Hershey: A Good Opportunity To Take Profits

About: The Hershey Company (HSY), Includes: DEO, MKC
by: Ian Bezek

In February, I said not to sell Hershey despite some clear negatives to the stock.

With the stock up another 30% since then, it's getting harder to stay bullish.

Hershey has some attributes of a "never sell" holding, and I'm personally sticking with the stock.

But the valuation is becoming quite problematic; shares could trade flat for quite awhile from these levels.

Much of the recent "growth" at the company was due to tax cuts. Operational performance needs to pick up to justify the P/E multiple.

In February, I published an article entitled Don't Sell Hershey Despite So-So Management. It was a good call; the stock is up 31% since then compared to a 6% rally for the stock market as a whole. In that article, I made an impassioned pitch to hold onto Hershey (HSY) stock despite some iffy management decisions and acceptable, if modest, business growth in recent years.

Now, just four months later, I'm making a case for taking profits on Hershey stock. What's changed, and how am I not being a hypocrite?

Well, simply put, the price has gone up too much, at least compared to the slow-moving nature of the underlying business. In my previous article, I made the case for the attractive nature of its underlying business. It needs almost no capital to keep producing steady profits every year - it's the brand that does all the hard work here. And unlike many food products, chocolate isn't particularly susceptible to cheap/generic competition.

At a 18x forward P/E, such as Hershey was selling at in February, Hershey was offering a more than 5.5% earnings yield. With expectations of even modest earnings growth going forward, you'd expect to trounce bonds in forward returns. The conservative stock as a bond alternative analogy has flaws, but it's a useful frame of thought for a company like Hershey where earnings are steady and it needs little capital to keep generating consistent profits.

At closer to 25x forward earnings now, Hershey currently offers a low 4% earnings yield, which isn't nearly as attractive of a starting point. Sure, treasury yields have plummeted as well, so the spread has held fairly steady. But if the 10-year bond goes back to 3%, getting a 4% earnings yield from Hershey doesn't give you that much edge against the safer bond. You can take a lower earnings yield and still get solid total returns going forward assuming you have decent earnings growth. But Hershey really hasn't, bringing us to an oversight in my February article - Hershey was a huge beneficiary of the corporate tax cuts which, to be clear, will not be a source of ongoing earnings growth.

Growth Not Nearly As Great As It Looks

Since 2014, Hershey has shown modest, at best, growth. Reported numbers have looked better but this is largely due to the benefits of the corporate tax cut rather than improvement in the underlying business.

Over the past five years, annual revenue has improved from $7.4 billion to $7.8 billion. That certainly beats shrinking revenues, as has happened with so many consumer staples companies lately. But this comes with two asterisks. First, the company has made acquisitions which have helped generate much of the revenue growth. Second, the company has a weak position overseas. This means it has suffered much less than its peers from the strong dollar, and won't get the same sort of FX boost in reverse when the dollar drops at some point in the future.

Regardless, it's not revenue growth driving earnings expansion here. It's the tax cuts along with Hershey's extremely disciplined handle on its operating expenses. The company's overall SG&A has actually gone down from $1.92 billion in 2013 to $1.8 billion last year. Given that its overall revenues are up and that wage inflation exists, it's rather remarkable that Hershey has shed $120 million annually in overhead budget over the past six years.

Unfortunately, some other rising costs have offset much of these gains. Merger and restructuring costs have generally trended upward though they are bumpy from year to year. Meanwhile, net interest expense has nearly doubled over the past five years to $147 million annually now.

Add it all up, and Hershey has increased earnings before taxes over the past five years by just $50 million (3%). So where is all the growth in earnings coming from? If you said taxes, you'd be right.

In 2014, Hershey paid $459 million in income tax, which represented a 35% tax rate. Last year, Hershey paid just $239 million in income tax which worked out to a mere 17% tax rate. As you can see, Hershey's effective tax rate got slashed in half.

Most companies didn't see nearly such a large benefit from the tax cuts because they have a lot of hard assets. These make it much easier to get deductions and write-offs that reduce your marginal tax rate. Hershey, as an asset-light business, was almost fully exposed to the headline corporate tax rate and is thus enjoying windfall benefits from the low tax rate.

