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Hershey Foods (NYSE HSY) is North America's largest chocolate producer. With 42.5% of the US chocolate market,^[1] Hershey sells products in 50 countries under 60 brand names including, Hershey's, Reese's, and Kisses.^[2] Additionally, Hershey maintains the right to manufacture and sell competitors' products, such as Kit-Kat bars, through licensing agreements with foreign Nestle (NSRGY) and Cadbury Schweppes (CSG).^[3] Although Hershey must pay for these rights, the company insulates itself from foreign competition through the agreements. With over 90% of its revenues coming from the United States, Hershey is one of the most geographically concentrated major food and beverage companies.^[2] However, the company has taken steps to expand internationally, including the acquisitions of Godrej Beverages and Foods in India and Van Houten in Singapore, as well as an agreement with Lotte Confectionery Co. to manufacture and sell chocolate products in China.^[4][5]

Rising costs are a particularly difficult challenge for Hershey; in 2008 alone, input costs increased more than $100 million.^[6] The company is particularly vulnerable to market prices of key ingredients like cocoa, milk, sugar and peanuts, all of which saw price increases in 2008^[7]. In order to combat rising costs, the company both lowered product weight and raised domestic wholesale prices.^[7] Given the price increases, Hershey has committed to refocusing on its core chocolate brands with a 20% increase in advertising spending through 2009.^[8]

Contents 1 Company Overview 1.1 Business Financials 1.1.1 Quarterly Earnings 1.2 Products 2 Trends and Forces 2.1 Rising Commodity Costs Pressuring Margins 2.2 Growing Global Demand Makes International Expansion Attractive 2.3 Premium and Dark Chocolates are Fast Growing Segments 2.4 Restructuring Initiative Promises Increased Savings 3 Competition 4 References

On January 19, 2010, Kraft Foods (KFT) bought Cadbury for $19.5 billion, outbidding Hershey to create the largest chocolate and confectionary company in the world.

Company Overview

Hershey is a manufacturer of chocolate and other candy items, selling its products in over two million retail outlets in 50 different countries.^[2] Although Hershey has global reach, more than 90% of its revenue and profits come from the United States.^[2]

Business Financials

Hershey's sales have stagnated since 2005 as competitor Mars has eaten into Hershey's share of the US chocolate market.^[1] In 2008, the company posted $5.13 billion in revenue, a 3.8% increase from 2007.^[10][11] In order to cut costs and regain competitiveness in the US, Hershey embarked on a three year, $575 million supply chain transformation program in 2007.^[12] Under the program, the company will cut the number of production lines by one-third in order to more effectively utilize productive capacity, outsource low value-added items, and construct a more cost efficient factory in Mexico.^[13] Hershey expects annual savings of $190 million by the time the project is completed in 2010.^[14]

The restructuring program has had a large impact on Hershey's net income, sending it up 47% in 2008 to $311 million.^[10] The increase is due to the success of the restructuring plan, increased advertising for the company's core brands, and higher prices introduced late in 2008. Hershey's income was also increased by the fact that the company recorded most of the restructuring costs in 2007 and therefore had fewer charges on its 2008 income statement.

Quarterly Earnings

Q1 2009

In the first quarter of 2009, Hershey posted revenues of $1.236 billion, a 6.5% increase over Q1 2008 figures; net income grew 20% to $75.9 million.^[15] The majority of the increase in revenue is attributable to an 11% price increase across chocolate and sugar confectionery lines initiated in August 2008. Stronger international sales muted foreign currency exchange losses. Total charges associated with the 2007 business realignment initiative shrank to $18 million from $30 million in Q1 2008 as the program nears completion.^[16]

Q2 2009

In the second quarter of 2009, Hershey posted revenues of $1.17 billion, a 5.9% increase over Q2 2008 figures; net income grew by 72% to $71.3 million.^[17] As in Q1 2009, the increase in revenue was due to the net pricing increase from August 2008. Although volumes fell slightly, a 46% boost in advertising from the first quarter helped stem any significant decreases. Unlike other international candy makers such as Nestle (NSRGY) and Mars, Hershey makes most of its sales in the US, so it was relatively unaffected by adverse currency fluctuations and the strengthening of the US dollar. Business realignment charges were $42.7 million in the quarter. From the initiation of the program to Q2 2009, the company has spent $591.7 on the initiative, and expects to end the program in late 2009 or early 2010 for a grand total of $640-665 million. The majority of remaining charges involve non-cash pension settlements.^[18]

