirardelli and other brands. On a year-to-date basis, premium and trade-upsales represented approximately 60% of total category growth and about 20 % oftotal chocolate category sales. Solid growth will continue at a double-digitcompounded growth rate.

We have participated in this segment primarily withHershey's Extra Dark and Hershey's Cacao Reserve. These products have performedwell. However, they have not been sufficient to deliver share leadership inthis fast-growing segment.

Our strategy to win in the marketplace is to bring portfolioscale to the category to allow us to utilize our category management and retailcapabilities. Last quarter, we announced a strategic alliance with Starbucks,one of the world's most recognized brands, which portrays an image of qualityat a premium price. Our Starbucks chocolates will compete in the premiumsegment of the market, with entries planned for late Q1.

Today, we are pleased to announce the addition of Hershey'sBliss to our premium and dark chocolate platform. This product has beendeveloped using extensive research and delivers a smooth, creamy and rich-tastingchocolate experience, meeting the consumers desire for indulgence. We'll beoffering bags of individually wrapped pieces of solid milk, dark chocolate aswell as the milk chocolate with a meltaway center. Bliss will compete in thetrade-up segment and will launched along with the Starbucks chocolate line atthe end of Q1 2008.

To further capitalize on the trade-up segment, we will alsobe introducing a Signatures line that will leverage Hershey's mainstreamexisting brands. For example, Reese’s Select Clusters are scheduled to launchmid-2008 and will be incremental to the total Reese's franchise. This producthas tested very well, with new and existing Reese's consumers and includespecans, peanuts, peanut butter and caramel wrapped in milk chocolate.

This portfolio approach will leverage our scale and categorymanagement techniques. Combined with Cacao Reserve, Scharffen Berger, JosephSchmidt and Dagoba, Hershey will have a broad portfolio, enabling consumers andcustomers to select from a wide variety of on-trend, superior premium chocolateproducts that deliver unique benefits and then also satisfy multiple usageoccasions. We'll place numerous dedicated merchandising fixtures, which willcarry our entire line of products in early 2008.

Turning now to refreshments, a segment that continues to beon trend and has grown throughout the year. Competitive activity continues toincrease. This backdrop has been a challenge for our business, which hassuffered this year, as we have discontinued stick gum brands such as Carefreeand many rolled mint items and slowly rebuilt distribution on more relevantitems, such as Icebreaker Ice Cubes gum, Ice Breaker Wellness mint and gums, aswell as York Mint tins. These have performed well at retail, where indistribution.

During the first half of the year, our gum and mint takeawaymarket share declined. However, in Q3 gum takeaway increased 2.8% and shareimproved sequentially by 80 basis points. We expect to continue to improve ourperformance in C-stores, where refreshment is disproportionately represented inQ4 and in 2008, primarily behind the new sales associates, who were addedduring the year to increase retail coverage. We'll expect to increase our C-store coveragemarkedly.

In 4Q, we'll have new product news around our refreshmentplatform, including prepriced merchandise shippers and the launch of IceBreakers Ice Packs. This is a unique product that delivers a superior burst ofcooling sensation, by coupling breath strips in a pouch filled with Xylitol. Wehave even more news to follow on refreshment in early 2008.

So as you can see, we are ready in consumer and customeractivity to compete in these two category segments -- refreshment and premium-- where we are currently losing significant share.

Let me quickly talk on two other key areas of our business,which are critical to our future growth and are largely on track. The first isour international business, which produced another good quarter. Our JV in Indiawith Godrej is on track and we are pleased with our end market results. Localproduction in Chinais on stream in our manufacturing JV with Lotte, and our broad-based entry isoccurring in most of the major cities in China.These initiatives are expected to be significant contributors to our top linegrowth in the next few years.

The other key area which will contribute to our futurefinancial success is our global supply chain project. As Bert highlighted, weare hitting all key mile stones and believe both the savings and flexibility wehave envisioned will be delivered in 2008 and beyond.

Let me now look ahead. We do expect the trends the business hasexperienced in Q3 to continue into Q4. We'll begin to gain some traction inpremium and refreshment, but the big news there is in Q1 2008 behind Starbucksand Hershey's Bliss. We will continue to aggressively invest in Q4, with anearly 20% increase in U.S.advertising spend and continued strong merchandising support at key customers.We therefore expect the core chocolate business to hold the marketplacemomentum we gained in Q3, although we do expect continued competition on pricepoints.

Shipments will be muted further by further pressure ondistributor inventory levels and seasonal shipment timing. As such, we now havea goal to deliver 2007 full year EPS diluted from operations in the $2.08 to$2.12 range.

As we look to 2008, we continue to see growth in ourinternational business, and we'll capture the supply chain savings and continueto reinvest in key U.S.strategic growth areas. These include further increases in consumer andcustomer support, with increased advertising investment and improvedmerchandising programs behind our core brands.

New product efforts focused on the fast growing premiumchocolate and refreshment segments of the category and the strengthening of ourcompetitive advantage at retail, with markedly more resources, particularly inthe food and convenience classes of trade.

We are making progress in some areas and I'm excited aboutthe 2008 plans to build on our recent gains in takeaway. These plans have beendeveloped in the face of increasing competitive activity and changing categorydynamics. This environment has driven us to evaluate our entire consumer andcustomer value proposition, with work already under way to analyze ourportfolio, pricing, packaging, usage occasions and retail formats, to ensure weaugment the programs already outlined for 2008 and further reaccelerate topline growth. This work is being done with the backdrop of a volatile cost basket,with inflation affecting most inputs and dairy and fuel being particularlyvolatile.

As we look to 2008, we are assessing the cost andcompetitive landscape, as well as how quickly our initiatives will gaintraction in the marketplace, as well as the impact of other strategicinitiatives.

I remain confident that our strong brands, advantaged retailsales force and supply chain capabilities can be leveraged for success. Manyinitiatives, such as Hershey's Bliss, Starbucks and retail coverage will haveimpact early in 2008. Others will take some additional time. I believe that thecontinued focus on the programs that are currently gaining traction, combinedwith new strategic initiatives upon which we are currently working, willrestore a strong growth profile in the future. I look forward to reporting onour progress and providing you with details of the company's 2008 expectationsin January.

Let me now turn it back to Rick.

Richard Lenny

Thanks, Dave. As this will be my last conference call as CEOof the Hershey Company, I would like to share a few thoughts. In 2001 wedeveloped our value-enhancing strategy and began its implementation later thatyear. The overarching objective was to deliver superior shareholder value overthe long term. This was to be accomplished through a balance of profitable organicgrowth and margin expansion.

