|Shares Out. (in M):||223||P/E||20.8||19.4|
|Market Cap (in $M):||20,947||P/FCF||17.0||15.9|
|Net Debt (in $M):||2,055||EBIT||1,615||1,705|
|TEV (in $M):||23,002||TEV/EBIT||14.2||13.5|
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Knowing the VIC audience, I want to frame this opportunity. I believe HSY is attractive on a relative basis to packaged food peers and the broader consumer staples group.
I believe that HSY is an attractive compounder trading at a relatively attractive valuation today. I believe the street is too low for 2015 sales which has the following implications: (1) 2015 EPS/Sales will be revised higher; and (2) as the company moves to “beat and raise” from a period of poor execution the multiple will move towards best in class packaged food peers.
Business & Current Sentiment Overview-
Hershey (HSY) is a manufacturer of chocolate, non-chocolate candy, and other confectionery. The company’s products are marketed under the following brands: Hershey; Reese’s; York; Almond Joy/Mounds; Kit Kat; Good & Plenty; Jolly Rancher; and Payday; among others. Some brands are owned, and others are under long-term licenses. It is estimated that 75% of sales are derived from chocolate, with the remainder generated from non-chocolate candy, mint, and gum. 81% of 2014 sales were generated in the U.S.
Investors have cooled on Hershey due to struggles in emerging markets, dairy inflation, snacking competition, and consistent earnings misses and guidance reductions.
The company has had to lower guidance every quarter since Q4 2013. HSY moved sales guidance down as they became concerned about elasticity surrounding the July 8% price hike, foreign currencies worsened, and the international business softened. Gross margin was also ratcheted down due to heightened dairy costs v. initial expectations. Lastly, the company reduced advertising to minimize EPS impact (not a preferred method).
2015 started out with more of the same as China witnessed a 47% sales decline. After the China business grew 35% last year the business showed signs of strain in Q4 (chocolate category slowed in Q4), and slowed further in Q1. The major reason for the dramatic decline was HSY actively managing inventory levels, sell through actually grew 5% for the company. Other international markets, like Brazil and Mexico, have shown strength after rebounding from depressed 2014 results. For 2015, management expects organic (including FX, excluding M&A) sales in international to grow 5%.
In addition to continued guidance reductions, investors are also concerned about the aggressive growth needed in H2 2015 to meet HSY’s 2015 EPS outlook of 8-10% (18% needed in H2 to hit guidance). This is aggressive, but follow through from the 2014 price increase, increasingly favorable commodities, and my expectation that HSY can grow sales above consensus (see Variant View below) should allow the company to exceed guidance.
As discussed more fully below: HSY has strong brands and market share in enviable markets. The company has historically performed well above peers and I think it deserves a multiple in-line with the best in class players (MDLZ/MKC).
I view the Hershey Trust Company as neutral to the investment thesis of HSY. The trust effectively controls HSY’s BOD, and manages it's assets for the benefit of the Milton Hershey School.
I believe that sales expectations are too low (street is looking for <5% growth, while I expect growth of 7%). This has implications for EPS, but also for the multiple. I would expect the multiple to expand to its historical premium and in-line with best in class peers (MKC/MDLZ) if they can hit 7%.
Management guidance from late April was for 2015 sales to grow 5% (4% organic, 2.5% from net acquisitions, and a negative 1.5% from FX). This includes 5% growth in international (v. prior expectation of 10% increase), excluding Shanghai Golden Monkey.
This is likely too harsh since management is forecasting a -1 price elasticity:
Source: Bloomberg, HSY Q4 2014 Transcript
Historically, this has not proven to be the case, as can be seen during other periods of aggressive pricing:
Source: Company Reports
Nor has it been proven out in Q1 results. In Q1 2015, North American pricing increased 4.3 percent, while volumes declined 90bps. What makes this result even more encouraging, 2015’s Easter selling period was 15 days shorter.
Sell-side analysts generally agree that North America guidance is conservative, implying International is too aggressive.
Deutsch Bank is modeling 3% growth in N.A. and 9% growth in international. To put this into perspective, Q1 international sales registered 8.5% growth, while China, its largest market, declined 47% due to HSY forced inventory destocking. Here are my assumptions:
Source: My Figures & Company Reports
It would take drastic cuts in my international sales estimates to get close to 9% Y/Y growth.
If management can once again start delivering on guidance (which my sales estimates would suggest they can and will) and sales growth moves to the higher end of LT targets, I expect a multiple closer to 14.5x EBITDA. Meaning my 12-month price target would be $118 (14.5x my estimate of 2016 EBITDA).
Putting Aside Catalysts, Favorable Company and Category Attributes-
Confectionery Category Is Attractive-
The confectionery and chocolate categories are highly concentrated. Hershey controls 42% of the U.S. chocolate market, and Mars controls 27% according to Deutsch Bank analysis of Nielsen data. The following graphs show market shares for chocolate confectionery, gum, and sugar confectionery:
This high level of concentration has historically resulted in a rational category, with competitors typically announcing price increases (no decreases seen in recent history) around the same time. HSY also expects to earn a certain gross margin percentage, this typically occurs in a rational industry, whereas commodities are more pass-through in nature (at least in my experience).
