EUR 850.00 For Business Accounts Only

Morningstar | Hershey's Sluggish Sales and Profits Spook Investors, but Wide Moat Unwavering; Shares a Bargain

On the surface, Hershey's third-quarter results left a sour taste, with organic sales up a measly 0.5% (due to a 150-basis-point hit from lower prices) and adjusted gross margins down 130 basis points to 44%. Even though adjusted operating margins ticked up 60 basis points to 22.6%, this improvement resulted from a high-teens pullback in advertising and marketing spend, which we've historically viewed as a crucial element to back the firm's intangible assets. But we don’t contend that this bespeaks early signs of an eroding competitive edge, particularly on its home turf. For one, management repeatedly emphasized that this spending reduction was concentrated within its mix of smaller brands, where mass-media advertising has failed to generate sufficient returns. In this vein, the firm articulated that investment in core brands (about two thirds of its underlying sales) was flat in the quarter, suggesting Hershey's aim isn’t to bolster profitability at the expense of supporting its brand intangible assets (both its portfolio and its entrenched retail relationships), which in combination underpin our wide moat rating. Further (and similar to its peers), Hershey spoke to efforts to leverage its analytical insights as a means to reduce non-consumer-facing spend, which we view as prudent.

Results are tracking towards our full-year forecast (3.9% reported sales growth and EPS of $4.87) and management held the line on its outlook (sales growth of 3.5%-5.5% and EPS of $4.82-$4.97). As such, we see little to warrant altering our $116 fair value estimate, outside of a $1-$2 bump from the time value of money. Further, our long-term outlook, calling for 3%-4% annual sales growth and a more than 300-basis-point bump in operating margins to just shy of 24% by fiscal 2027, remains in place. With shares down at a mid-single-digit clip on the news, we'd suggest that investors treat themselves to Hershey’s shares, which are trading at a 15% discount to our valuation.

While North American organic sales (nearly 90% of its consolidated total) were tepid (down 0.6%), international continued to shine, with Brazil, China, India, and Mexico each up more than 7%. We attribute this performance to the firm's efforts over the bulk of the past two years to rationalize unprofitable stock-keeping units and focus its investments on the highest-return opportunities. While we aren’t blind to the fact that Hershey is going head-to-head with large, established peers in each of these markets (namely, wide-moat Nestle, wide-moat Mondelez, and privately held Mars/Wrigley), we believe this focus could stand to steady its competitive standing and ultimately lead to more profitable sales growth in the longer term. Further, we’re encouraged that these gains abroad aren’t coming at the expense of profitability, as segment operating margins amounted to more than 13% in the quarter, up from less than 7% in the year-ago period, which we believe provides added credence to the merits of management’s strategic agenda to slim down and refocus its mix abroad.

However, commodity and transportation costs continue to eat away at profits across the industry and likely reflect structural challenges that we don’t believe will subside in the near term. As such, we have a favorable view of management’s proactive endeavor to remove $150 million-$175 million in costs (a low- to mid-single-digit percentage of cost of goods sold and operating expenses), particularly in light of the fact that we think Hershey will funnel a portion of any savings toward its leading brand mix. In this vein, we forecast research, development, and marketing to amount to 8% of sales, or $700 million annually, over the next decade, supporting the intangible asset source of the company's wide moat.

From a capital-allocation perspective, despite poaching two snack food operators over the past year (Amplify and Pirate Brands), we believe Hershey will still look to indulge in further tie-ups in the domestic snacking aisle (with an ideal target falling in the $300 million-$400 million range). We’ve heard from management that it is Hershey’s retail relationships that seem to appeal most to smaller startups (including its two recent additions), which struggle to get a foot in the door at leading physical store outlets. However, we don’t posit that Hershey will veer from the capital allocation prudence it has exhibited in the past--partly due to the sizable ownership stake of the Milton Hershey School Trust (which maintains more than 80% voting power, despite its mere 30% ownership share), an operation that depends on the stable cash flows the business generates. But more encouraging in our view is that these actions don’t suggest the firm is merely looking to bolster top-line growth at any cost, as evidenced by the announcement earlier this year that it is parting ways with two loss-making businesses in Tyrrells (the international piece acquired with the deal for Amplify late last year) and Shanghai Golden Monkey (the Chinese confectionery business Hershey scooped up in 2013, which has been fraught with challenges, as Hershey has incurred impairment charges amounting to nearly half of the enterprise value at purchase), which we view as prudent.