Fundamental to this strategy was the understanding that themarketplace was evolving and what had characterized success for Hershey in thepast would need to change. Consumer and customer behavior was shifting, andwhile Hershey benefited from enormous sources of competitive advantage,meaningful changes in terms of building our brands and winning at retail wererequired.

Over the ensuing five-and-a-half years, we did just this.Through the first half of 2006, Hershey delivered top tier performance in termsof sales, market share growth and profitability, as measured by earnings pershare from operations. Unlike virtually our entire peer group, internationalgrowth did not play a role in our success.

Just as in 2001, we're identifying the key opportunities forprofitable growth while addressing the barriers that have hampered ourperformance in 2007. Specifically, we've identified structural changes withinthe category and among our competitive set. We're beginning to address theseshifts and will do so from a position of strength. Regardless of currenttrends, Hershey remains the clear leader in the attractive U.S. confectionerymarket. This leadership is broad-based in terms of product segments and acrossclasses of trade.

We're building new capabilities from insights to productdevelopment to supply chain to retail effectiveness, all focused on deliveringa superior value proposition to both consumers and customers. Where we puteverything together, it's worked. These efforts will expand in 2008 and beyond.

In addition, we fully recognize and are respondingappropriately to the long-term growth potential in key emerging markets. Ourinitial efforts via joint ventures are focused on developing a relevant productportfolio and advantageous route to market.

Strengthening Hershey's leadership position in the U.S.,building new capabilities that recognize new marketplace realities andexpanding globally will work synergistically to deliver superior shareholdervalue over the long term. This company has a long history of success. I'mconfident that Hershey will continue to be successful.

A key enabler of Hershey's success is leadership. OnDecember 1st, David West will become CEO of the Hershey Company. Dave'sappointment is the result of a very thoughtful and effective successionplanning process. Over the past six years, Dave has developed a keenunderstanding of what it takes to win, while building a strong following amongall employees. His strategic insight, yet pragmatic approach to getting thingsdone, will serve this company, employees and shareholders well. Dave has thefull support of our board and of me. Dave's energized by Hershey's futureprospects and I look forward to his leadership of our company.

Now we'll open it up for questions.

Question-and-AnswerSession

Operator

Your first question comes from Robert Moskow - CreditSuisse.

Robert Moskow - Credit Suisse

Thank you. I'm sure you're going to get a lot of pointedquestions today, but I guess I'll start with fourth quarter. It seemedinconsistent to me that you will be dialing up advertising by 25% and then alsoyou're citing some sequential improvement here during the third quarter,especially in chocolate. But then fourth quarter, the implication is for a 3.5% decline in sales coming off a fourth quarter a year ago where you had a 1%decline. I'm just wondering, how can Ijustify that in my forecast?

Secondly, you're talking about credit problems on behalf ofyour distributors. That seems new to me. Is that a reflection across theconfectionery industry, or do you think it's augmented by the fact that yourproducts aren't working as well as you thought?

Richard Lenny

Rob, let me startwith the first part, which is what's happening with the increased investmentand sequential improvement and then the reduction in sales. What we have highlightedis that we're seeing the major change in fourth quarter today versus what wehad anticipated was the significant reduction, as we said, in inventory levelsat key distributors and certain classes of trade.

Let me highlight one overall way to think about it, thenDave's going to provide a couple of specifics. Let's take the C-storesituation. For the past few years, we've been very successful focusing onC-store distributors. This was appropriate when if you think about us introducing a lot of newitems, building out retail distribution and experiencing strong takeaway. Aswe've shifted out this approach to one of driving more core brand growth andyou've seen it with some success with the Elvis program and other initiatives,our efforts are now being more pull oriented, meaning being more focused on theC-store operator, the C-store retail, which is why we're increasing retailcoverage.

Distributors have been reducing their inventory levels inlight of this change, as well as we've also cited a slower performance atretail as well as the tighter credit conditions. However, given the improvementin trend that we've experienced in C-stores over the past several weeks, we dobelieve as we go into 2008 that we expect to have a more normalized shipment totakeaway pattern in 2008, but the major delta in Q4 is what we're seeing is areduction in inventory, primarily on loose bars and primarily throughdistributors.

David West

Rob, let me add to that. On top of the distributor issue isthat we are expecting seasonal shipments in the fourth quarter of 2007 to belower than 2006. Anumber of factors working there. One of them is in Valentines and we don't havethe premium gifting line-up that we would like and we are starting to developthat and have that coming in 2008 and it is a much shorter Easter season nextyear, by a number of weeks.

So we have lower holiday shipments in the fourth quarter, lowerseasonal shipments in the fourth quarter than we did this year and as I said,there are still a lot of items out in the marketplace, discontinued items andas we've dialed the portfolio a little differently, those items are stillscanning in takeaway at the 3.5% numbers we are quoting, but we are not reallyreplenishing them at nearly the same rate, so some of that prior yearinnovation, as we're working through that in the portfolio, it is creating adrag on shipments versus the takeaway.

Robert Moskow - Credit Suisse

When you say that you're looking at alternatives to improveyour consumer and customer value proposition, does that mean that you'relooking at taking price down on any of your product lines?

David West

I don't want to really comment specifically about pricepoints or pricing. Let me just talk to you in a couple of ways. The categoryhas really continued to grow. It is a good category. Retailers make money andmanufacturers make money. Realistically, as we look at it, there have been someshifts. We've seen premium really grow. We've also seen the a value componentof the portfolio, that there is still a very strong value component of theportfolio, as well as refreshment has grown.

So there is a shift in consumer demographics and price-valueexpectations out there in the marketplace that's created some new usageoccasions. Convenience continues to grow as a need and then retailers havebecome much more focused on their own formats, looking at gourmet and storewithin a store concept.

So there are parts of our portfolio, which frankly right nowdon't really have a very well defined price-value positioning, or certainlythere's some things that we need to do from a benefit or usage occasion where we'renot meeting them right now, which is refreshment or premium.

We are evaluating our whole set of consumer and customerinsights and it's going to be necessary to transform some of the segments ofthe business and get them back on a better growth trajectory. The solutions onthose things are going to take some time. I don't want to talk specificallyabout pricing up or pricing down or any of those things. It's really aboutprice value and we're looking at that, at some of those parts of the portfolio tomake them a little bit more meaningful to the consumer and that work isunderway and we'll be talking about that sometime in early 2008.

