The Hershey Company: Don't Bet On The China Market For Growth

| About: The Hershey (HSY)

Summary

Chinese consumers may be spending more, but it isn’t on chocolate.

Health-conscious consumers are on the rise, cutting back on sugary treats.

We believe the company hoped the China market would fuel its growth.

Instead, things have gone backwards and we expect it to get worse, slowing its growth further.

One company we've been keeping an eye on in the last couple of years is The Hershey Company (NYSE:HSY). Following a slowdown in sales in its key North American market, the confectionary giant looked overseas for growth. But even after the $584 million acquisition of Shanghai Golden Monkey in China, we are yet to see any marked progress. In fact, things appear to be going backwards in its international segment. But will they improve in FY 2017?

As you can see in the table below, in the last three years, The Hershey Company has delivered tepid sales growth. Furthermore, there has been a real deterioration in its international sales despite the acquisition of Shanghai Golden Monkey. This is certainly not what we were expecting when the company parted with half a billion dollars for the business.

Sales mn

FY 2014

YoY%

FY 2015

YoY%

FY 2016

YoY%

North America

$6,352.7

2.5%

$6,468.1

1.8%

$6,533.0

1.8%

International

$1,069.1

13%

$918.5

-14%

$907.2

-1.2%

Total

$7,421.8

3.9%

$7,386.6

-0.1%

$7,440.2

0.7%

Source: Company data

Investors can at least take a little comfort in the knowledge that its operating income and operating margins have been edging higher, as shown below.

Operating income mn

FY 2014

% sales

FY 2015

% sales

FY 2016

% sales

North America

$1,916.2

30.2%

$2,074

32%

$2,041

31.2%

International

$40

3.7%

($98.1)

NA

($29.1)

NA

Total

$1,956.2

26.4%

$1,975.9

26.7%

$2,011.9

27%

Source: Company data

What's behind the decline?

In Hershey's FY 2016 10-K, and again in its recent fourth quarter release, management explained that the macroeconomic environment in China is largely to blame for the decline in international sales.

"During 2016, we successfully completed the SGM integration. However, additional challenges remain, including challenges associated with the macroeconomic environment in China, which could affect our strategy and could have a negative impact on the results of operations and cash flows of our International and Other reportable segment."

We don't believe the Chinese economy is to blame for the decline in Hershey's international sales. After all, recent data shows that Chinese retail sales are on the rise again. Rather, we think it is more likely down to a change of consumer preference to a more healthier diet. He Jingtong, a professor of consumption studies at Nankai University, recently told the China Post that recent spending patterns "indicate an upgrading trend in Chinese people's shopping habits. The growing acceptance of healthy eating and a healthy lifestyle has accelerated the sales of local products, fresh fruits and vegetables, and healthcare products."

Whilst we don't necessarily expect Chinese consumers to shun chocolate completely, we do think that a reduction in consumption is likely as consumers watch what they eat. Unfortunately, dark chocolate offerings will not necessarily be the answer either. Recent research by Mintel has shown that over 56% of Chinese consumers are unaware of the health benefits of dark chocolate, with 47% of those surveyed believing it was high in calories. In many respects, The Hershey Company couldn't have timed its acquisition of Shanghai Golden Monkey any worse, unfortunately, in our opinion.

The North American market hasn't been much better either for the company. Competitive product and pricing pressures have plagued its sales and restricted margin improvements despite favorable commodity prices. Luckily, the strong brand and its wide distribution have kept sales edging higher.

China isn't living up to expectations

When Hershey acquired Shanghai Golden Monkey, the China market was seen as the future for confectionary, with some even predicting that it would become the world's biggest chocolate market eventually. But since then, things have gone backwards. Euromonitor estimates that consumption in China fell 2.4% in 2015 and predicted further declines in 2016. We think that further declines will occur in 2017, leading to The Hershey Company posting another drop in international sales.

Sales mn

FY 2016

YoY%

FY 2017E

YoY%

FY 2018E

YoY%

North America

$6,533.0

1.8%

$6,630

1.5%

$6,696

1%

International

$907.2

-1.2%

$898

-1%

$902

0.5%

Total

$7,440.2

0.7%

$7,528

1.2%

$7,598

0.9%

Source: Company data

At present, the market expects the company to deliver sales of $7.61 billion in FY 2017, followed by sales of $7.79 billion in FY 2018. As you can see above, our forecast falls approximately 1% and 2.5%, respectively, below the consensus estimates. We think the market is too optimistic on sales and for the reasons listed above, expect the company to fall short of top-line expectations.

Based on this revenue forecast, an operating margin of 20.4% (as provided in FY 2017 guidance), an effective tax rate of 29%, and 218 million shares outstanding, we expect FY 2017 net profit to be $1.01 billion. This is the equivalent of diluted adjusted earnings per share of $4.64, falling short of analyst expectations and the company's guidance of $4.72 to $4.81. It is also just 5.2% higher than last year's adjusted earnings per share of $4.41.

So with its shares priced at 23x estimated full year earnings, we think Hershey is looking incredibly expensive. While we would be happy to pay 23x earnings for a company growing earnings in the double digits to mid-teens, we certainly would not for annual bottom-line growth of just 5%.

Because of this, our recommendation is to take profit on Hershey now and wait until it trades at a more reasonable valuation more suited to its growth profile.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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