Hershey: A Lot To Like, Except The Price

Investment Thesis

The Hershey Company (NYSE:HSY) is the leading chocolate manufacturer in the U.S. with a 33% market share, 7% more than its peer Mars (second-leading). When it comes to capital spending priorities, the company is extremely focused on returning cash to its shareholders. With a dividend payout ratio of 46%, the company returns almost half of its profits to shareholders. Annual dividends per share have increased by 114% in the past 10 years. This translates into an annual increase of 11.4%. In the last five years, stock buybacks have also been a recurring theme with HSY, allocating approximately $1.5 billion, or 22% of free cash flow, to share repurchases. This has enabled EPS to grow at a rate of 15% over the same period, more than double the sector's median. HSY has averaged an ROIC of ~22%, which is way higher than my calculated WACC of ~6%, further indicating the company's effectiveness at deploying capital and creating positive value for its shareholders.

HSY is also well positioned financially, with net debt/EBITDA that has averaged less than twice in the past five years. Better than most peers. The company has recently acquired Pretzel's, a salt snack company, to further diversify its business. In my opinion, HSY's management is top-tier. They have beat expectations (EPS) for the past 10 consecutive quarters and delivered on revenue, EPS, and CapEx guidance for the past five years. HSY's strong brand equity has enabled a cost advantage, and frequent price increases have allowed for higher margins than peers. As you can see from the image below, according to seeking alpha, HSY's margins are in a much better position when compared to its sector, earning the company a profitability grade of A. I believe the company's elevated margins and strong cash flow generation should help it maintain its dividends and allow for buybacks here and there.

Company Overview

With a $41 billion market cap, Hershey was founded in 1894 by Milton S. and is one of the largest snack companies in the world. The company markets, sells and distributes products under more than 100 brand names in approximately 80 countries worldwide. Some of HSY’s major brands include Hershey’s, Hershey’s Kisses, Reese’s, Twizzlers, SkinnyPop, and Pirate’s Booty. The company reports revenue across three segments:

North America Confectionery (82% of revenue): This segment included the sales of traditional chocolate and non-chocolate confectionery in the United States and Canada. Products include chocolate, gum, protein bars, spreads, snack bites, and more. Margins experienced a jump in 2022, mainly driven by price increases.

North America Salty Snacks (10% of revenue): This segment is responsible for salty snacking products in the United States. Products include ready-to-eat popcorn, baked and trans-fat-free snacks, pretzels, and other snacks. Revenue experienced a boost in 2022, mainly due to the acquisition of Pretzels in 2021.

International (8% of revenue): International is a combination of all other operating segments, including those geographic regions outside of North America. Such as in Mexico, Brazil, India, and Malaysia. 2020 the company reported no profit for segment income, but the operating margin has experienced stellar growth, surpassing post-pandemic highs.

HSY continues to refine its portfolio of brands. In December 2021, HSY completed the acquisition of Pretzels (a salt snack company); in June 2021, it completed the acquisition of Lily’s Sweets (which sells a line of sugar-free and low-sugar confectionery foods); and in January 2021, it completed the divestiture of Lotte Shanghai Foods Co., Ltd. Some competitors include Mars, Ferrero, Mondelez, and Nestle.

I believe the company's moat is derived from its brand equity and leading position within the industry. Being a company with such a long tradition has allowed the firm to build trust with customers, which in turn results in pricing power. HSY's frequent price increases have allowed them to have higher margins than most peers. The company's products are also not that expensive, so I believe an occasional price hike here and there won't matter to the consumer.

Recent Developments

HSY's stock is down by 11% YTD and 26% from an all-time high in March. On the other hand, the S&P 500 (SPY) is up by 12% YTD as of the time of this writing. The company reported second-quarter earnings on July 27th, EPS of $2.01 ($0.10 beat), and missed revenue by $9.68 million. Organic sales edged up 5% in the second quarter, reflecting a nearly 8% benefit from higher prices. HSY's ADJ gross and operating margin improved by 130 bps and 71 bps, respectively. The firm guided ADJ EPS in the range of $9.54–$9.46 and revenue of $11.2 billion in 2023. All in all, I believe HSY's second quarter could have been worse especially as sugar and cocoa prices rose, forcing the company to increase prices.

The company is expected to report third-quarter earnings on November 2nd. The consensus estimate is an EPS of $2.46 (+13% YoY) and revenue of $2.965 billion (+9% YoY). I believe these estimates are hard to top but not impossible because my belief is that HSY will have to raise prices as the higher cost of Sugar and Cocoa eat into their profits, but yet again, the company's products aren't that expensive, so slightly raising the price will perhaps not be enough to drive the consumer away.

Valuation

HSY is trading at a forward PE of 20.95x the FY23 consensus of $9.55 and 19.41x the FY2024 consensus of $10.31. My estimates are an EPS of $9.56 for FY23 and $10.21 for 2024. On a trailing free cash flow basis, the stock yields over 3.6% relative to its enterprise value. I used discounted cash flow to value HSY.

My base case implies a value per share of ~$208. I expect the company's top line to grow at a CAGR of 4.31% from 2023–2030, driven by price growth, volume, and share gains. I used a 1.50% terminal growth rate, a WACC of 6.30%, and a tax rate of 17%. I have a gross margin of 45.2% by 2030 (+200 bps from 2022), driven by moderate price increases.

My bear case implies a value per share of $176. My assumptions are as follows: revenue growth of 3.31% from 2023–2030, driven by low pricing growth and volume. I used a 1.50% terminal growth rate, a WACC of 6.30%, and a tax rate of 18.5%. I assume a gross margin of 44.7% by 2030 (+150 bps from 2022) driven by price increases.

My best case implies a value per share of $242. My assumptions are as follows: revenue growth of 5.31% from 2023–2030, driven by strong pricing growth and volume. I used a 1.50% terminal growth rate, a WACC of 6.30%, and a tax rate of 15.5%. I assume a gross margin of 45.80% by 2030 (+250 bps from 2022) driven by stronger pricing power.

Risks/Mitigates

I believe HSY investors should be concerned about two risks: volatile input costs and competition. To keep up with demand, HSY requires a large amount of sugar, cocoa, sweetener, and more. Inflation can cause these prices to become volatile, which can hurt HSY's profitability from time to time. The company faces competition globally and domestically, especially after it acquired Pretzel's, which will increase competition. Most of the company's revenue is derived from the U.S. If consumer tastes were to shift away from HSY's chocolate and sweetness to other healthier snacks, That could eventually hurt the company's top line.

Conclusions

The main takeaway is that HSY is a leading company in an industry with stable demand. Management has further diversified its business with the acquisition of Pretzel. The company's elevated margins have enabled shareholders to benefit from increased dividends, buybacks, and accretive M&A. I expect that to continue. Despite the great prospects of the business, I assign a hold because my valuation indicates HSY stock is fairly valued at ~$200 per share.