EUR 850.00 For Business Accounts Only

Morningstar | Despite Sluggish Sales and Profits in 1Q, Investors Should Indulge in Wide-Moat Hershey's Shares

While lackluster sales and profits characterized Hershey’s first-quarter results (organic sales edged up 1%, adjusted gross margins contracted 260 basis points to 44.9%, and adjusted operating margins eroded 150 basis points to 21.7%), we haven’t wavered from our belief that the firm is prudently investing to enhance its long-term competitive position. In this vein, we applaud the enhanced focus CEO Michele Buck has brought to bear during her first year at the helm--ramping up investments behind its core domestic brands while pulling back international spending. Further, we think recently announced actions to rightsize its brand mix on its home turf (incorporating the learnings from similar steps taken abroad over the last 12 months) should lead to improving sales and profits over our explicit forecast despite prompting the firm to guide to the low end of its prior 5%-7% sales targets for fiscal 2018. In our view, these efforts should ultimately enable Hershey to more effectively focus its resources, both financial and personnel, on the highest-return opportunities, ultimately supporting the brand intangible assets that form the linchpin of our wide moat rating while also taking complexity (and costs) out of its business, which we view as prudent.

We intend to review the assumptions underlying our discounted cash flow model and will likely trim our $118 fair value estimate by a few dollars (primarily reflecting a more tempered near-term sales and profit trajectory), but don’t foresee a material change to our long-term outlook of 3%-4% annual sales growth and operating margins improving to north of 23%. However, with shares trading at more than a 20% discount to our valuation, we think investors would be wise to feast on this wide-moat name.

As has been the case across the industry of late, higher volumes (up 2.4%) were partially offset by lower prices (down 1.4%). And although we don’t expect competitive pressures to subside, particularly from other branded offerings and smaller niche operators, we perceive the seeming traction outside its home turf as a plus (just 10%-15% of total sales, but up more than 6%, excluding the benefit from favorable foreign currency movements). These gains were particularly notable in Greater China (where Hershey has fallen victim over the past few years to its own executional stumbles and decelerating market growth) which posted a nearly 1% increase in underlying sales during the first three months of the year. However, this growth follows several quarters of declining performance, and as such, we aren’t yet convinced that top-line acceleration in this market will prove sustainable. More specifically, we’ve long thought that Hershey would struggle to secure an edge beyond its home turf where its larger competitors are already entrenched. In this context, we don’t surmise that Hershey is poised to grab meaningful share abroad, but we think the firm’s sales can trend up from the flat level we forecast in fiscal 2018 to a mid- to high-single-digit clip beginning in fiscal 2020 as investments to reignite operations (following the rationalization of its base of stock-keeping units since 2017 and the extension of distribution for its core mix) take hold.

In addition, although commodity and transportation costs (which are eating into industry profits) are unlikely to abate over the near term, we’ve been encouraged by the proactive steps management is taking to extract $150 million-$175 million in costs (a low- to mid-single-digit percentage of cost of goods sold and operating expenses), with about half of the improvement resulting from its less-profitable international operations. Rather than allow the entirety of these savings to fall to the bottom line, we anticipate that Hershey will continue to fund further investments behind its leading brand mix, particularly domestically. As such, we forecast more than 8% of sales, or $600 million annually, will be directed toward research, development, and marketing to support the intangible asset source of the company's wide moat.