Investors Can't Seem To Get Enough Of Hershey

By Stephen D. Simpson, CFA | April 25, 2013 AAA

I have to give credit where it's due – Hershey (NYSE:HSY) is definitely one of the strongest stories in packaged/branded food today. While there are a few relative newcomers showing better volume growth (from a much smaller base), Hershey continues to lead the way when it comes to the large U.S. companies. Better still, Hershey is mixing that growth with strong margin leverage and making a pretty pleasing combo. Although I still think these shares carry a premium valuation, it's hard to argue with a story where management is making so many of the right moves.

SEE: Evaluating A Company’s Management

First Quarter Results Were Good, And Probably Could Have Been Even Better
Expectations were pretty high going into Hershey's first quarter, with more than a few analysts claiming that the average estimates were too low. Even though Hershey actually missed the average sales target, I don't think that's really going to matter.

Revenue rose 5.5% this quarter, with a better than 5% improvement in volume, as well as some pricing improvement. It's worth noting, though, that the company's relatively new Brookside business contributed more than a third of that volume growth.

Hershey did very well on margins. The company continues to see significant input cost improvement, and that supported a better than two point improvement in gross margin (and almost one point better than expected). Operating income was up 9% and the company could have done better if it had wanted to, as management increased ad spending by 22% this quarter. While that ad spend didn't seem to impact takeaway all that much this quarter, we'll see how it impacts sales later in the year.

It's Good When Rivals Choose To Be Rational
One of the real positive developments for Hershey so far this year has been the behavior of its chief rivals. Mars, Nestle (OTC:NSRGY), and Mondelez (Nasdaq:MDLZ) all clearly want to improve their U.S. sales and market share, but nobody is getting aggressive with pricing. Given the leeway created by the lower input costs that could have been a real option, but so far it looks like most of the players in the U.S. confectionery market are focusing on margins and building growth through new product introductions.

SEE: 3 Secrets Of Successful Companies

Will Shuffling Management Lead To Any Bigger Moves?
The night before the earnings release, Hershey announced a series of management moves. The biggest move was switching Humberto Alfonso from his role as CFO to President of the International Business. Given how badly some analysts and investors want Hershey to make a move to acquire a stronger international presence, I have little doubt that some will see this move as a prelude to M&A activity.

I'm not in a rush to join that sentiment. I do believe that overseas M&A makes sense for Hershey (and should be a “when”, not an “if”), but I also see this move making sense simply as a way of creating a deeper bench of management talent. Perhaps having a “numbers guy” running the international business will lead to incremental changes, but I wouldn't necessarily assume that big changes are on the way in the near term.

SEE: Cashing In On Corporate Restructuring

The Bottom Line
Hershey stock has long carried a premium, and the combination of the melt-up in consumer stocks and Hershey's above-peer volume growth and margin performance hasn't hurt that at all. To that end, it's hard to call Hershey a real bargain today. I understand that Hershey has a well-respected management team, valuable brands, strong returns on capital, and well above-average earnings persistence. But as is the case with other strong brand companies like Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), and Nestle, I'm just not willing to accept a mediocre long-term rate of return in exchange for the incremental security of that return.

I still expect Hershey to grow its free cash flow (FCF) at a high single-digit rate, but I wouldn't be too interested in the stock unless it pulled back into the $70s. For investors who already own Hershey and have been basking in the market's love for all things consumer, I'd recommend enjoying the ride but considering placing some stops to guard against a sudden end to this love affair.

At the time of writing, Stephen D. Simpson did not own shares of any of the companies mentioned in this article.

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