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Morningstar | Investments to Enhance Retail Relationships Sweeten Hershey's Competitive Edge; Shares Undervalued

We walked away from wide-moat Hershey’s investor day, held Aug. 28 in Hershey, Pennsylvania, with renewed conviction that the firm’s efforts to leverage its scale and reach on its home turf to further entrench relationships with its retail partners are bearing fruit. As such, we aren’t altering our $116 fair value estimate, which is based on 3%-4% annual sales growth and a more than 300-basis-point increase in operating margins to nearly 24% by fiscal 2027. With the shares trading at a 15% discount to our valuation, we think investors should look to stock up.

Hershey’s dominance in the U.S. confectionery space is undeniable; the firm holds about a 45% share of the chocolate aisle, versus just a 1% share for private label. When combined with the resources Hershey invests behind its brands (we forecast research, development, and marketing to average 8% of sales or $700 million annually over the next decade), we think the firm remains a valuable partner to retailers. But questions have surfaced as to whether these relationships will hold the same clout online, particularly in snacking, where impulse purchases are commonplace and small, niche startups are also vying for share. Chief digital commerce officer Doug Straton, who joined the firm about 10 months ago from Unilever, suggested that Hershey is working with its retail partners to meld its online and offline strategies, an essential undertaking, given that three fourths of the time when consumers initiate a search, it occurs on retailer websites. Evidence of the success of these efforts is in Hershey placing second (behind General Mills) in Gartner’s L2 Digital IQ Index among its U.S. food peers, illustrating that the firm understands the necessity of investing to build out this area of its business. Overall, we think these efforts support our contention that Hershey is poised to drive accelerating sales growth over time and sustain its solid competitive edge at home.

While e-commerce sales are relatively negligible at this point, representing just around 1.5% of Hershey’s sales, the company forecasts that online consumer product sales will account for a middle-single-digit percentage of the market over the next five years. As such, Hershey is investing resources to ensure it is poised to take advantage of this growth. For one, the firm is launching packaging innovation to appeal to an online shopper, with a focus on ensuring product and quantity are clearly visible. Further, Hershey is now selling 30-bar variety packs to appeal to the impulse purchaser online. Importantly, it is bringing these innovations to market in a more timely fashion, with some of its recent innovations taking just 12 weeks to move from concept to shelf. These efforts have bolstered averaging selling prices online, which now stand at 1.2-3.5 times the level Hershey derives across its portfolio in brick-and-mortar outlets. But management stressed that it isn’t abandoning efforts to help retailers drive traffic in physical stores. Because consumers are opting to shop the perimeter of the store at the expense of center-store categories, Hershey is working to ensure its products are in front of consumers--underneath checkouts, between self-checks, and at curbside pickup locations.

Management said that the margin gap is just 100-150 basis points lower for e-commerce sales and that the gap relative to the corporate average is shrinking. As such, we don’t believe that growth through this channel stands to materially dilute the margin structure. Further, we believe Hershey is focused on driving efficiencies throughout the organization while investing to support its commercial initiatives, with plans in places to extract $150 million-$175 million in costs (a low- to mid-single-digit percentage of cost of goods sold and operating expenses), which we view favorably.

Management also reiterated its penchant to remain a consolidator in the space, with a focus on expanding into broader snacking adjacencies on its home turf, similar to the recent tie-up with Amplify and its Skinny Pop brand (in the past, the firm has indicated that an ideal target will fall in the $300 million-$400 million range). The firm expressed it is Hershey’s retail relationships that often appeal most to smaller startups (including Amplify), which struggle to get a foot in the door at leading physical store outlets. Given that Hershey has historically operated with capital-allocation prudence--reflecting 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--we don't expect it will veer from this bent. And we don’t believe the firm will hold on to laggards under the guise of driving growth, following recent announcements 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.