Hershey Is A Long-Term Buy, But Not Right Now

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About: The Hershey Company (HSY), Includes: GIS, K, KHC, MDLZ
by: Bull's Run
Summary

Food stocks have remained out of the limelight this year on account of soft growth rates.

Positive dynamics of chocolate confectionery and diversification into salty snacks market will favor Hershey.

Hershey’s new round of expansion in India is expected to yield even better results.

Despite sound fundamentals, Hershey is currently not a buy due to rich valuation.

Food stocks have remained out of the limelight this year as well, shedding almost 13% value YTD. That’s attributable to soft demand dynamics of the packaged food industry, increased intensity of competition among the players for market share retention, and elevated pressure on profit margins due to an uptrend in commodity and logistics costs. Consequently, many big names in the packaged food industry, including General Mills (GIS), Kellogg (K), and Kraft Heinz (KHC), have exhibited abysmal price decline so far this year.

Source: Yahoo Finance

The steady revenue and earnings growth, led by intact demand for chocolate confectionery, is keeping shares of The Hershey Company (HSY) afloat against the market headwinds. Given slightly better growth prospects of chocolate confectionery than some other mainstream packaged food categories, including soup and ready-to-eat cereal, it seems likely that Hershey will continue to perform resiliently. Hershey's enhanced focus on digital strategy and more frequent launching of new products will also help unlock value for the shareholders. Additionally, the diversification into salty snacks category, resulting from the acquisition of Amplify Snack and Pirate Brands, is expected to bode well for Hershey over the medium to long-term.

I wouldn't suggest buying the stock due to rich valuation at current price levels despite steady growth prospects, healthy profit margins, and sound cash flows position. But a long-term position can be initiated if the stock falls below $100.

Expect Steady Growth

According to Mintel, the retail sales of the U.S. chocolate confectionery industry are expected to reach $18.5 billion this year, representing a healthy growth rate of 15% since 2012. The chocolate confectionery has exhibited resilience to health and wellness trends in the past, but growth momentum is slowing down as of recently as consumers continue to reduce their sugar intake. Similarly, according to Packaged Facts, approximately 81.7% of American adults have indulged in chocolate this year, up 7% from a decade ago, though the consumption rates have slightly decreased over the past few years. Euromonitor projects that chocolate sales in the U.S. will grow at a CAGR of 1.4% by 2022, driven largely by trends like a premium indulgence, bite-size, and functional ingredients. The estimation is that premium chocolate with innovative flavors will account for a big chunk of incremental sales in the coming years, as around 76% chocolate buyers are willing to pay a little more for premium indulgence.

In the recent past, Hershey has struggled to keep the competition at bay despite its top spot in the U.S. chocolate confectionery. The company held 43.5% market share during 52-week ending July 15, 2018, representing a decline of approximately 60 basis points from a year ago. Additionally, Hershey has also exhibited a more modest retail sales growth of 0.2%, as compared to the category growth rate of 1.6% over the same period. Thereby, in response to the changing snacking preferences, Hershey is now stepping up innovation game for some of its iconic brands to accelerate organic sales. The rollout of Reese's Outrageous chocolate bar with peanut butter, caramel, and Reese's Pieces has helped attain 0.9% volume sales growth during the first nine months of 2018. The introduction of a mashup of Hershey milk chocolate and Reese's Pieces in the bar form is also expected to create a lot of buzz in the market during the Christmas and Holiday season.

Hershey has also introduced Hot Cocoa Kisses in the bite-sized format, its first seasonal chocolate in ten years. Introducing new limited-time flavors tied to a season would help Hershey better compete against the likes of Lindt and Ferrero, who have steadily been chipping away market share by aggressively expanding in the U.S. Moreover, Hershey’s plan to introduce Reese's Thins in the first quarter of 2019 will help retain those customers who want to indulge in chocolate, but in small quantities.

