Hershey Foods (HSY)

Hershey's should benefit from changing US demographics. The company enjoys a very strong position in the dark chocolate segment and growth in this segment is highest among older Americans.

Although the company was able to raise prices for the second time in a year, the hike “will help offset increases in areas of the Company’s input costs, including raw materials, fuel, utilities, and transportation.” Not offset, help offset. That is still a signal of shrinking margins. But shrinking margins are exactly what the company told us to expect in late January. Hershey’s expects a sales increase of 3-4% this year, but for diluted EPS from operations to decline from the $2.08 reported in 2007 to the $1.85-$1.90 range. And that excludes the impact of an estimated $0.37-$0.40 in restructuring charges. Since Hershey’s has reported such charges in seven of the last eight years, treating them as non-recurring stretches both my credulity and my patience.

Regardless of the ultimate impact on results, the price increase could distort results during the current quarter. During the four-week period ending February 24, 2008, existing customers may, based on their historic order patterns, order and take delivery of up to eight weeks of inventory at current prices. Given that the consensus estimates expect the first quarter to show the worst performance compared to last year, inventory builds could result in a one-time positive surprise that should be ignored.

No matter how many problems a company may have, however, there comes a time that the stock price is cheap enough to qualify as a good investment. I think that time may finally have come for Hershey’s.

The Hershey Trust has thwarted takeover attempts in the past, one of which sent the stock vaulting into the 70s. The recent announcement of the Wrigley-Mars deal woke HSY up from its slumber in the mid-30s amid speculation the company might consider a joint venture with one of its major rivals Nestle NA or Kraft (KFT) to compete with the new Wrigley giant.

With a dividend of 3% and double-digit earnings growth forecast for 2008, it might be sweet to hang around here.

Overall, the quality of earnings at Hershey’s has been reasonably strong. Based on the accrual ratio, which measures the difference between cash earnings and accounting earnings (closer to zero is better) Hershey’s earnings quality has been relatively stable – seldom drifting more than 15% in either direction. Note too that when it did drift widely it marked an excellent time to sell, which to me helps validate using the accrual measure for this purpose.

Hershey’s also generates tons of cash flow. Over the last 12 months, its free cash flow yield has been about 6.7% - a healthy premium over the Treasury yield. A little more than 40% of the cash flows are given to investors as dividends, and the 3.4% dividend yield is more than 1.1% above the Treasury yield on an after-tax basis.

Finally, I think growth estimates are reasonable. The consensus five-year growth rate, at 7.5% per year, is in line with the 6.5% reported over the last five years and well below the sustainable growth rate implied by Hershey’s 33% return on equity. Although I don’t expect organic growth equal the sustainable rate, using the cash flow for acquisitions and share buybacks can make up a good chunk of the difference. Since 2002, buybacks have reduced the diluted share count by nearly 17%, which should eventually pay off in EPS growth.

At this point, even if Hershey’s problems don’t go away, merely not getting worse should be enough to get the shares back on track[1].

In June 2008, Hershey announced plans to boost advertising this year and in 2009 by at least 20%^[1]. Increased ad dollars will be devoted to the company's core brands like Reese's and Hershey's Kiss which currently generate 60% of the company's sales. This is a long awaited, positive development for Hershey. The company has long under-invested in its core brands. A sales boost from increased advertising may offset the effects of rising input prices. Increased ad spending may already by paying dividends, in the quarter ending September 29th, 2008, HSY reported a 6% increase in sales on the back of a 25% increase in advertising spending.

Hershey's has the dominant position in the US market and owns some of the most powerful consumer brands. The company can leverage these strengths to offer new products, such as snack nuts and premium dark chocolate, and enter new markets.

Hershey's restructuring initiative will lead to meaningful reduction in costs enabling the company to be more flexible and invest in new markets.