This Candymaker's a Sweet Deal

We believe the market is pricing

Hershey's volume in the United States, where the firm derives nearly 90% of its consolidated sales, has come under pressure the past few quarters following the company's decision in July 2014 to raise prices an average of 8% across its instant consumable, multipack, packaged candy, and grocery product set in light of commodity cost pressures, particularly for cocoa, sugar, and dairy. Other leading industry players quickly followed this announcement with their own price increases.

It is not uncommon for Hershey's volume to be constrained in the periods immediately following a price increase; in fiscal 2009, volume tumbled 6%, and 2012, volume ticked up just 2%. However, growth tends to resume in fairly short order. As evidence, consolidated volume accounted for nearly two thirds of Hershey's organic sales growth (around 3.5%-4%) outside of the years when higher prices hit the shelves. In our view, this shows that volume declines have historically not indicated that Hershey's competitive position has deteriorated on its home turf.

As such, we believe Hershey is competitively advantaged and will remain so, generating returns on invested capital in excess of our cost of capital estimate for at least the next 20 years. Brands can be a significant advantage for consumer product firms. To assess the strength of a brand, we look at a firm's ability to consistently pass inflationary pressures to customers. Hershey has historically generated price/mix at or above inflation, as measured by the consumer price index. In that light, we assert that a firm with a solid brand portfolio, like Hershey, is best positioned to charge higher prices without a lasting negative hit to volume. This supports Hershey's wide economic moat rating and our forecast that volume growth will resume to a low-single-digit rate before long, an aspect that the market fails to appreciate.

Further, we think consensus fails to appreciate that Hershey stands to add to its dominant position in the domestic chocolate business over our 10-year explicit forecast. Hershey operates as a leading confectionery manufacturer and has actually expanded its market share over the past four years to 45% of the U.S. chocolate space, including two brands that each generate more than $2 billion in annual sales and one that produces $1 billion-$2 billion in sales each year. We believe this makes Hershey a valued partner for retailers, supporting its intangible asset moat source. We continue to believe that building and maintaining a reputation as a critical supplier can help consumer packaged goods manufacturers carve out sustainable competitive advantages. All else equal, retailers would rather do business with an established vendor with whom they have had a long-term relationship in an effort to avoid costly out-of-stocks and also to help them contain or even reduce costs. As Hershey invests in research and development and marketing to support its leading chocolate share position, we think it stands to bolster its retailer relationships and the intangible asset source of its wide moat as a result.

Ability to Leverage Customer Acquisition Costs Solidifies Competitive Edge We contend that Hershey maintains a cost edge, which should ensure it is able to fund further investments to support its leading brand mix and its retail relationships to a greater degree than new entrants with limited budgets, ultimately creating a barrier to entry. To highlight this, we've stripped out customer acquisition costs (R&D, advertising expenses, and some other discretionary costs) to compare the go-to-market cost structures of companies across the consumer staples industry. On that basis, it is evident that Hershey's scale on its home turf affords a vast network over which to leverage its fixed costs. When adjusted for expenses not directly linked to the production and distribution process, Hershey's profitability and costs per employee run in line with or are superior to other global packaged food operators. As the firm gains further share (and scale) at home, this cost edge should prove more advantageous.

We believe that with its dominant brands, strong retail relationships, and cost edge, Hershey is poised to drive accelerating sales growth over the course of our 10-year explicit forecast at home, despite the market's more muted outlook. We forecast Hershey's domestic volume degradation will ease over the course of the upcoming holiday season and volume will return to a low-single-digit rate of growth over our 10-year explicit forecast. As a result, the firm will gain additional share of the U.S. chocolate space. When including a low-single-digit contribution from higher prices and favorable mix each year, our forecast calls for U.S. sales growth to approximate 3.5%-4% annually longer term.

Consumers are increasingly shopping the perimeter of the store at the expense of center-of-store categories, but we've been encouraged that Hershey is working with its retail partners to ensure its products are in front of consumers where they are shopping, stocking its wares underneath checkouts, between self-checkouts, and at curbside pickups, which we view positively in light of the intensely competitive environment in which it plays. These efforts support our contention that Hershey is poised to drive accelerating sales growth over time and sustain its solid competitive positioning at home.