Operator

Your next question comes from the line of Jonathan Feeney -Wachovia.

Jonathan Feeney - Wachovia Securities

First off, Rick, you talked about the well thought out and long succession plan. What made this the right time for you to move onand hand off to Dave given us being in the middle of a lot of the initiativesyou outlined?

Richard Lenny

Well, if you thinkabout for me, after six-and-a-half years, I just thought it was the right timefrom both a personal and professional standpoint to announce my retirement fromHershey and obviously exceedingly confident in Dave and the leadership team'sability to take this company to the next level. It certainly is a professionaland personal decision. It certainly wasn't a 90-day decision.

Jonathan Feeney - Wachovia Securities

Do you have some fun things planned?

Richard Lenny

No, no.

Jonathan Feeney - Wachovia Securities

So onto the quarter,if you wouldn't mind, you talked about increasing, you're shifting somespending from promotional to coupon dropping. At a time when commodity costsare up, it surprises me a little bit to see you increasing your coupon activity.It maybe speaks to trying to lower some price points, increase valueproposition to consumers. Would that be a fair characterization?

Specifically, is this couponing going on all across theportfolio, or is it specifically related to maybe some of the discontinueditems you're trying to move out of the channel?

David West

Actually, the two biggest components of that were reallytrial and generating trial and then getting some repeat activity on some of thenew items, particularly Cacao Reserve and Ice Breakers Ice Cubes gum, where wefeel really good about the product and the repeat rates have been very good, wedid not get to the trial rates we wanted to as quickly as we would like. We didstimulate good trial on those two products during the quarter there.

There are some other couponing activities going on andfrankly, some of that is really not about price reduction as much as it isgetting merchandising against the coupon. That has increased a little bit morein the category in the last six months than it had in the previous six months,but for the most part where we coupon was much more around trial generation onthe new items.

Jonathan Feeney - Wachovia Securities

Finally, maybe this is a question directed for Bert. Itseems like while distributors are taking down inventories, looks like day salesoutstanding was up a little bit year-over-year for you guys. That had beencoming down pretty steadily for certainly most of the past three or four years.Could you talk about maybe some of the trends there and what you're doing toimprove working capital?

Bert Alfonso

We had some very specific plans around working capitalimprovements this year. A lot of them revolved around our payables management.In terms of the DSO, I wouldn't call that a trend. The receivables remain inthe mid-90s in terms of being current. There has not been any incremental orunusual dating or pricing that we've entered into, into the quarter. So we havevery clean receivables. The DSO, really more related to mix around seasons. Thefocus on reduction of working capital will continue and we're very pleased withthe progress we've made to date. We think there's more progress we can makethere.

It is related to other elements of our business in terms ofhow we improve our sales and operations planning. So we expect that to continueto be the bright spot in the business.

Jonathan Feeney - Wachovia Securities

Does this commentary about distributor credit concerns, youdon't have any issues with collections at all, do you?

Bert Alfonso

No, not at all.

Jonathan Feeney - Wachovia Securities

Most of yourdistributors are pretty highly rated, right? Pretty solvent?

Bert Alfonso

I can't comment onthe ratings of our distributors. I would tell you that what we're signaling isnot necessarily that distributors are in trouble from a credit perspective, butwe're saying is that as their financing costs increase, they are more consciousof the level of inventory that they keep and so they are making efforts toreduce those and improve their own working capital.

Bert Alfonso

We don't haveconcerns that there's any imminent issue in terms of their ability to dobusiness continuing.

Operator

Your next question comes from David Palmer - UBS.

David Palmer - UBS

The trust board has been rather public lately with some ofits comments; more or less they have expressed disappointment with the valuedestruction in the stock. They have said that their two major principles orrules need not be constrained to growth. Do you share these sentiments thatthey have expressed publicly or perhaps do you think that there might becertain critical limitations that have been placed upon you, that perhaps havelimited your ability to create value for shareholders?

Richard Lenny

I think you're referring to the trust statement that wasissued last week and we have ongoing discussions with the trust and that'sbecause we're both keenly focused on how do we deliver superior shareholdervalue over the long term? As a major shareholder, that's what they areinterested in and that's what we're interested in, so I think I'll leave it atthat if I might.

David Palmer - UBS

The separatequestion, with regard to the past platform innovations that were meant toreally replace limited editions as a growth driver for you, particularly in theC-store channel and also with regard to premium growth, could we maybe go oversome of these platforms? What have been the highlights and the low lights,including Cacao Reserve, Kissables, Take 5, snack bars, cookies, nuts. Thesense is that some of these perhaps have not been sustaining as a growth driverand perhaps have been accelerating some of this inventory reduction at thetrade.

Richard Lenny

Let me start andmaybe Dave can fill in some more. I'm not certain about the specifics. We havetalked before that particularly within snacks -- and that was a few years ago-- we saw some opportunities, as the distinction between certain snack segmentswere blurring and we thought there would be an opportunity to leverage some ofour sources of competitive advantage into some snack adjacencies. I think whatwe have said in the past, we might have gone too far at one point in terms ofhaving too many potential platforms.

We've learned a lot, but at the same time as we were doingsnacks, don't forget there was very little growth in what has become premiumand dark chocolate and refreshment and we believe premium and dark chocolate,which is obviously much closer aligned with our core capabilities and our 40-plusshare of chocolate, we view that as a long-term trend that's highlysustainable.

So when we have items such as Take 5 and Kissables thatprovided good merchandising support and brought some news to the category, whatwe've said in the past is in the future we do those, they will be viewed moreclose in as opposed to broad-based platforms, and as they are viewed more closein and related to our core brands we'll size them and invest in themaccordingly.

I think the more important aspect is going forward as we'vesaid, this year has been one shifting from what had characterized success inthe past, recognizing shifts in consumer behavior and looking to do two thingsand do them both well: (1) restore growth to our core brands, which we areseeing some success, and (2) create scale in some high-growth platforms.

David Palmer - UBS

What I was maybe hoping to focus on more would be theKissables and Take 5, which would be more of a move against Mars and some ofthe portable single serve, and those were bolder efforts to perhaps gain share,drive a sustaining megahit, and certainly net pricing. If you cannot succeed inthose sorts of innovation going forward, it seems to limit the growthopportunity for Hershey.

