Hershey Seriously Outperforms

By Stephen D. Simpson, CFA | April 19, 2012 AAA

Financial reports from packaged food companies haven't been all that spectacular lately, as almost every company has had to raise prices to preserve margins and suffer the volume consequences. Hershey (NYSE:HSY) looks like a pretty big exception to that rule, as the company rode serious price leverage to a very strong first quarter 2012. That said, Hershey is not cheap and investors need to ask themselves how much good news is already within the wrapper.

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A Real Blowout in the First Quarter
Words like "blowout" are used too often in describing company earnings, but I'm not sure that another word fits Hershey's performance better. While most analysts expected 4 to 5% revenue growth, Hershey came in with nearly 11% reported revenue growth and more than 10% organic growth.

Simply put, Hershey pulled the lever on pricing and suffered little for it. Pricing was up nearly 11% for the quarter, but volume fell less than 1% (and international volumes were up 2%). That's dramatically better than the recent performance of Nestle (OTCBB:NSRGY), Kraft (NYSE:KFT) or Tootsie Roll (NYSE:TR). Interestingly, it's also better than the Nielsen data would suggest it ought to be - as register data suggests that Hershey has been giving up some share in chocolate.

With better revenue came better profits as well. Gross margin rose one point on a reported basis and about 130 basis points on an adjusted basis. Operating income jumped 27% and the margin (adjusted) improved about three points. Not surprisingly, bottom line results also beat expectations.

SEE: Understanding The Income Statement

Tame Guidance - How Much Did Easter Matter?
Not surprisingly, Easter is one of the big candy holidays of the year and Hershey saw some benefit from the timing of the holiday this year. It's also interesting to me that the company did not raise full-year numbers by a magnitude that matches this quarter's outperformance. So, either management is playing cautious (not unusual for this group), or the "Easter effect" took a little momentum out of the second quarter and moved it forward.

Plenty of Growth Still Possible
Hershey is an interesting company - it has top share in the United States chocolate market, but it's not nearly so strong outside of the U.S. In fact, it's not really an exaggeration to say that Hershey is less than an afterthought everywhere but in North America.

Although Hershey is a solid No. 2 in North American confectionery (behind Mars), it's well below names like Arcor, Ferrero, Tiger, Strauss, Lotte and Meiji in Latin America, Europe, Africa and Asia. That's a mixed blessing. Obviously it makes the company more dependent on U.S. economic conditions and reduces global sourcing leverage, but it also means that there's a much longer growth runway in these markets.

To that end, Hershey has been reporting impressive-looking growth in markets like Mexico, China and Brazil, but isn't even close to being enough of a threat for Nestle, Kraft or Mars to feel the need to respond.

The Bottom Line
In my mind, Hershey has almost always looked expensive, and I suspect that's because there's a built-in buyout premium attached. While some believe the ownership of the Milton Hershey School Trust minimizes the chances of a deal, the Trust did apparently consider (albeit briefly) a sale a while ago. There would be enormous synergy with Nestle (as North America is Nestle's weakest confectionery market), but the huge sum Nestle just paid to Pfizer (NYSE:PFE) for its nutrition business probably means that another deal is not in the cards right away. Hershey could fit in with other companies - it would be a reasonable expansion for PepsiCo's (NYSE:PEP) snack business or a good starting point if Coca-Cola (NYSE:KO) wanted a food business - but those are long shots at this point.

Accordingly, while Hershey delivered a great quarter, the stock is just too expensive to excite me. The company does the best returns on capital in the sector (that I'm aware of) and a solid plan towards more consistent free cash flow execution, but even robust growth assumptions can't deliver a compelling fair value today.

SEE: 5 Must-Have Metrics For Value Investors

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

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