Expansion Into China Proving a Bitter Pill Hershey's challenges have extended abroad, where the firm derives the remaining 10%-15% of its total sales. Hershey's international organic sales were bleak in fiscal 2015, tumbling in each of the quarters following flat sales to start the year.

This lackluster performance has been particularly acute in China, but the relatively small contribution to Hershey's overall business mutes this impact; we estimate the country is the firm's second-largest market, accounting for 40% of Hershey's international sales but just 5% of its consolidated total. Hershey has been plagued by a marked deceleration in overall market growth, intentional efforts to reduce trade inventories to match recent demand trends, and challenges surrounding its acquisition of Shanghai Golden Monkey. While the slowdown in market growth and trade inventory reductions have afflicted firms throughout the consumer product space, the pronounced disruption for Hershey following the acquisition of Shanghai Golden Monkey has been a bit more concerning. We generally think that acquiring local firms or taking part in joint ventures with native companies that understand respective markets helps to minimize the risk inherent in international expansion. However, since the deal was inked in December 2013, we suspect Shanghai Golden Monkey generates about half the level of sales, or around $90 million annually, which equates to about 25% of Hershey's China sales but only 1% of its total sales base. In acknowledgement of the issues that have ensued since the tie-up, Hershey incurred a $250 million impairment charge in the second quarter of 2015, nearly half of the enterprise value at purchase.

We don't perceive these issues as insurmountable, and we think the market is placing too much emphasis on Hershey's ability to turn around its operations in this region. Hershey is extending its distribution in China, particularly in online sales channels (which is growing at 3 times the rate of the overall category), and expanding its product set to include more everyday items, moving away from gifting, where sales have faltered following heightened regulatory scrutiny. We've long thought Hershey may be challenged as it extends abroad and believe it stands to own a smaller slice of the overall global confectionery pie over time.

While we view efforts to improve its trajectory as prudent, we don't expect they will drive a material acceleration in the firm's international sales over the near term. Our forecast calls for international sales to remain muted in fiscal 2016, posting an increase in the low- to mid-single-digit range, before resuming a high-single-digit growth rate in fiscal 2017 as investments to reignite operations take hold. We don't anticipate that sales outside the U.S. will meaningfully move the needle on Hershey's consolidated results, but rather will account for just around 15% of total sales longer term. Hershey's operations in China have a muted contribution to its consolidated business, a point that we think the market has lost sight of.

We Don't Foresee Hershey's International Presence Bolstering Its Edge Hershey has failed to replicate its dominant U.S. confectionery position abroad, but we never anticipated it would post outsize growth or gain meaningful share outside its home market. According to management, Hershey derives the bulk of its $1 billion in international sales from four primary markets: Brazil, China, India, and Mexico.

We don't believe that Hershey's challenge to grow in these markets is the result of lackluster demand for chocolate as a category. Chocolate growth in India is forecast to soar more than 500% between 2005 and 2017 (according to Euromonitor), while growth in China is expected to jump nearly 150%--although we note this growth is coming off a very low base of consumption, as these two markets boast annual per capita chocolate consumption of less 1 kilogram versus around 10 kilograms in Switzerland, 8 kilograms in Germany, and 4 kilograms in the U.S. We believe that a firm's ability to take advantage of this growth will ultimately be a reflection of whether it's able to tailor its mix to meet local consumer tastes and preferences.

In this vein, we continue to believe that Hershey stands to own a smaller slice of the overall pie over time, as established rivals (namely Mondelez MDLZ, Nestle NSRGY, and Mars/Wrigley) maintain beachheads in attractive emerging markets, particularly the regions in which Hershey has sought to play. While we don't foresee Hershey's international presence bolstering its competitive edge, we still believe the firm has growth opportunities for its brands in many overseas markets, beyond the favorable demographic and disposable income trends that we anticipate will support emerging-market growth longer term. For one, we think efforts to increase penetration in alternative channels, including e-commerce (which is expected to grow at around 3 times the rate of the category in brick and mortar), stand to bolster Hershey's top-line prospects. We contend that growth will also result as the firm extends its product reach beyond gifting occasions and builds out its brand set abroad. In the aggregate, our forecast calls for international sales to resume high-single-digit top-line growth beginning in fiscal 2017, resulting from a mid- to high-single-digit increase in international volume annually and a low-single-digit uptick in prices.