David West

I don't think that that's true. If you think about Take 5,Kissables, even the S'mores products we have, variety clearly has a role inthis category. This is a variety-seeking category. Consumers have more than onebrand on their menu. They do tend to shift around. Frankly, we went too far onthe variety and frankly, we were just meeting the same usage occasion, or sameneed state for consumers with different items. So we didn't get the kind ofincrementality that we originally thought and that was a mistake on our part.

We just came with too much and really over time started tocannibalize ourselves and that is part of our issue right now with inventorylevels out in the marketplace. We're consuming a lot of those things in the takeawaynumbers, but we're not really replenishing them with shipments at the samelevels. So that did create an issue.

I think as you think forward in the category, we have greatbrands in the category. The brands should be able to meet new usage occasions;think about what's happened in premium. We have our Hershey's Bliss items,Starbucks coming, Cacao Reserve has done fine, but we actually need to do muchmore to compete more effectively there. Refreshment category has beenreinvented. It's gone from rolls of mints and stick packs of gum to tins to LiquidIce. We drove a lot of that early innovation change and frankly Cadbury andWrigley have really stepped up their innovation in the last 12 to 18 months.

So there are new usage occasions and new places for us togrow in the category. I think we were a little too anchored in the core barbusiness, which wasn't as incremental. As we looked at 2008 and beyond, we aremuch more focused on the things that are more incremental, but the importantthing for us is our brands and our category management skills and our retailcapabilities are just as leveragable in those as they are in the core.

Operator

Your next question comes from Vincent Andrews - MorganStanley.

Vincent Andrews - Morgan Stanley

David, if I could just ask you, every CEO does thingsdifferently, and as you look out to your pending tenure, what do you think youwill do differently at Hershey?

David West

Rick and I have worked together for a long time and I havethe utmost respect for Rick, but we're different people and we would both tellyou that. I think I have somewhat of a different style than Rick and I'll leaveit at. I think that his style is effective, as is mine, and people go at thepeople side of things a little differently. So I think there will be somewhatof a difference there.

In terms of the architect of the strategy that we have beenexecuting here, I am the architect of that strategy. Clearly as I said thereare some things within the portfolio where we are not meeting the emergingconsumer and customer needs, particularly price value and new formats. We havea lot of work underway already. It has not been completed as quickly as any ofus would like and therefore we've kind of found ourselves in a transitionalperiod, where we're working to the right things and just haven't gotten theminto the market fast enough.

So we will be completing a lot of that work and I thinkyou'll see some bold steps from us in terms of how to approach growth in theportfolio.

Vincent Andrews - Morgan Stanley

If we look out twoyears from now, how would you define your success? Are there specific thingsyou're looking to achieve?

David West

I think clearly theglobal supply chain transformation that's already underway is a huge enablerfor us. It's going to create a lot of cost savings to reinvest in ourbusinesses. It's also more importantly going to create flexibility to competein new segments of the market. The international growth, particularly verypleased with our progress in Mexico,and then also in Indiaand China. Wewill have a much more robust and strong global footprint that we're currentlybuilding. It's going to take some time for that to start to become asprofitable as we like, but it certainly will add to growth.

Within the core U.S.business, we have some leveragable strength and we will continue to leveragethose strengths, but, again, it's really much more around providing a muchbetter set of a bundle of consumer value to the customers.

Vincent Andrews - Morgan Stanley

What about from a share repurchase perspective, I know youbought back $50 million worth of stock in the quarter, but you still have abalance remaining on the existing repurchase program and you also have whatwould be considered a fairly under levered balance sheet. Given your stockseems like it's going to be down today, how should we think about thosedynamics going forward?

David West

You're quite right.We did repurchase $50 million and that's $150 million this year. There still is$150 million remaining from the $250 million that was authorized last December.We look at our capital structure on a consistent basis. It's a question that weget often and a topic that we do review with our board of directors. It is aboard decision in terms of how we look at our capital structure and theelements that we seek to finance. So I think it's a valid question and one thatwe look at from time to time.

Vincent Andrews - Morgan Stanley

Lastly, you brought guidance down three times during theyear, which leads to the conclusion that you've been more reactionary in thisenvironment. What do you think is going to allow you to kind of be moreanticipatory of the changing dynamics in the marketplace, whether they becompetitive or input-cost related? What do you think is going to change toimprove your performance on those metrics?

David West

We will be participating much more broadly in the marketnext year, aggressively in premium and trade-up with Starbucks and Hershey'sBliss. We have not held our share certainly in that segment. This year we'vebeen playing defense. Next year we'll be playing offense with some very goodlaunches, as well as in refreshment. We've got much better C-store coverage andsome better items and we will certainly be much more aggressive there.

I think that the challenge for us this year, the biggestsingle challenge was dairy costs, and dairy costs came at us in the April/Maytimeframe and that certainly changes the profile and the way you think aboutthe year. We have chosen to continue to reinvest in our brands and in ourpeople in the face of those costs and just frankly can't price to those kind ofcosts in the short term.

I think as we go forward next year, we have a much betterview of what the commodity markets may bring for us and I think a much betterplan to deal with that.

Operator

Your next question comes from Christine McCracken -Cleveland Research.

Christine McCracken -Cleveland Research

Rick, I just want to say it's been a pleasure working withyou.

Richard Lenny

Thank you, very much. Likewise.

Christine McCracken -Cleveland Research

I just wanted to delve a little bit into thus premium andsuper premium launch. Sounds like now you're adding another brand to the mixand obviously it seems like it fits an area that you're not hitting squarelywith the products that you have now.

I'm wondering, looking back at where you've had troublelaunching with maybe too many brands and splitting your resources and focus, doyou anticipate having any similar issues as you launch yet another brand in whatseems to be an area where you already have quite a bit of coverage?

David West

Christine, the launchof Hershey's Bliss, it is clearly a Hershey's brand and therefore will get theconsumer recognition of the fact that it is Hershey's and the consumer clearlybelieves that Hershey can and should play in the trade-up and premium segmentsof the marketplace.

The Cacao Reserve, as I said, we've gotten to the pointwhere we're pleased with the trial and repeat levels. Cacao Reserve was anecessary entry into the premium area, but certainly not sufficient to gainshare in that segment. As we said, I wish we would have been more quick to comeup with some other alternatives and entries. We were not. As we get to firstquarter of next year, the important thing is as we get into the premium andtrade-up spaces that we compete with scale in the category, which is ouradvantage, and that's all about retail coverage. It's about merchandising andfixtures and bringing category management.