Albeit on a small scale, Hershey’s diversification into salty snacks market is also a smart move. During the first nine months of 2018, Hershey has generated a 4.2% growth in net sales from its North America business, mainly on account of a push into better-for-you snacks with the acquisition of Amplify Snack Brands, which owns SkinnyPop, Oatmega, and Paqui. SkinnyPop is considered the market leader in the ready-to-eat popcorn category that is growing at a fast pace. According to Mintel, popcorn sales in the U.S. have increased 32% over the past five years to reach $2.5 in 2017, driven largely by flavor innovation in ready-to-eat popcorn, which has posted a robust growth rate of 118% and now accounts for 44% of total popcorn sales. As ready-to-eat popcorn category is likely to continue benefiting from a healthy image and strong demand for innovative flavors, the limited-time-only releases, such as SkinnyPop gingerbread cookie and white chocolate peppermint varieties, will continue to generate healthy sales growth.

While the competition is getting stronger, adjusting its portfolio to be more in line with the better-for-you trends coupled with the more frequent rollout of new products and accelerated marketing around core brands should Hershey attain organic sales growth in a range of 2% - 3% over the long run.

HSY - Financial Summary ($M)

2013

2014

2015

2016

2017

TTM

5-YR CAGR

Revenue

7,146

7,422

7,387

7,440

7,515

7,743

1.6%

Operating Income

1,357

1,438

1,413

1,243

1,531

1,535

2.5%

EBITDA

1,544

1,605

1,228

1,493

1,473

1,754

2.6%

EPS

3.61

3.77

2.32

3.34

3.66

4.84

6.0%

DPS

1.81

2.04

2.24

2.40

2.55

2.69

8.2%

Payout Ratio

50%

54%

97%

72%

70%

56%

n.a

Total Debt

1,962

2,185

2,420

2,980

2,920

4,706

19.1%

Total Debt/EBITDA

1.3

1.4

2.0

2.0

2.0

2.7

n.a

Operating Cash

1,188

838

1,214

983

1,250

1,516

5.0%

Free Cash

837

467

858

714

992

1,167

6.9%

Cash Conversion Cycle (Days)

42

50

57

50

49

67

24

Current Ratio

1.8

1.2

0.8

1.0

1.0

1.0

n.a

Source: SEC Filings, Author’s Workings

Accelerated Focus On India

As 88% of total revenue comes from North America, Hershey has been missing out sizeable growth opportunities in the emerging markets. While an aggressive push is unlikely, Hershey is now making considerable efforts in the emerging markets to leverage huge population growth and increasing disposable income. The company is actively expanding its presence in India, which is considered one of the fastest growing chocolate markets in the world.

Building a sizeable customer base is a sweat-breaking task as Indian chocolate market is largely dominated by Mondelez (MDLZ), which held 55% share of retail value sales in 2017, but the long-term opportunities are lucrative as the market is still in the nascent stage. In India, per capita chocolate consumption is around 128 grams per annum, which is considered lowest among the emerging markets and nearly four times less than the U.S. With the increasing consumption in the urban areas, the Indian chocolate market is expected to reach just over $2.0 billion by 2022, up from current retail value of $1.2 billion.

As a part of its 5-year investment plan, the company has launched its iconic Hershey’s Kisses chocolate brand in India via retail and e-commerce channels, and the launch is being supported by Hershey’s first-ever TV commercial in India. While keeping the price point in perspective, Hershey will also manufacture bite-sized chocolates in India tweaked with local taste to appeal masses.

Hershey is also rolling out a new line protein biscuits under the umbrella of Sofit brand to explore the sizeable opportunities presented by India’s premium biscuit market. The organized biscuit market generated approximately $3.5 billion in sales last year, of which 60% were from premium biscuits. Hershey will have to confront domestic brands, such as Britannia, Parle, and ITC, who have dominant market position across price points. However, Sofit is already an established brand in the soy milk market and hence launching a premium line of biscuits in the better-for-you category should help capture some market share. Hershey is already doing quite well in India, as depicted by a healthy 26% growth in organic sales during the first nine months of 2018 - a considerable acceleration from 17% growth during FY17. Given the launch of new chocolate and biscuit brands, backed new marketing campaigns and supply chain investments, it seems likely that Hershey will be able to sustain healthy growth momentum in India over the long-term.