However, it is important to note that our forecast for international sales does not imply meaningful local share gains; we expect the firm's growth to lag that of the underlying category abroad. Based on estimates for local chocolate market growth through 2019 as cited by Euromonitor and Hershey's disclosures surrounding its own country-specific share positions, our international sales forecast implies that Hershey's share in each of its four primary international markets will stay about the same or decline marginally between fiscal 2014 and 2019. While the chocolate space in Brazil, China, India, and Mexico is forecast to grow at a low-double-digit rate compounded annually over the next five years, we expect Hershey's sales to tick up at a mid-single-digit compound annual rate.

We See Margin Gains in the Cards Hershey is exclusively focused on the snack aisle, which boasts higher growth (approximately a mid-single-digit rate annually) and profitability (operating margins in the mid- to high teens) than other categories in the grocery store. However, competitive pressures persist, and Hershey isn't just resting on its leading share position. Similar to industry peers, Hershey is attempting to extract costs from its operating platform, including improving its supply chain efficiency at home and abroad. But rather than merely beefing up its profits, the firm continues to allocate a portion of any savings realized to bringing new products to market (including "hand to mouth" offerings) that win with consumers and touting that fare in front of consumers. In that vein, we anticipate Hershey will reinvest in R&D and marketing, which together amount to 8% of sales annually, or $600 million, to support its brand intangible asset.

Whether this level of spending will be sufficient to offset competitive pressures and ensure its products win with consumers around the world is debatable, but to put these expenses in perspective, we compared the percentage of sales we expect Hershey to apportion among cost of goods sold, selling, general, and administrative expense, marketing, and R&D over our 10-year explicit forecast with a group of its industry peers. This comparison revealed that Hershey could stand to extract additional SG&A costs from its operations, since it continues to spend more than its peers as a percentage of sales but spends a commensurate level of sales behind its brands relative to a group of its packaged food peers. Further, we anticipate that Hershey's operating margins will remain in excess of its packaged food peers', reflecting the firm's strong brand mix, entrenched retail relationships, and cost edge, with operating margins averaging north of 21% over the next 10 years versus nearly 18% for its peer set.

Given that Hershey does not have a significant tenure operating internationally and is still working to build out its sales and distribution network abroad, it is not surprising that operating margins in its international markets remain muted relative to those generated on its home turf. While we forecast that Hershey will realize profit gains around the world as it works to leverage its scale and drive supply chain and manufacturing efficiencies, we anticipate that operating margins in the U.S., which we forecast will average nearly 32% over our explicit forecast, will remain about 3 times those generated in the global arena, averaging just less than 7% over the same period.

Long-Term Investors Have a Chance to Indulge We don't believe the market shares our stance that Hershey's solid competitive positioning will enable the firm to withstand recent headwinds at home and abroad. We forecast around 5% consolidated sales growth over the next 10 years, with just north of two thirds resulting from increased volume and the remainder from higher prices and favorable mix. We expect Hershey to generate modest gross margin improvement of 170 basis points over our explicit forecast to nearly 47% and expand consolidated operating margins nearly 300 basis points to 22% by the end of our 10-year forecast. These assumptions drive our $103 fair value estimate, which implies forward fiscal 2016 price/adjusted earnings of 23 times. Returns on invested capital (including goodwill) have historically exceeded our 7% weighted average cost of capital estimate by a factor of more than 3 times, averaging 23% the past 10 years. We forecast that ROICs will average 27% over the next five years, supporting our stance on the firm's wide economic moat. We view Hershey as an attractive investment opportunity for those looking to gain exposure to the packaged food space.