So it's important that we have a breadth of portfolio whichplays to our strength. When you think about having Starbucks items, CacaoReserve, Joseph Schmidt and Scharffen Berger and now we're adding Hershey'sBliss to the line, Reese's Select product, we now have the scale with goodbrands and scale to compete in the segment. So we believe that the Bliss itemis a Hershey's Bliss item and therefore it is not a new brand, it is just the logical extension of Hershey's tradeup into premium.

Christine McCracken -Cleveland Research

Just a quick question on dairy costs. Is there a lag on howquickly you could see the benefit from the declines in dairy costs, given thelength of time from manufacturing to the shelf?

David West

Christine, we obviously produce an inventory. So costswind up on the balance sheet at some point in time. But dairy is one of thosecommodities, which we frankly, particularly fluid milk, really can't coverforward on. There's not a ready market to do that. So it is one that affects usmore immediately than most of the other commodities where we can take a longerposition on some of the others.

Operator

Your next question comes from Eric Katzman - Deutsche Bank.

Eric Katzman - Deutsche Bank

Rick, best of luck. Dave, same to you in your new position.My first question has to do with, maybe it goes back to the question on thepricing. I mean normally the chocolate category has been viewed as a prettyrational category. When you talk about the value proposition, is that afunction of your opinion as to how the consumer has changed, or how theposition has changed? Which are you reacting to?

David West

Actually, it's probably a combination of both, Eric. Theprice realization in the category has really come from a lot of trading up intopremium and the trade-up phenomenon. We have not participated as broadly inthat as we would like to and we see the opportunity to gain price realizationthat way.

There's still a large portion of the category that meets theneeds of seasonal occasions and that is a much more price sensitive consumer. Frankly,the biggest issue around the price points is to get the merchandising and ourmerchandising calendar this year was in a bit of transition. In the past, wewould have certainly merchandised much more around news and new items. This year,we've made a shift to merchandising much more around events, such as a S'moresevent or a Reese's Elvis event. When we got that merchandising around the eventthis year it was the best share periods and the best performance we've had. Wejust didn't have enough of them.

So as we look to 2008, we'll have a much, much more fullyloaded merchandising event calendar. We have a tie-in to the Batman movie, we'rean Olympic sponsor, we have a very good program with Dale Earnhardtcommemorative bars. We've got a lot more merchandising events headed for nextyear and that's the cause to get merchandising, the event much more so thanneeding to get to a price point. So we are a little bit in transition this yearfor merchandising innovation to merchandising events, and we weren't as robustas we needed to be, so I think that's part of the issue we've had this yearwith price points.

Eric Katzman - Deutsche Bank

I don't know how well known it is, but I think it's fairlywell known that Starbucks is looking at Godiva. I'm just wondering, given the approach to thepremium or super premium category, if they were to acquire Godiva, does thatreally have any impact on the agreement that you have with them?

Richard Lenny

Eric, we're not goingto comment on any of the potential M&A speculation.

Eric Katzman - Deutsche Bank

Rick, you came in as the first outsider in the company'shistory. I think in many respects you've done a great job and there's been aculture clash, whether it's with some of the folks in Hershey or the trust. I'mwondering, Dave, as you go forward, culture is so important to a company, howdo you balance needing to bring in talent from the outside, given that Chris isnow at Kraft, versus what are clearly the desires of the workers, the union, thetrust to maybe have more of an internal job flow? Maybe you could just touch on how you see your imprint onculture and human resource talent.

David West

Eric, if you're considering Rick to be the first outsider, that would have made me the second.

Eric Katzman - Deutsche Bank

Good point.

David West

The reality of it is over the my tenure here and my tenuregoing forward obviously, the culture here at Hershey is extremely supportive ofthe Hershey brands and wants nothing more than Hershey to succeed. It is avery, very strong culture that way and wanting to do the right thing andfrankly I have found it to be very welcoming of me from day one and continuesto this day.

We have done some things in the last several years to changethe way we went to market with our customers, with the sales force realignment.We have done some manufacturing realignment. The employees have by and largeembraced those changes as necessary components to compete in the marketplace. That'sreally one of the things that I would say about this company and its employees,is that they recognize they want this company to win more than anything. Theyare very, very loyal and dedicated employees when it comes to that.

I feel very good about the ability of the culture to adaptto new changes and new initiatives. And obviously we have been able to attracttalent from the outside as well and blended that very nicely with our internalexperience in confectionery category in many cases we've got people with 25 or30 years of experience. That blend has happened nicely.

Frankly as we become a more global company, we will need toattract more international talent. We don't have a lot of home growninternational talent and that's an area where we continue to look and as we'regrowing, I feel very good about that. Overall from a culture standpoint, Eric,I'm pleased with where we are.

Operator

Your next question comes from Terry Bivens - Bear Stearns.

Terry Bivens - Bear Stearns

Rick, best of luck to you, and I guess one thing you can'tsay is there were a lot of dull moments out there.

Richard Lenny

You're right, Terry. Thank you.

Terry Bivens - Bear Stearns

The one thing I didwant to get is a little more clarity on the marketing and there I'm getting tothe split between your trade promotion and stuff we would consider moreconsumer-oriented. Trade promotion up in the third quarter. Now in the fourthquarter, you have said pretty clearly that the entire marketing spend is goingto be up markedly. Is there a split there you can give us between what would bedeemed trade money and consumer money in Q4?

Bert Alfonso

The way the accounting works is we do segregate advertisingfrom consumer promotion and both of those are contained within our marketingbudgets. We already mentioned that when we do trial coupons, while they mightseem like marketing, we do account for them because of the accountingrequirements in the trade budget and we see both of those, as has beendiscussed in the past, as really the mix with which we compete in themarketplace.

This year, we have had both increases in marketing,primarily advertising and more couponing than we've had in the past to drivetrial of new products. But overall, ifyou looked at those two elements collectively, both trade promotion and themarketing elements, we are putting more behind the business.

Terry Bivens - Bear Stearns

My concern is kind of similar to Eric Katzman's on this. AsI hear Dave talk about '08, it sounded like the first things out of his mouthwere like more merchandising events, which I understand it's a category thatdoes respond to merchandising. But my concern is, I'm just hoping there isn'tmore of a tilt towards trade spending that is somehow emerging here that mighterode rationality in the category. Iwanted just a little bit more clarity on how you see the balance between whatwe would typically look at as trade spending versus couponing or whatever, thatwould be more aimed at the consumer. If you could just give us a little moreclarity on that, I would appreciate it.

