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Morningstar | While Accelerating Sales and Profits Have Proved Elusive, Hershey Is Showing It's on Right Course

CEO Michele Buck’s strategic agenda since taking the helm at Hershey in March 2017 has centered on ridding the business of underperforming assets (particularly overseas), while extending its scale and reach in its core North American market. We’ve long viewed this as prudent, given we believe the firm’s wide moat stems from the brand intangible assets (namely its solid retail relationships) resulting from its dominant share position in U.S. chocolate.

And we believe these initiatives are beginning to bear fruit. While second-quarter consolidated sales growth languished on an organic basis (down 0.6%) and margin deteriorated (with adjusted gross and operating margins off 260 basis points and 140 basis points, respectively, to 44.5% and 19.4%), international sales ticked up 5% and operating margins jumped 420 basis points to 8.7%, its highest ever mark, evidencing the efforts to slim down and refocus its mix abroad. Further, we portend that more improvement could be in the cards (with our segment forecast calling for high-single-digit annual top-line gains by the end of our 10-year outlook and operating margins approaching the low-double-digits), following the announcement that Hershey is parting ways with two loss-making businesses in Tyrells (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).

The market seemed to acknowledge the merits of this enhanced focus, sending shares up at a mid-single-digit rate. However, the stock still trades at a 15% discount to our $116 fair value estimate (based on 3%-4% annual sales growth and a more than 300 basis point increase in operating margins to nearly 24% by fiscal 2027), which we don’t intend to alter. In our view, investors should indulge in this name.

Even though commodity and transportation costs have impeded profits across the industry and are unlikely to abate over the near term, we view 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) favorably. However, rather than allow the entirety of these savings to fall to the bottom line, we anticipate that Hershey will continue to direct a portion of any savings toward its leading brand mix. Our forecast calls for 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, while it is continuing to digest the owner of the Skinny Pop brand, we still surmise that Hershey maintains an appetite to build out its presence in the domestic snacking space further through acquisitions (with management slating an ideal target in the $300 million-$400 million range). However, 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 going forward. Further, we haven’t wavered from our stance that Hershey will opt to return excess cash to shareholders, as it announced a $500 million share repurchase authorization and a 10% increase in its dividend. We forecast that it will repurchase shares to the tune of 2% outstanding on an annual basis, while also increasing its dividend at a mid- to high-single-digit clip through fiscal 2027 (maintaining a payout ratio of more than 50%).