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Morningstar | While Hershey Posts Uninspiring 4Q, We Think Management Is Working to Support Its Edge Long Term

From our vantage point, the market is once again honing in on Hershey’s weak headline fourth-quarter numbers (0.1% organic sales growth and 20 basis points of degradation in adjusted gross margins to 42.5%), but we think there is more to the story. For one, across its operations, the company has been intentionally rationalizing its fare to ensure it's allocating shelf space and ad dollars to the highest-return opportunities (which management cited as a 100-basis-point drag on fiscal 2018 organic sales, without quantifying the hit to the fourth quarter). Further, management suggested there is still room for improvement in this regard, expecting a similar hit to fiscal-year 2019 results. Despite tempering reported financials, we view this decision as judicious, as it allows the firm to focus its resources on its leading brands.

Second, although adjusted operating margins popped 180 basis points to 18.6%, as has been the case, this improvement ensued because of a more than 13% pullback in advertising spend. However, we don’t believe this foreshadows an unwillingness to support entrenched retail relationships and leading brand mix (which when combined with its cost edge underpin its wide economic moat rating). Rather, we surmise Hershey is prudently opting to reduce spend on its smaller brands (where marketing has failed to elevate sales performance), while also leveraging its analytical insights as a means to reduce non-consumer-facing spend, which we view as wise.

With shares down at a low-single-digit clip, we'd suggest that investors consider snacking on Hershey’s shares, which are trading at nearly a 15% discount to our $118 fair value estimate, which remains in place. Further, we don’t intend to make any changes to our longer-term forecast, which continues to call for 3%-4% average annual sales growth and operating margins improving to almost 24% over the next decade (around a 300-basis-point increase relative to the average over the past five years).

Assessing the firm’s results through a geographic lens, international continued to shine (only 10% of sales, but up 2.6%), with Brazil, China, India, and Mexico each positing growth of more than 7%. 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 these gains are resulting from the firm’s focus (which CEO Michele Buck put in place when she took the helm nearly two years ago) to pull back spending abroad and concentrate its investments on where it maintains an edge, which we posit is steadying its competitive standing and should continue to lead to more profitable sales growth in the longer term.

Even though commodity and transportation costs continue to chip away at profits across the industry, we still 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). However, we don’t think the bulk of these savings will fall to the bottom line; rather, we anticipate Hershey will direct a portion of any savings toward its leading brand mix. As such, 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.