Hershey Earnings: Margin Gains Not Enough to Placate the Market, Rendering Shares a Bit Undervalued

While our $196 fair value estimate shouldn’t see much change, the market continued to sour on wide-moat Hershey HSY despite fair third-quarter marks: 10.7% organic sales growth, 240 basis points of adjusted gross margin expansion to 44.9%, and a 230-basis-point bump in adjusted operating margin to 24.9%. In this context, Hershey’s stock price is down around 17% since January but has slid around 30% from its peak in early May.

We attribute the weakness to a host of concerns, ranging from potential volume degradation as a byproduct of increased usage of weight-loss drugs to whether penny-pinching consumers could leave confectionery fare on the shelf in favor of more essential, daily products. Despite these looming headwinds, we surmise Hershey is playing from a position of strength, given its dominant standing (controlling around 45% of the U.S. chocolate space) combined with the robust resources it maintains to ensure its lineup continues to evolve with consumer trends.

In this context, we’re encouraged that it is firm in its commitment to funnel resources toward its brands, with advertising spending up around 20% in the period; we think Hershey will expend a high-single-digit percentage of sales (nearly $1 billion) toward research, development, and marketing annually over the next 10 years. And even though management has been forthright that its innovation pipeline was a bit scant this year, this coincided with stepped-up spending to build out its capabilities and capacity (with capital expenditures set to approximate 7%-8% of sales, outpacing the less than 5% average that has historically characterized the business), which we see as prudent. And with these investments in the rearview, we think Hershey intends to flavor its mix over the coming quarters.

When taken together, the recent downdraft is creating an interesting opportunity for investors looking to indulge, in our view, with shares trading below our intrinsic valuation for the first time in about four years.