David West

Specifically, as I said in my, in my remarks, advertisingand consumer promotion investment behind the core brands, we expect to be upagain in 2008 and we will continue to invest behind those brands. Weparticularly are pleased with the new item portfolio that we have in trade-upand premium and we are going to support that from a consumer standpoint, boththe Hershey's Bliss as well as the Starbucks line.

In terms of trade promotion, the reason the merchandisingevents frankly are more helpful is because the strength of the merchandisingevents, Terry, the better the merchandising event is as it appeals toconsumers, the less likely we actually are to have to go to a deeper pricepoint. If we have very good merchandising events that create consumer suction,if you will, we don't have to get to a price point to move the items through.

That's why I feel very good about the merchandisingcalendar, coupled with the huge increase that we have in retail salesforcehours next year, which will make our merchandising that much more effective.Again, it's effective in terms of getting it set up and getting the quality ofmerchandising to be higher and therefore less of a need for price points in thecategory and to hit those sharper price points in the category. That was theclarification I would make with Eric.

Terry Bivens - Bear Stearns

Just in terms of inventories, can you kind of give us a readon where trade inventories are right now, either at the customer or the distributor?The important thing is how much longer, I think you mentioned the destocking islikely to play out more in the fourth quarter. How are you looking at '08 in that regard? Do you thinkinventories are reasonably clean as we go into next year?

David West

Terry, I think they will be. We've been actually all yearlong, loose bar instant consumable takeaway has actually been exceedingshipments all year long, so we've had a correction in the inventory levels fromthe new items and limited editions coming in and out of the system all yearlong. It just was really exacerbated in the third quarter by the credit crunch.A lot of our distributors work on fairly thin margins and a couple of pointsincrease in interest rates really eats into their margin that they have got tomake a choice about what inventory to carry and what not. So we saw somecorrection of that in the third quarter, we'll see that into the fourth. Butthen as we look into next year, we look to be at normalized levels.

Terry Bivens - Bear Stearns

One last and rather basic question, what exactly is HersheyBliss going to be? Is that solid bars, bag candy? Maybe I missed that.

David West

It's individually wrapped pieces, Terry, and it will be inbags but it will be individually wrapped pieces. There will be a dark chocolatevariety, a milk chocolate variety, and then a milk chocolate variety with ameltaway center. Very rich, indulgent and we will be selling it at a higherprice point than our normal package candy line up of either Kisses Miniaturesor et cetera.

Operator

Your next question comes from Eric Serotta - Merrill Lynch.

Eric Serotta - Merrill Lynch

I just wanted to touch back on this distributor creditcrunch issue. You guys seem to be the only ones among the manufacturers thatplay into the C-store arena that have cited this. I'm just wondering how muchof the inventory destocking at distributors is really attributable to thiscredit crunch, which I recognize is real for small distributors, but is less ofan issue for your largest customer, McClain which is owned by Berkshire, andhow much of this is really related to more company-specific issues or yourproduct line specific issues?

Richard Lenny

We would likely be the one who would talk about it. The restof our confectionery competitors don't have conference calls and if they do,confectionery is a smaller part of their business.

Eric Serotta - Merrill Lynch

The ones selling cigarettes or carbonated soft drinks thoughare the ones that I'm referring to.

Richard Lenny

Correct, and if those folks are selling those things DSB,they aren't going through the same distributor network. The largest twocategories in the distributor network are cigarettes and then also candy. Theterms are cigarettes are buy them today and pay for them net two days, sothere's not a whole lot of inventory and float in that system. Candy is the onearea in that system, the candy and tobacco distributor system, which hasinventory float in it and so we are affected by it as are others, but for us,it's more notable and frankly, exacerbated by the fact that our takeaway usedto be in the 8% to 10% range. It's now down more notably. We're getting out ofa lot of items, limited editions and some items that aren't turning as well, soit would be natural for those inventories to come down first.

Eric Serotta - Merrill Lynch

A follow up on the question on price competition that hascome up a bit, could you point to areas within the portfolio, whether it'sloose bars, seasonal, refreshment, where you've seen price competition fromother players in the industry already?

I'm also wondering, is some of this competitive dynamicbeing exacerbated by your need to still clear some of the sale inventory outthere or returning inventory?

Richard Lenny

Eric, it has nothingto do with any inventory issue and it is really not specific to a part of ourportfolio. It has really become much more specific to certain customers andit's not widespread across all customers. It is in selected classes of trade atselected customers and I would prefer to leave it at that.

Eric Serotta - Merrill Lynch

Lastly, I think it was on the last conference call and thelast few Rick has expressed confidence in the 3% to 4% top line targetlong-term and then 9% to 11% long-term EPS target. It seemed like your commentat the end of we'll be able to restore a strong growth profile in the futurewas certainly a bit more tepid than Rick's endorsement of the long-termtargets. I am just wondering how you're looking at them, given the very changedmarketplace environment and recent performance of the company?

David West

Eric, I'll take that. The reality of it is we have thelong-term targets of 3% to 4%, 9% to 11%; for a good solid five-plus yearsthose targets were basically exceeded. We have hit a patch here over the last18 months that has been more difficult. Some of that is commodity costs and thecommodity markets have become more difficult. Also, the category has shiftedinto other segments, refreshment and premium have been growing more rapidly.

As we look at our business right now, we are assessing whichof those factors are long-term going to be with us. Is it commodity costs at ahigher level? Is the category going to be played in a different area? Andfrankly, our international growth prospects have ramped up over the last 12 to18 months. So we're making that assessment. As I said, we're looking at some ofthe price-value equations in the portfolio and trying to get a read on some ofthe commodity cost baskets, et cetera.

So right now, what I would tell you as we get back to you inearly 2008, we'll take a look at those growth targets and see whether they arerealistic for the long term and give you some sort of a statement at thatpoint.

Eric Serotta - Merrill Lynch

Well, best of luck in your new role and best of luck to you,Rick. Thanks a lot.

Operator

Your next question comes from Steven Kron - Goldman Sachs.

Steven Kron - Goldman Sachs

Just to follow up on this drive to improve the consumer andcustomer value proposition. It just seems taking a step back, that you'rethrowing a lot at the business. You're evaluating pricing, you're doing somecouponing, you're increasing your ad spend by a significant amount. This isobviously a category that not only has been rational in the past, but has alsoresponded to just one of these things in the past, not the need for all thesefactors.

So taking a step back, are you talking about a change in thesensitivity by the consumer to certain price points out there, or is this morereflective of the portfolio having not kept up on the innovation front and youfeel as though you have the pipeline of product going forward to really spendbehind?