Q3 2009

In the third quarter of 2009, Hershey posted revenues of $1.48 billion, a decrease of 0.4% from Q3 2008 (which had increased 6.4% from the previous year); net income grew by 30.1% to $162 million.^[19] The price increases instituted in 2008 increased revenues by 10%, however this was offset by a significant decline in volume. As discussed in Q2 2009 above, Hershey has a relatively small international presence, but adverse foreign currency exchange rates decreased revenues by 1.1%.^[20] Sales at retail increased 4.8% from the previous year and Hershey's market share remained the same.^[21] The company attributed the decline in sales to its decision to discontinue high-end Starbuck's Chocolates and Cacao Reserve bars; excluding these items, revenues would have increased approximately 4.8%.^[22] Compared to Q3 2008, lower dairy costs and the decreased volume led to a 9.4% decrease in costs. Charges related to the company's business realignment initiative totaled $8 million for the quarter, primarily the result of pension settlement losses and plant closure costs.^[23] Negotiations are continuing in Hershey's bid for Cadbury (CBY) however Kraft Foods (KFT) currently is the largest bidder and Cadbury (CBY) has said that any credible bid would have to be worth at least $19 billion. With a current market value of $8.25 billion (compared to Cadbury's value of $17.7 billion), Hershey may have trouble making a large enough bid.^[24]

Products

Hershey’s primarily makes cocoa for the production of chocolates, candies and other confectioneries. With 90% of its sales in North America^[25], Hershey's production facilities are primarily located in the U.S., Mexico and Canada. Beyond production, Hershey's offers its products through a variety of distribution channels including wholesale distributors, chain grocery stores, mass merchandisers, chain drug stores, vending companies, convenience stores, dollar stores and department stores^[26]. The McLane Company, distributor to Wal-Mart (WMT), is Hershey's largest customer, accounting for 26% of sales in 2007.^[27]. Hershey's offers products in several categories:

Chocolates:

• Hershey’s
• Reese’s'
• Hershey’s Kisses
• Milk Dud
• U.S. licensing of Nestle's Kit Kat

Premium Chocolates:

• Cacao Reserve
• Joseph Schmidt
• Dagoba

Refreshment products:

• Ice Breakers
• Breath Savers
• Bubble Yum

Trends and Forces

Rising Commodity Costs Pressuring Margins

Rising commodity costs are putting negative pressure on Hershey's operating margins. Hershey's is particularly sensitive to the prices of commodities like cocoa, milk and sugar which are all key ingredients in Chocolate making. Since the beginning of 2008, prices for key ingredients like cocoa, milk, sugar and peanuts are all up 20% to 40%^[28]. These rapid price increases show no signs of abating as Hershey's predicts commodity prices will increase twice as fast in 2009 compared to 2008^[29]. Much of this rise comes increases in sugar, which almost doubled between January and August 2009.^[30] Hershey's combats increasing input costs with a combination of price increases and various hedging strategies. In 2008 alone, the company has twice raised wholesale prices^[31].

Growing Global Demand Makes International Expansion Attractive

Huge markets in China, India and other developing countries also present a big opportunity for Hershey's. Chocolate sales in China have doubled to $813 million over the last five years while India's chocolate sales have risen 64% over the same period^[32] Hershey's has tried to move into these markets with through joint ventures with Lotte Confectionery of South Korea and Godrej in India. Still, with 90% of sales within North America, international expansion remains a big opportunity.

Premium and Dark Chocolates are Fast Growing Segments

As the U.S. chocolate market matures, Hershey's is seeking out new avenues for growth. Premium and dark chocolate are two rapidly growing segments of the chocolate market. U.S. premium chocolate sales grew 129% from 2001 to 2006 while dark chocolate sales increased 49 percent to $1.88 billion between 2003 and 2006^[34], much faster than the overall chocolate market. By 2011, premium chocolate is expected to make up 25% of the US chocolate market, amounting to more than $4.5 billion in sales.^[35] Dark chocolates are gaining popularity due to their newly perceived healthiness; studies have shown that dark chocolate has antioxidant properties and may provide cardiovascular benefits^[36]. Hershey's has taken advantage of this trend by introducing it's own dark chocolate products, Extra Dark and Cacao Reserve, as well as acquiring smaller premium chocolate companies such as Dagoba and Joseph Schmidt^[37].

Restructuring Initiative Promises Increased Savings

Hershey's lags behind its competitors in terms of operating margins. While traditional margins in the packaged food and Chocolate industry have been around 25 percent, Hershey's margins are below 20 percent.

In order to expand margins, Hershey's is undertaking a $525-$575 million supply-chain restructuring plan. As part of its "Global Supply Chain Transformations" the company will reduce production lines, outsource the production of many of it's low value-added products and build a new cost effective facility in Mexico. The company expects to save $180 million annually by 2010 if this plan is implemented properly. Hershey's has indicated that this initiative would lead to greater manufacturing flexibility and allow the company to support its strategy to penetrate into new markets^[38].