The Top-Notch Profit Margins

The sustained profitability is one of the positive attributes of Hershey. Hershey has been able to sustain healthy profit margins despite intensifying competition, mainly on account of better pricing mix and cost optimization initiatives. Hershey’s gross and operating margins have averaged at 44.7% and 19.1% over the past five years. Although the gross margin has declined by 162 points to 45.3% during the first nine months of 2018, the current margins of the company are still considered a tad bit better than peer group, as shown in the following graph. Additionally, Hershey’s operating and free cash flows have increased at a 5-year CAGR of 5% and 7%, respectively, on the back of solid profit margins. Thus, despite an uptick in debt to EBITDA ratio, the financial health of Hershey deems satisfactory.

Source: Morningstar

Hershey’s North America segment reported a profit margin of 29.8% during the first nine months of 2018, a decreased of 1.9% from a year ago period, mainly on account of notable inflationary pressure and higher-than-expected logistics costs. On the contrary, due to the divestiture of poorly performing Shanghai Golden Monkey business in China, the profit margin of international segment improved by 590 basis points to 10.1% over the same period. However, a lot has to be done to uplift the overall profitability of international operations.

Hershey still has the potential to improve further its profit margins, albeit at a rather slow pace. The planned increase of 2.5% in selling prices, starting from the next year, for one-fifth of its product portfolio will erase some pressure from margins. Other key initiatives, such as rationalization of SKUs, optimization of supply chain, and streamlining of the operating model will positively also help grow the operating margin to 22 - 23% by 2019. Additionally, the premium chocolate currently accounts for less 20% category share, but its demand is continuously increasing. Thereby, with its dominant market position and extensive distribution network, Hershey has the opportunity to leverage consumers’ willingness to pay more for premium indulgence and further strengthen its profitability.

Concluding Remarks

Hershey’s shares have rallied nearly 15% over the past six months on the back of the product and geographic diversification, recouping most of the price decline of the first half of 2018. As most of the big packaged food names are still holding onto significant losses, Hershey is looking a bit expensive based on the trailing and forward price to earnings multiples of 23.3x and 19.3x, respectively, as shown in the following table. According to Yardeni, the market is currently pricing the packaged food industry at a forward price to earnings multiple of 15.5x. On the contrary, the stock seems attractive based on the EV/EBITDA multiple of 11.4x, which is lower than the peer group average of 13.5x (excluding CPB).

Peer Analysis

YTD Return

TTM P/E

Fwd P/E

PEG

EV/EBITDA

P/S

Debt/EBITDA

Yield

HSY

-4.0%

23.0

19.1

2.4

11.4

3.0

2.5

2.68%

MDLZ

1.8%

19.7

17.3

2.4

20.2

2.5

5.1

2.39%

GIS

-37.0%

13.8

11.5

2.4

12.1

1.4

3.1

5.24%

K

-11.2%

11.4

14.0

3.4

10.8

1.6

3.4

3.71%

PEP

-5.0%

19.7

19.1

2.8

13.7

2.5

3.0

3.26%

CPB

-18.6%

222.5

15.0

n.a

25.4

1.3

1.8

3.58%

CAG

-20.7%

20.5

12.3

2.6

14.3

1.9

4.3

2.84%

KHC

-39.0%

16.8

12.7

2.5

13.3

2.2

3.8

5.27%

SJM

-18.0%

20.4

12.3

2.4

12.2

1.6

2.9

3.34%

Average

-16.8%

40.9

14.8

2.6

14.8

2.0

3.3

3.59%

Source: Finviz, Gurufocus

Hershey’s recent bullish momentum is due to important steps taken by the management over the past one year to sustain organic growth. Besides diversification into salty snacks market, Hershey has significantly enhanced its focus on building scalable digital capabilities. Hershey’s digital strategy is spot on, as nearly half of Americans purchase consumer packaged goods online and the number is expected to reach 70% by 2022. Additionally, the optimization of the marketing approach to get more yield out of reduced marketing spending by leveraging analytical tools and creation of an in-house production studio are also expected to contribute towards shareholders’ value creation.

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.