Starbucks launches chocolate line:

Starbucks Coffee Co. (SBUX) has launched a line of chocolates laced with the flavors of its coffees and teas, such as Milk Chocolate Caramel Macchiato Truffles, and milk and dark chocolate infused with Tazo brand teas.The chocolates, which are made by The Hershey Company (HSY), were launched this month at grocers and other retailers nationwide. For now, however, the chocolates are not available at Starbucks coffee shops.

When I wrote about Hershey’s, I said “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.”

One of Hershey’s problems has been market share loss to premium chocolates. A difficulty in fighting this is that Hershey’s own brand will not attract premium customers. Enter Starbucks, who has exactly the right kind of brand for the task at hand.

I’ve also said that the problem for Starbucks is in the licensed stores, which are typically located inside other retailers such as Safewa. These stores dilute the brand by failing to provide the “Starbucks experience.” Licensed products, on the other hand, can fit into the premium brand (if done right.)

That said, it seems clear to me that this partnership offers more to Hershey’s, whose $5 billion in annual sales come from chocolate products sold primarily at grocers and other retailers, than to Starbucks, whose $10 billion in annual sales come primarily through coffee products sold in its own coffee shops.

Disclosure: At time of publication, William Trent owns shares of Starbucks (SBUX)

Disclosure: Author is long Starbucks (SBUX) at time of publication.

photo credit: Zesmerelda

This article is a reprint of my February 25, 2008 RealMoney column

What is wrong with Dean Foods (DF)? After all with everyone from Starbucks (SBUX) to Hershey’s (HSY) getting hurt by rising milk costs, I would expect the “largest processor and distributor of milk and various other dairy products in the United States” to be living in the land of milk and honey.

Yet somehow, Dean has managed to get itself on the wrong side of every dairy-related position (so much for Peter Lynch’s invest in what you know theory.) For example, the company describes the current dairy environment in its latest 10Q: “As a consequence of higher raw milk costs, we have seen a related increase in shrink costs and reduced profits from excess cream sales. At the same time, sales volumes in the Dairy Group have softened as consumers react to the higher retail prices. We are also seeing a shift from our branded fluid milk products to private label products resulting in reduced gross profit. In our White Wave segment, results continue to be negatively impacted by the oversupply of organic milk.”

High commodity costs during a period of oversupply? It is as if the law of supply and demand has been overturned. And Dean doesn’t expect to see much improvement. “As we look beyond the first quarter, we find it difficult to have much confidence in current dairy commodity forecasts given these unprecedented levels of dairy commodity market instability,” management warned.

As a result of this lack of confidence, the consensus earnings estimate for 2008 has dropped from $1.45 to $1.33 over the last month. The Zacks rank, a measure of earnings momentum, has fallen two points to the worst level of five. That rank puts Dean among the worst 5% of companies followed on the basis of earnings momentum. Yet still the estimates are well above management’s own guidance for “at least $1.20 per share.”

If there is a bright side to Dean’s horrible earnings outlook, it is that the quality of earnings remains relatively sound. The accrual ratio, which represents the difference between cash earnings and accounting earnings, should ideally hover around zero. That is more or less what Dean’s has done.

Source: Zacks Research Wizard, compiled by William Trent

So, with the earnings quality indicating that the lousy earnings are at least trustworthy, I have to ask whether the current “50% off” share price reflects all the bad news. Unfortunately, no matter how I look at it it’s hard for me to think that it does.

The P/E of 20x management’s guidance is above the company’s five-year average of 17.5x. And even being willing to look way ahead, assuming the current consensus estimate of $1.76 for 2009 doesn’t get cut and that investors are willing to pay the average multiple for them, the target price would be about $30. The potential 25% gain over 1-2 years curdles when it has to be based on so many assumptions.

The consensus five-year growth rate of 11.5% also seems incredibly optimistic, given that the same analysts are expecting a 5% sales increase this year to be followed by a modest decline next year. And even assuming the 11.5% growth occurs due to margin expansion, I’d expect much of it to be eroded by a contracting valuation given Dean’s outlandish 63x price/book ratio. Considering that total return is a function of growth and the change in valuation, I think the two would offset each other in this case, perhaps resulting in annual total return in the mid single digits.

Finally, my favorite measure is the free cash flow yield, and Dean looks far from attractive on this basis. On either a free cash flow to equity or a free cash flow to enterprise basis, the yield comes to about 4%. True, it is better than the current yield on 5-year Treasuries. But given the risks involved, I think there are many more attractive opportunities.

In fact, either of the other two victims of milk pricing look far better to me. Starbucks could have a 6% free cash flow yield based on its plans to slow expansion (and related expenditures) while Hershey’s is already at a 6.7% free cash flow yield.

Long story short, I think Dean’s chairman is on the right track by selling shares.

Disclosures: William Trent owns shares of Starbucks (SBUX)

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

Hansen Natural (HANS) is giving back the last month’s gains today after reporting higher than expected sales and lower than expected margins. Both were explained by customers stocking up ahead of a price increase. Count on the same thing happening to Hershey’s (HSY) when they report a March quarter enhanced by customer stock-ups and an early Easter.

While it’s true that the sales were boosted by robbing sales from next quarter, that is a short term issue. I said last month that “Hansen should be able to maintain its current free cash flow yield as long as the company keeps growing, which suggests potential upside in line with the 30% growth rate this year. Unless the growth rate slows substantially, it looks like a keeper.”

That’s my story, and I’m sticking to it.

Disclosure: William Trent has no position in the companies mentioned.

photo credit: cindiann

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

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.