David West

Steve, the category has been rational and will continue to be rational. I think whatwe're talking about really more is the consumer looking for price points? No.The consumer's looking for a value proposition. I mean, premium brings a higherprice point. It's where a significant portion of the chocolate category growthis, so that's not going to hurt price realization over time. It's going to helpit. We haven't participated in it as effectively as we would like.

So I think from a rationality and profitability standpoint,refreshment, where refreshment is going, refreshment is moving up in pricepoints. We're moving up to $1.99 tins, but what we have to do is bring theappropriate level of innovation into that. We have not gotten that done in 2007as readily as we would like. I feel much better about the launches we talked abouttoday for 2008 to start to do that.

I don't want you to read anything into the fact that somehowthis is going to become a price-oriented category, because it isn't. Privatelabel is still very small in the category. There are some parts of the businessthat this year we have chosen based on market share and some other initiativesthat we've invested behind, but the biggest investment we have made is inadvertising and consumer, behind the core brands and as you see that startingto work and grow.

I wouldn't want you to leave this call very focused on thefact that it's all about trade promotion in the category because it's not. It'sabout where the consumer's going, which is into higher price points and bettervalue propositions and we're going to be there with them. Advertising andconsumer spending has been up this year and it's going to be up again nextyear.

Steven Kron - Goldman Sachs

Then on the gross margin line, I just want to make sure Ihave the numbers right. I think you mentioned that commodities impacted thegross margins by I think you said 280 basis points. Gross margins were down220. You had unfavorable mix in your sales. You also had negative sales, so I'mjust curious; what's the offset that I'm missing there, if I have those numbersright, that benefited that line by 60?

David West

We did have some price realization that was offset to someextent with mix. The other elements that you noted, those were correct.

Steven Kron - Goldman Sachs

So going forward, if I think about pricing and I know forthe most part you have been honoring your commitments on the 4% to 5% priceincrease, when might we start to see a bit more realization, or is that goingto really be funding a lot of the above the sales line trade spend?

David West

You'll certainly see much more of this year's pricing actionbenefit next year. We had already commented that when we took the pricing thisyear, at that point we had a lot of our promoted pricing already in themarketplace with our consumers, a lot of our seasonal price points already outthere, because we book those well in advance and so the flow-through is verymuch '08.

Richard Lenny

Back to the gross margin, we also had very good supply chainproductivity during the quarter.

Operator

Your next question comes from David Driscoll - CitiInvestments Research.

David Driscoll - Citi Investments Research

I want to wish you the best of luck, Rick.

Richard Lenny

Thank you, Dave.

David Driscoll - Citi Investments Research

Dave, welcome, but of course, you've already been here. Solet's just get to a couple of questions.

The one thing I really wanted to try to understand a littlebit, Dave, if I could direct it to you, why is it that you didn't see thisinventory reduction coming last quarter, given the trends that have been goingon? I feel like the proverbial rug's been jerked out again here and that this inventory situationis something that people have been worried about for a long time.

We've been hearing quite often about the thoughts that therewas a trade loading going on by Hershey, those distributors building upinventories, now we're going the other direction. I'm just curious as to exactly what changed.Is it simply your answer, it's really the credit crunch that developed duringthe quarter?

David West

The reality of whatexacerbated the change was the credit crunch which occurred in July. The wayour programming has historically worked, there are growth targets for quarters.There are growth targets on an annual purchase basis. So distributors havereally until September to decide what they are finally going to buy for theentire quarter. While the credit crunch really occurred in July, it's not untilthe end of September that we really have a great read on what the total for thechannel's going to be.

UnidentifiedCorporate Participant

I think you have to step back in context. If you think back18 to 24 months ago or 36 months ago, we had 8% to 9% to 10% takeaway in theconvenience channel and a very significant pipeline of items in limitededition. In that environment, it was in the distributor's best interest to takeon our inventory, because it was getting pulled out of their system veryrapidly at retail.

The shift that occurred towards the middle of last year and over the lastseveral quarters, as we've dialed back on items and innovation and some of theinnovation has not worked as well, such as Take 5 or Kissables, that velocity fell off, the inventory levels, just based on the sheer mathof it is, as consumption goes down and some of the items don't turn, weeks ofsupply go up and we've been working through that this year.

As I said, takeaway has certainly exceeded our shipmentsinto the convenience channel all year long, so as we were working through a lot of discontinueditems, the inventories were naturally coming down all year, but as we got tothe third quarter and in terms of what happened, many of the distributors didnot buy as much because they were managing their inventory levels and that's,that's really what happened for us.

David Driscoll - Citi Investments Research

In the dairy side can you quantify for us what the dollarimpact for dairy will be for the full year?

David West

No, we don't comment on individual commodities. Needless tosay, dairy has been by far the most significant this year. I already mentionedwe see it moderating some. We don't see it returning to historical levels nextyear, and I will just leave it at that.

Operator

Your next question comes from Alexia Howard - Sanford Bernstein.

Alexia Howard - Sanford Bernstein

A quick question about where you are on attitude towardsacquisitions. Historically the international growth strategy has been very muchalong the lines of organic growth and joint ventures and sort of smaller, more froman organic model. Given what the statement from the Hershey Trust last weekabout pursuing aggressive growth both domestically and internationally, can youclarify what your attitude is towards acquisitions today and how that mighthave changed over the last year to 18 months?

Richard Lenny

I certainly wouldn'tclarify any perception or perspective on acquisitions in the context of thetrust statement. I think what we've always said in the past is we will look atacquisitions as an accelerator to top line growth and as long as they'reconsistent with our overall strategic direction.

Your question regarding organic growth internationally, Ithink it is really a hybrid organic growth because when we went into the jointventure with Godrej in India,they acquired [Lutrane] so when the combined Hershey Godrej joint venturereally has an acquisition embedded into it. We've also seen very good growth inMexico, a market we don't talk about, and we acquired Pelirocco a few yearsago, so we're going to look at ways that we can build our business in theemerging markets, whichever is the right combination, whether it be anacquisition of a local business, whether it be a joint venture and certainlythrough organic means as well.

Operator

Your next question comes from James Amoroso - Helvea.

James Amoroso - Helvea

I have a statement and then a question. The statement isreally the recent quarters obviously haven't looked too good, but from where Ihave been sitting, Rick, you've done apretty good job in regenerating the company.

Richard Lenny

Thank you.

