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Hershey Company – Hold the Candy!

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The Hershey Company (HSY) is one of the largest manufacturers of candy bars and a household name in the US, with products including consumer favorites like Kit Kat and Hershey’s Kisses. The company, which markets its brands in over 70 countries around the world, is also a leader in the gum and mint category.

But despite the universal appeal of its products, Hershey is heavily dependent on the US market and has a comparatively smaller footprint in the high-growth foreign markets. As of fiscal year 2013 (FY13), it generated merely 16.1% of its net sales from outside US. Encouragingly, however, the company looks set to increase its share in these markets as it expands production abroad.

And although consumer staples companies like the Kellogg Company (K) and General Mills, Inc. (GIS) have recently seen the demand for their products mature in the US, Hershey has continued to expand on the back of chocolates sales.

This seems to run counter to the healthy living trend that is picking up in the US, wherein consumers are increasingly turning to healthier food choices. But chocolates seem to be here to stay, largely because there are very little substitutes available for sugar-rich food. Hershey seems to be benefitting more from this trend than its peers, and investors have taken note.

Strong Growth Prospects

Hershey beat earnings estimates for its third quarter (3Q) FY13 results by over 3%. The dollar value of its net sales was 6.1% higher over the comparable year-ago quarter, driven primarily by 6% growth in the number of candies sold. Growth in core brands, stronger demand for new products in the US, and consistent double-digit growth in international markets all contributed to higher sales.

The company’s gross margins also improved 3.6 percentage points (ppts) over the year earlier, boosted by lower input costs, improvements in productivity and a better product mix.

Having reported better than expected earnings, Hershey’s raised its guidance for growth in per share earnings (EPS) by 1ppt to 9-11%, but refrained from revising its revenue growth guidance, keeping it at 5-7%. The cautious optimism reflected the management’s confidence in succeeding in their productivity improvement plans.

Expansion into International Markets

International markets remain a key revenue growth driver for the company. Over the last three years, sales in foreign markets grew at a compound annual rate of 12.2%, significantly higher than the 7.1% growth in its US market. Similarly, for the recently-reported quarter, higher revenues from China, Mexico, and Brazil contributed to 14.2% growth in international sales, compared to the 6.1% growth in sales in the US. The management also expects international markets to post 15% higher sales for the full 2013 fiscal year.

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The company’s Hershey’s, Reese’s, Hershey’s Kisses, Jolly Rancher and Ice Breakers brands have gained considerable popularity in international markets, thanks to the company’s continuous investments in market research.

The acquisition of Canada-based Brookside Foods Ltd. for $173 million in 2012 also provided a big boost to Hershey’s growth. Brookside generated $90 million in annual sales at the time of its acquisition, and Hershey now plans to boost revenues from its acquisition by researching its markets and improving its manufacturing capabilities.

The Hershey management also plans to build a new confectionery manufacturing plant in Johor, Malaysia, which is to be completed by 2015 at a total cost of $250 million. The project will ease some of the production burden on the company’s jointly operated plant in China, and boost sales growth in emerging markets. It is expected that Hershey will serve 25 markets across Asia from the Malaysian plant.

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The company is also expanding its market share in China, Mexico, Brazil, and Canada, hoping to grow its chocolate category in China by launching Hershey’s Kisses Deluxe and Hershey’s Drops to the market. The move is expected to boost growth in the chocolate category in China by over four times.

Success with New Products

Hershey has continued to improve and innovate with its products, as evidenced by its venture into the non-chocolate candy (NCC) category in 2013 with products like Twizzlers Bites and Jolly Rancher Bites.

Its new products have so far been quite successful, if the 3QFY13 results are to be believed, and the company plans to spend 22-23% more in FY13 over the previous year to spur growth in its new products.

Hershey expects the introduction of such new products, along with the launch of Brookside’s product line, to be the significant growth drivers in the final quarter of the year. The company also plans to continue launching new products through 2014, including new offerings like York Minis, Hershey’s Spreads, and Lancaster Caramel Soft Cremes.

Gross Margins

Over the last five years, Hershey’s gross margins have improved by nearly 10ppts, partly because raw material prices are lower since then, and partly because it has improved its efficiency. And even though input costs fluctuated at various times in that period, the company was able to offset their impact by hedging its costs and improving its productivity. For example, the company was able to expand gross margins by 60 basis points (bps) despite an increase in input costs in FY12, mainly due to better productivity in its supply chain.

The company’s gross margins were up another 300bps in 3QFY13, and the management has raised its guidance for gross margin growth from 225bps to 245bps.

An increase in sales volumes also impacts the company’s margins positively, since it reduces its average fixed costs. Therefore, expected revenue growth from the sales of Brookside and Mini products will also contribute to gross margin expansion in the future.

Hedging to Spread Risks

Hershey hedges its input costs through forward contracts 3-24 months before it actually needs the raw materials. The strategy has largely been successful, as is evident from the fact that the company’s gross margins improved between FY08 and FY10 even though the prices of a key input, cocoa, rose over the period.

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Valuation

Hershey’s stock is currently priced at a multiple of 24 times its expected earnings for next year, which is a 40% premium to its peers’ valuations. The stock traded at a premium to its competitors over the last twelve months as well, which reflects the company’s strong growth prospects. In addition, its current forward price to earnings multiple is also significantly higher than its five-year average of 19x.

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Conclusion

Hershey’s prospects seem strong, and the market agrees that the success of its new products and its expansion into international markets will drive future revenues. The company also looks set to meet its net sales growth target of 9.5% in 4QFY13, which means it will likely meet its guidance of 7% sales growth for FY13 as well. Similarly, the company’s margins are also expected to expand following improvements in productivity.

Nonetheless, these factors seem to have already been priced into the high valuation of the company’s stock. For this reason, Bidness Etc rates Hershey as a hold even though we like the stock, and recommends investors to buy only on dips.

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