For instance, due to cocoa and dairy inflation, HSY implemented an 8% price increase on July 15th, 2014. On July 23rd, Mars announced a price increase of 7%.
The following graphs shows volatility in cocoa (30% of HSY COGS) and the pricing actions of the top chocolate players:
Historical Front Month:
Pricing in Chocolate Category:
Source: Barclays (Andrew Lazar) analysis of Nielsen data
Historical and forecasted future growth rates:
In addition to the strong attributes outlined above (strong historical/forecasted growth), confectionery is also a reward and it is a category where brands matter. When viewed as a reward (management states that confectionery only represents 2% of caloric intake) it makes sense that a 10% price increase doesn’t deter the purchase. Also, it is less likely that your “reward” will be private label. Private label share of chocolate confectionery is 1.3%, much lower than private label’s share of packaged food, which is 17%.
Organic Growth & Valuation-
Source: Company Filings
HSY has grown organic sales at an average 5.8% from 2009 through 2014. There are two buckets I would use for comparable companies: advantaged (MDLZ, MKC) and disadvantaged (GIS, K, CPB). The former has some combination of attractive categories, geographies, and/or competitive position and trade at an average EV/EBITDA multiple of 15.0x. The disadvantaged trade at an average EV/EBITDA multiple of 12.3x.
HSY currently trades at 12.9x consensus 2015 EBITDA. I think this is too low given the strong dynamics seen at the company.
On an EV/EBITDA basis, HSY’s median 10-year (weekly observations) premium to MKC has been a 4% discount, today it trades at a 15% discount (I excluded MDLZ, since it was historically KRFT for most of the past 10-years). HSY’s historical premium to GIS, K, and CPB was 12%, today it trades at a 5% premium.
Cocoa is an important input for HSY, with some analysts suggesting it could amount to 30% of cost of goods sold. Cocoa prices have expanded significantly in the past decade with annual average price per pound growing at a 7.1% CAGR since 2004. During the period of 2004 through 2014, gross profit margins expanded by 540 bps at HSY, which again points to an advantaged category.
Cocoa is grown in far eastern, West African, and South American equatorial regions with West Africa accounting for 72% of the world’s cocoa production. The Ivory Coast and Ghana represent 37% and 20% of 2012/13 production.
Mars, working with a consortium that includes the USDA, Indiana University, Hudson Alpha Institute, and IBM, has publicly revealed its work involving genome sequencing of the world’s most common cocoa plant. This research is expected to allow scientists/farmers to target which plants contain the most desirable attributes beforehand. Today cocoa production largely involves the planting of different varieties. The consortium expects the yields of the “Costa Rican Matina” to increase to 3-3.5 tons per hectare up from 0.5, a 550% increase in yield. This is an important development when considering 20% of the plants produce 80% of the output today; weeding out unproductive varieties, and planting optimized varieties will greatly improve productivity.
Cocoa demand has increased at a 2.2% CAGR from the 2005/2006 season to the 2014/2015 season (as estimated by International Cocoa Organization), supply has increased at 1.2% CAGR. The biggest grinding markets are Europe and Africa (58% of total grindings). The fastest growth in grindings has been coming from Asia and Africa.
The initial genome work started in 2010 and the release of the genome map occurred in 2013. It takes 7 years for a cacao tree to reach maturity, so it’s possible there could be a supply response at the end of this decade.
After cocoa, the next biggest input cost for HSY is class II milk at 13% of COGS. Prices of milk were between $0.22 and $0.26 per pound in 2014, specialists estimate that the price of class II (the appropriate benchmark for HSY) is likely to fall 25% to 30% in 2015 (prices already fell dramatically at the end of last year). This is driven mainly by supply, as high prices earlier in the year and low feed costs encouraged production. A curveball is the elimination of EU milk quotas. The current system gives each milk manufacturer a quota to meet (intended to inflate prices and boost farm incomes), these quotas will be eliminated in March. The ultimate impact is uncertain with some saying it’s not a big deal (USDA) and some suggesting European farmers are ready to produce well in excess of the current quota (Bernstein). Both USDA and Bernstein predict 2015 prices would be softer.
Management has suggested that they are seeing increased competition in the snacking category. The company has called out specifically meat and bakery snacks. The snacking category in general grew 3.5% last year, much better than broader packaged food which declined 70 bps. Meat snacks posted 7.1% growth. Although its troubling to see faster growing categories, HSY’s historical categories chocolate and non-chocolate candy have held up well. Chocolate candy sales grew 2.7% in 2014 while non-chocolate candy sales grew 1.7%. Both categories saw the rate of change improve through the year.
HSY spends a fair amount of money on acquisitions. HSY purchased Shanghai Golden Monkey (SGM) in the fall of 2014 for $500 million (of which $400 million has been paid). SGM is expected to give HSY a distribution pipeline in China, so that HSY can move its product into tier 2 and 3 cities. Another recent acquisition, though smaller, was Krave, a U.S. based jerky company. Reuters reported that HSY paid $200 to $300 million for the business, which would imply an EV/EBITDA multiple of 29-34x according to analysts. Although this is certainly rich, the company has distribution of 23% in the U.S., meaning HSY can knock this multiple down quickly.
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