HSY: Sweet on Hershey’s
This article is a reprint of my February 15, 2008 RealMoney column
Hershey’s (HSY) stock has been anything but sweet for investors in recent times. The shares are off more than a third from the 52-week high and trade barely above half their value from the 2005 peak. From higher costs to increased competition, from product recalls to production disruption, you name the problem and Hershey’s has probably seen it. Throw in the Hershey Foundation’s voting control (and ability to block the company’s sale or merger) and it is no wonder investors seem bitter.
Although the company was able to raise prices for the second time in a year, the hike “will help offset increases in areas of the Company’s input costs, including raw materials, fuel, utilities, and transportation.” Not offset, help offset. That is still a signal of shrinking margins.
But shrinking margins are exactly what the company told us to expect in late January. Hershey’s expects a sales increase of 3-4% this year, but for diluted EPS from operations to decline from the $2.08 reported in 2007 to the $1.85-$1.90 range. And that excludes the impact of an estimated $0.37-$0.40 in restructuring charges. Since Hershey’s has reported such charges in seven of the last eight years, treating them as non-recurring stretches both my credulity and my patience.
Regardless of the ultimate impact on results, the price increase could distort results during the current quarter. During the four-week period ending February 24, 2008, existing customers may, based on their historic order patterns, order and take delivery of up to eight weeks of inventory at current prices. Given that the consensus estimates expect the first quarter to show the worst performance compared to last year, inventory builds could result in a one-time positive surprise that should be ignored.
No matter how many problems a company may have, however, there comes a time that the stock price is cheap enough to qualify as a good investment. I think that time may finally have come for Hershey’s.
Overall, the quality of earnings at Hershey’s has been reasonably strong. Based on the accrual ratio, which measures the difference between cash earnings and accounting earnings (closer to zero is better) Hershey’s earnings quality has been relatively stable – seldom drifting more than 15% in either direction. Note too that when it did drift widely it marked an excellent time to sell, which to me helps validate using the accrual measure for this purpose.
Sources: Zacks Research Wizard and company reports, compiled by William A. Trent
Hershey’s also generates tons of cash flow. Over the last 12 months, its free cash flow yield has been about 6.7% - a healthy premium over the Treasury yield. A little more than 40% of the cash flows are given to investors as dividends, and the 3.4% dividend yield is more than 1.1% above the Treasury yield on an after-tax basis.
Finally, I think growth estimates are reasonable. The consensus five-year growth rate, at 7.5% per year, is in line with the 6.5% reported over the last five years and well below the sustainable growth rate implied by Hershey’s 33% return on equity. Although I don’t expect organic growth equal the sustainable rate, using the cash flow for acquisitions and share buybacks can make up a good chunk of the difference. Since 2002, buybacks have reduced the diluted share count by nearly 17%, which should eventually pay off in EPS growth.
At this point, even if Hershey’s problems don’t go away, merely not getting worse should be enough to get the shares back on track.
Disclosures: None
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