Competition

Hershey’s enjoys the largest share of the US Chocolate market and is the leader in both single-serve and bulk (boxes/large bars/bags) Chocolate products. Mars is Hershey's closest rival, owning well-known brands such as Mars, Snickers, M&M's, Milky Way and Twix. In April 2008, Mars announced the $23B acquisition of Wrigley. The deal creates a confectionery giant combining many stable brands with global distribution^[39]. The new Mars-Wrigley could pose a serious threat in Hershey's core North American business.

The threat of competition in North America from powerful global confectionary companies such as Nestle (NSRGY) and Cadbury Schweppes (CSG) is effectively mitigated through Hershey’s licensing agreements. In the case of Néstle, Hershey's owns exclusive US licensing rights to Kit Kat – one of Nestle's strongest brands. Without the Kit Kat platform it will be difficult for Nestle (NSRGY) to gain a competitive edge in the US market. Hershey’s also owns the US licensing rights to all the Cadbury Schweppes (CSG) brands, thus preventing Cadbury Schweppes (CSG) from entering the US market.

On January 19, 2010, Kraft Foods (KFT) bought Cadbury for $19.5 billion, outbidding Hershey to create the largest chocolate and confectionary company in the world. The merger hurts Hershey's international growth prospects as the company had been hoping Cadbury would greatly expand Hershey's brands beyond their current domestic marketplace. In the wake of the merger, rumors have circulated that Nestle (NSRGY) is looking to buy a smaller competitor such as H.J. Heinz Company (HNZ) or General Mills (GIS), and Hershey's name has also been mentioned. However, a spokesman for the Hershey Trust has categorically denied any possibility of a takeover.^[40]

References

1. ↑ ^{1.0 1.1} Mars takes a bite out of chocolate giant Hershey.
2. ↑ ^{2.0 2.1 2.2 2.3} HSY 2007 10-K pg. 1  
3. ↑ HSY 2007 10-K pg. 3  
4. ↑ HSY 2007 10-K pg. 27  
5. ↑ Hershey to buy Van Houten Singapore consumer business from Barry Callebaut.
6. ↑ HSY 2007 10-K pg. 49  
7. ↑ ^{7.0 7.1} Hershey, Again, Raises Prices To Help Offest Higher Costs.
8. ↑ Hershey Hopes More Ads Will Sweeten Sales.
9. ↑ HSY 2007 10-K pg. 24  
10. ↑ ^{10.0 10.1} Hershey 4Q profit rises partly on raised prices.
11. ↑ HSY 2007 10-K pg. 21  
12. ↑ HSY 2007 10-K pg. 23  
13. ↑ HSY 2008 10-Q pg. 10  
14. ↑ Hershey sets restructuring plan, to cut 1,500 jobs.
15. ↑ HSY 2008 10-Q  
16. ↑ HSY 2008 10-Q  
17. ↑ Hershey Announces Second Quarter Results and Increases Full Year Net Sales and EPS Outlook.
18. ↑
19. ↑ HSY Q3 2009 10-Q, p. 3
20. ↑ HSY Q3 2009 10-Q, p. 22
21. ↑ HSY Q3 2009 10-Q, p. 23
22. ↑ HSY Q3 2009 Earnings Call Transcript, Seeking Alpha
23. ↑ HSY Q3 2009 10-Q, p. 22-23
24. ↑ Solo Hershey Bid For Cadbury Remains a Stretch, Telegraph, 1/14/2010
25. ↑ Hershey's 2007 10K- Item 1. Business- Reportable Segment
26. ↑ Hershey's 2007 10K- Item 1. Business- Customers
27. ↑ Hershey's 2007 10K- Item 1. Business- Customers
28. ↑ WSJ.com Hershey's Raises Wholesale Prices Again
29. ↑ WSJ.com Hershey's Raises Wholesale Prices Again
30. ↑ U.S. food companies seek easier sugar quotas.
31. ↑ WSJ.com Hershey's Raises Wholesale Prices Again
32. ↑ Motley Fool- Chocolate in Asia: A Very Sweet Megatrend
33. ↑ Mintel U.S. Chocolate Confectionery Report
34. ↑ Boston Globe- U.S. dark chocolate sales soar on health benefits
35. ↑ U.S. Chocolate Sales Forecast to Reach $18 Billion by 2011.
36. ↑ Boston Globe- U.S. dark chocolate sales soar on health benefits
37. ↑ Boston Globe- U.S. dark chocolate sales soar on health benefits
38. ↑ Hershey's 2007 10-K Item 7. Management's Discussion- Business Realignment Initiatives
39. ↑ Mars to Buy Wrigley's for $23b.
40. ↑ Is Nestle Looking to Gobble Up Hershey?, Pennlive.com, 1/27/2010
41. ↑ Mintel U.S. Chocolate Confectionery Report