That's fantastic for the business, and it's no surprise that HSY stock has shot up as the tax cut-driven earnings have arrived. But don't mistake a change in the tax code for organic or repeatable earnings growth. To repeat, Hershey's earnings before taxes are up just a few percent over the past five years.

While there's no sign of anything imminent on the horizon, it's worth considering that there's no guarantee that low tax rates will remain in place forever. With the election cycle in full swing and the government running a big deficit, it wouldn't be shocking if you see momentum build for an effort to jack the corporate tax rate back up.

If Hershey went back to a 35% effective tax rate, like it had in 2014, net income would drop from $1.13 billion now to ~$900 million with the old tax regime. That'd put EPS back to $4.30 which would represent more than 32x trailing earnings. Now I'm not saying the tax cut is going away anytime soon. But it's still worth thinking about the fact that Hershey's current 25x P/E ratio is close to seven turns cheaper due to a change in tax policy rather than the business' fundamental growth.

Don't Sell Your Great Stocks To Keep Your Good Ones

The key point is that Hershey is not as high a quality of a holding as my other top staples picks like Brown Forman (BF.B), Diageo (DEO), or McCormick (MKC) which are producing plenty of organic revenue and earnings growth.

If you feel the need to lighten up in the sector, you want to trim the "pretty good" companies that are on a wild ride higher rather than the great ones. Other weaker consumer staples companies making 52-week highs like Coca-Cola (KO) and Kimberly-Clark (KMB) would also fall into the sell first group if you want to lighten up on your holdings in the sector:

Chart Data by YCharts

Dating back to the late 1990s (when Diageo was listed in its present form), McCormick stock is up 2,200% counting dividends, Brown-Forman is up 1,660%, and Diageo is up more than 1,300%.

Hershey is up a more than respectable 1,140%, but it's not quite in the same tier as the rock stars of the sector. Meanwhile, the laggards like Kimberly-Clark (716%) and Coca-Cola (330%) have still made decent gains, but lack the combination of factors that have led companies like McCormick and Brown-Forman to life-changing returns.

Is Hershey A "Never Sell" Holding?

In the dividend growth investing community, there's the idea of having core holdings that you never let go of, regardless of valuation. As my portfolios are not tax-sheltered, I am particularly on board with the idea of never selling companies that can keep compounding indefinitely, thus letting my capital and dividends grow without paying cap gains tax along the way.

When choosing whether to view a stock as a "never sell" holding or not, the underlying business engine and management performance is far more important than current valuation. EPS growth makes up for a lot of valuation sins while the lack of growth can make a cheap stock rather expensive over the long haul. In Hershey's case, the core business is fantastic but the management team is merely average.

I personally am generally in the never sell camp for this sort of stock - or at least the valuation would really have to get out of hand (think Walmart at 39x earnings in 1999). I'm not selling any of my Hershey at this point as the brand is amazing and chocolate is a particularly attractive niche within the food space. But management has some flaws here, and the company has repeatedly bungled international expansion. Its recent M&A activity has underwhelmed as well.

Thus, if you feel like selling a consumer staple stock, I think you can make a case for taking your gains on Hershey, particularly after the monster move in the first half of 2019. I wouldn't be surprised if the P/E ratio drops back to its historical median of 22x or so in coming years, which would result in flat stock performance from here, assuming modest EPS growth over the same span. That might set up another long basing period like we just had while earnings grow to catch up with the valuation:

Chart Data by YCharts

Note how the stock did absolutely nothing from 2014 through to the beginning of 2019. Now that we've had a few years of gains occur over the course of six months, the stock may just settle into a new trading range of, say, $120 to $150 for the next five years. I'm fine collecting my dividends and holding, particularly since I highly value being tax efficient. But for other people that are interested in shorter-term position swapping, there's a case for rotating out of some Hershey stock here. You'll likely have another chance to buy it at $138 or cheaper over the next year or two.

Disclosure: I am/we are long HSY, DEO, MKC, BF.B. 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.