Hershey's Sweet Wide Moat Unwavering

We're holding the line on our $103 fair value estimate after incorporating recent results, which implies fiscal 2016 price/adjusted earnings of 24 times and enterprise value/adjusted EBITDA of 15 times. While the firm lowered its long-term sales (to 3%-5% growth from 5%-7%) and earnings target (to 6%-8% from 9%-11%) earlier this year, we'd held that its prior expectations were too sweet. Our long-term forecast, which remains in place, falls within Hershey's revised outlook.

Falling volume in the United States, where the firm derives 85%-90% of its sales, is far from a positive, but these trends echo times Hershey raised prices, most recently in 2009 and 2012. Given the firm’s strong brands and entrenched relationships with retailers, as well as efforts to bring new products to market and tout that fare in front of consumers, we suspect this volume pressure will ease throughout the year, and we forecast a low-single-digit uptick in domestic volumes in fiscal 2016.

Further, volume degradation has failed to abate in China, as the firm continues to reel from 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. Despite this, we still think the market is overemphasising Hershey's ability to turn around its operations in this region (which we estimate account for just 5% of the firm's total sales). Hershey may be challenged as it extends abroad; our forecast calls for international sales to remain muted in fiscal 2016, declining at a mid-single-digit rate, before resuming a high-single-digit rate of top-line growth in fiscal 2018 as investments to extend its product and distribution reach take hold.

The biggest risk to our valuation surrounds Hershey's ability to compete and continue generating further margin improvement in an aggressive category, both at home and abroad. As such, we assign Hershey a medium uncertainty rating. If Hershey is able to wring additional costs from the business--which ultimately drop to the bottom line--and input cost pressures fail to re-emerge, our current forecast may be too conservative. In addition, if consumer spending levels tick up and new products resonate with consumers more than our initial expectations, sales growth could accelerate. In this scenario, sales growth would average 6% annually through 2025 (compared with just 4% in our base case), and operating margins would approximate 24% (versus 22% in our base case) at the end of our 10-year explicit forecast. This case results in a fair value estimate of $137 per share. However, our current forecast could prove to be too optimistic if Hershey is required to ramp up its investments in product innovation and marketing support for core brands because of intense competitive pressures, which could make margin improvement unsustainable. Further, if consumers balk at Hershey's new product offerings or prices, sales growth could become sluggish. We assume that sales growth would subsequently average around 1.5% annually during the next 10 years, while operating margins would amount to just less than 21% by 2025. This scenario results in a fair value estimate of $74 per share.

On a consolidated basis, we forecast 4%-5% annual sales growth over the next 10 years, with just more than half resulting from increased volume and the remainder from higher prices and favorable mix. In addition, we expect Hershey to generate modest gross margin improvement of 90 basis points over our explicit forecast to nearly 47% and expand consolidated operating margins about 300 basis points to 22% by fiscal 2025.

Intangible Assets, Cost Advantage Confect Hershey's Moat but Global Expansion Won't Be Easy We assign a wide moat rating to Hershey resulting from its intangible assets and cost advantage. Hershey operates as a leading player in the confectionery space, expanding its market share over the past four years to 45% of the U.S. chocolate industry, with a portfolio that includes two brands that each generate more than $2 billion in annual sales and one that produces $1 billion-$2 billion in sales each year. Hershey has historically generated price/mix at or above inflation, as measured by the Consumer Price Index. We assert that firms with a solid brand portfolio, like Hershey, are best positioned to charge higher prices without a lasting negative hit to volume, supporting Hershey's wide moat rating. From our vantage point, 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.

We also 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.

However, even though Hershey still has these competitive advantages we think they are eroding as the firm expands abroad. the company will be challenged as it extends outside the U.S. and believe it stands to own a smaller slice of the overall global confectionery pie over time as it faces aggressive competition from several large and globally diversified firms, namely

Volatile Commodity Prices Could Hurt Profitability Volatile commodity costs--particularly for cocoa, sugar, and dairy--may hurt Hershey's profitability from time to time. In particular, dairy costs--which can't be hedged--can ebb and flow. Longer term, increased raw material demand in faster-growing emerging markets may keep upward pressure on commodity costs, and as such, may plague the leading domestic chocolate confectionery firm going forward. In addition, the firm faces heightened competitive pressures from not only other confectionery players but also other snacking options outside the confectionery aisle (a particularly challenging predicament, given that food channel traffic trends remain lackluster).

We still think Hershey's growth and expansion efforts could be hindered as larger and more diversified players maintain established positions in faster-growing emerging markets where tastes and preferences tend to be more localized. Given the significant consolidation in the global confectionery arena over the past few years, Hershey may feel compelled to take part by pursuing a deal of its own, which could add risk to operations if it extends the firm beyond its core competencies.

In that light, Hershey's acquisition record appears to have hit a snag following the tie-up with Shanghai Golden Monkey in December 2013. Based on management's commentary and our own estimates, we suspect Shanghai Golden Monkey generates about half the level of sales--around $90 million annually, which equates to about 25% of its China sales but only 1% of its total sales base--compared with when the deal was inked, prompting a $260 million impairment charge (which is nearly half of the enterprise value at purchase) in fiscal 2015. In addition, the firm has cited issues at its local partner surrounding accounts receivable collection and its distributor network. Given enhanced management oversight and the trust's ownership stake, though, the firm will exhibit more prudence in its pursuit of deals going forward.