James Amoroso - Helvea

You're welcome. The question is a little bit relating to thelast one. I asked you a question aboutfive or six years ago about internationalization, and the focus was very, very,very clearly at that time on North America and theexisting markets that you were in.

Obviously with the two joint ventures the focus has switchedmuch more aggressively pursuing international opportunities. Do you regret nothaving been more aggressive earlier or was that just simply not possible givenmanagement capacity?

Richard Lenny

I think the important thing -- and you have a very goodmemory -- but if you go back to 2001, 2002 as we had been saying, the goal wasto get our core business growing and to take advantage of clearly the largestmost profitable confectionary market in the world, which is obviously the U.S.,and we had strong leadership and made some very good progress on that.

As we started to see opportunities to expand in globalmarkets and in emerging markets, I think the important thing is if one were togo back in 2001 and 2002, we might have been looking at markets that didn'trepresent as sustainable a long-term growth trajectory as the ones we'reclearly focused on now in terms of going into India where the chocolate marketis obviously just developing, and we think we have an opportunity to influenceconsumer taste preferences along the way and build our category as the tradebecomes more modern.

I think the markets that we're focused on now representlong-term growth and whether we had been in China or India three or four yearsago I think is going to be less the story. And the greater story is going to behow successful the company is five or ten years hence in those markets.

Operator

Your next question comes from Andrew Lazar - LehmanBrothers.

Andrew Lazar - Lehman Brothers

One of the things that Hershey's has always talked about andyou have always talked about with a lot of pride is the scale you bring to thetrade at retail and the in-store presence and how you make that work for you.

In thinking about this uptick in retail store coverage andsuch, I just want to make sure I understand what really underlies that ornecessitates that? Just given that your strength all along I always thought ofas being the ability to get it done at the point-of-sale. Is it something thatcompetitively, have competitors raised their game at retail? Is it purely justthis sort of push to a pull model that you referenced earlier, Rick? I amtrying to get a better sense of that.

David West

Within the convenience stores, the change to more of a pull model does require moremerchandisers at the retail level, and we have added a significant number ofpart-time merchandisers who are going to provide that coverage in conveniencestores. Frankly, with the competitive intensity that has come in therefreshment items and how big that is in the class of trade, we feel the needto improve our coverage at the convenience store level.

Within the food class trade over the last several years wehave experienced very good retail productivity, and as we had gone throughthat, what we had done was rerouted andwhat we looked at in the middle part of this year was going back at coverage. Wetook an analytical view and then decided we thought we could do better from amerchandising standpoint if we added more resources back into food.

Operator

Your next question comes from Pablo Zuanic – JP Morgan.

Pablo Zuanic - JP Morgan

Rick, have you already signed a book deal?

Richard Lenny

No, first I am going to exhale.

Pablo Zuanic - JP Morgan

If I may, you gave us an overview of what you accomplishedover the last few years and obviously several great accomplishments there.Could you just give us two or three examples of issues that is maybe you regretor that you would call mistakes?

Richard Lenny

I think we've talkedabout a couple of them. At the time we do these things we're focused on ourstrategy and execution and if we thought it would be a mistake, we probablywouldn't do it.

I think the strategy to get into the snacks segmentsstrategically made a lot of sense. Executionally, I think we can say we misseda couple of the critical success factors. We tried to do too much in too manysegments. I think we learned a lot. I don't think it necessarily hurt us thatmuch, as much as it might have taken some resources away from some things thatwe think have more staying power.

I think the focus on core brands has been consistent fromthe very beginning. How we have chosen to support core brands is maybe open todebate, and I think the focus where we're headed now more closer in makes a lotof sense. If you think about the limited editions in '02 and '03, that was oneof the key drivers to bring news and innovation to core brands, and itcertainly worked because we got merchandise and we got takeaway and it enabledus to expand our share.

Clearly over the past let's call it 12 months we've seen explosive growth in the non-trendsegment called premium and dark chocolate, and we hadn't participated asbroadly, and that's been a drag on our business. The best part about that iswe're not talking about trying to create a new segment. We're talking aboutdoing what Hershey does well, which is build and leverage a scale in anon-trend high growth segment that is very attractive to both consumers andcustomers.

So unlike snacks or unlike another business we might betrying to grow from scratch, here we are leaning into a high growth profitablesegment. I think those are maybe the couple of areas, Pablo, that I wouldhighlight.

Pablo Zuanic - JP Morgan

How much more marketing is needed? Because when I asked thatquestion, you're saying 25% increase in the fourth quarter. Your advertising is [inaudible] If I annualize the 25% for '08,that's only like $25 million, and that would mean going from 2% to 2.5% ofsales. I know that chocolate and gum are different, but the way I think aboutit, if you're moving more into bars, more into single-serves, moving to pull, asyou said, your advertising needs to go up maybe another 400, 500 basis points.

Could you give us a sense of how much more is really needed?Sounds to me like 50 basis points on a base of 2% is not big enough.

David West

Obviously I don't want to get into our future plans onspending levels in any of the lines of the P&L. We have this year been muchmore focused on our core brands, and while some of our investments in the past,in let's say advertising behind snacks or Take 5 or Kissables, were not nearlyas effective as we would have liked, we have redeployed that money this year.

So in addition to the increase you already mentioned, whenit comes to the core brands, spending is up significantly, almost 2 bips onsome of the franchises like Kisses and Reese's and in the Hershey's platform.

We have redistributed the existing level of advertising tomake it much more focused on the core and then are adding to it, will continueto grow the advertising and consumer investment into the future.

But I don't want to get into giving away pieces of how muchwe're going to invest and where we're going to invest it. But we are focused onit, have done a better job this year about where we're spending, have spentmore and will continue into 2008.

Pablo Zuanic - JP Morgan

One last one, Dave and maybe more for your lawyer, butreferring to the Hershey's trust deal, I am wondering how, when I look at theWall Street Journal saying that Hershey's Trust has been involved indiscussions with Cadbury, didn't they break the law in the sense that they wererequired to disclose that those discussions were taking place on a publicbasis?

David West

I am not going to commented on speculative reports in thepress about meetings that may or may not have happened. That's not what we'regoing to do. With respect to the trust, the trust understands its fiduciaryresponsibility, and I will leave it at that.

Operator

At this time there are no further questions.

Mark Pogharian

Hearing no more questions, we'll conclude today's session.We will be available to answer any follow-ups you may have. Thank you very muchfor participating.

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Source: Hershey Q3 2007 Earnings Call Transcript

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