Thursday, July 2, 2015

Why I Invested in Hershey

Financial independence isn’t going to achieve itself, folks. As such, I continue to aggressively put capital to work by exchanging dollars for equity in wonderful businesses that reward me as a shareholder with growing cash flow. And it’s that cash flow that will one day render me financially independent and able to live life completely on my terms.
This transaction represents the fifth stock purchase this month, and now the 60th position in the portfolio. And it also gives me exposure to a whole new industry, which I’m pretty excited about.
Jason, the chocolatier? 
I purchased 15 shares of Hershey Co. (HSY) on 6/11/15 for $90.82 per share.


Hershey Co., founded in 1894, is a producer and marketer of a variety of chocolate and sugar confectionery products. Their products are sold in more than 70 countries across the world.
Hershey has more than 80 brands, including Hershey’s, Reese’s, Hershey’s Kisses, Almond Joy, Kit-Kat, Twizzlers, Jolly Rancher, and Ice Breakers.
The company has two reportable segments, based on geography: North America (86% of fiscal year 2014 sales), and International and Other (14%).


The first thing we’ll look at as growth across the top and bottom lines over the last decade. Any company, to me, is ultimately worth all the cash flow it can produce from now until forever, discounted back to today. As such, growth is a critical factor when trying to determine a company’s future potential as well as its worth.
Revenue is up from $4.836 billion in FY 2005 to $7.422 billion in FY 2014. That’s a compound annual growth rate of 4.87%.
Earnings per share grew from $1.99 to $3.77 over this period, which is a CAGR of 7.36%. Not too shabby for a chocolate company that’s over 100 years old.
The company reduced its outstanding share count by approximately 9% over the last decade, which has helped propel some of the growth in profit per share. In addition, margins have steadily improved over this time frame.
As a dividend growth investor, one of my primary concerns is that of a company’s dividend, the growth of the dividend, and the sustainability of the dividend. Hershey looks pretty strong across the board here.
Now, HSY might fly under the radar as a dividend growth stock, and that’s probably because it only has five consecutive years of dividend raises to show for itself after holding the dividend static for just over two years during the financial crisis.
However, the company has been paying a dividend to shareholders for over 80 years, so there is a rather significant and impressive record of shareholder remuneration.
Over the last five years of the dividend growing once again, it’s increased at an annual rate of 11.4%.
The payout ratio is currently quite moderate at just 52.8%. That is right in line with that of management’s long-term goal of ~50%, but the dividend has been increasing at a rate faster than EPS over the last decade. So I suspect that future dividend raises will be more or less in line with EPS growth.
The stock yields a fairly attractive 2.41% right now. I say attractive because it’s well above that of the broader market and also about 20 basis points higher than the five-year average yield for HSY.
Hershey maintains a fairly solid balance sheet, though I would like to see this continue to improve in the future. The company’s long-term debt/equity ratio is 1.06 and the interest coverage ratio is over 16. Both of these metrics have markedly improved over the last five years, and I hope that trend continues.
Profitability is robust, though it’s difficult to compare to peers because Hershey’s largest domestic competitor, Mars, Incorporated, is a private company. Over the last five years, HSY has averaged net margin of 10.43% and return on equity of 63.99%. The ROE has to be taken in context with the debt, but margin is impressive for this space.

Qualitative Aspects

The chocolate and confectionery business is attractive to me for a number of reasons. It’s simple. It’s easy to understand, and I like easy. It’s not difficult to understand their main products, how they make money, and how they’ll likely continue to make money for many years to come. This investment is dead center within my circle of competence.
There’s not much change in this industry, which, as a very long-term investor, I love. Chocolate bars are largely the same today as they were fifty years ago, and I don’t see much of a reason why that’ll be very different fifty years from now. The biggest change I see is the switch in ingredients as time goes on to address changing consumer preferences/concerns. For instance, Hershey is working incredibly quickly to change the ingredients in some of their most popular brands, moving to what they call “simple ingredients” – stuff people can understand, like milk, sugar, etc. – and the Hershey’s Milk Chocolate Bar and Hershey’s Kisses should have “clean labels” by the end of the year. This is in response to  many consumers’ desire to consume products with all-natural ingredients.
Meanwhile, Hershey’s brands dominate the US chocolate market: They lay claim to an approximate 45% market share, which is substantially higher than that of its nearest competitor. Even more impressive, this market share has been consistently increasing over the last few years. And this dominance in the domestic market gives them a massive opportunity to concentrate resources internationally as opportunities present themselves. The US market is still Hershey’s primary focus, and rightfully so, but that also means there’s a ton of growth potential abroad.
And that growth potential is possible through two avenues. The first is through volume growth and price expansion of current brands and products, as well as the possible rolling out of new brands and products. In addition, the company is aggressively acquiring outside companies as bolt-on pieces to complement the existing business. Recent examples include the acquisition of Brookside Foods Ltd. (in 2012), a privately held confectionery company based in Canada, and the acquisition of an 80% stake in Shanghai Golden Monkey Food Joint Stock Co., Ltd. (in 2014), a privately held confectionery company based in Shanghai, China. Hershey is set to acquire the remaining 20% of the latter late this year.
In addition, there’s only so much shelf space that can be afforded to confectionery companies. And Hershey has built incredible competitive advantages through the fact that it lays claim to much of that space. This gives them pricing power and economies of scale.
Their brands are well-known and allow the company to expand in other categories. Products like Hershey’s and Reese’s spreads and syrups are a good example of this.
Although major food and beverage companies are facing challenges and headwinds right now due to trends away from sugar and processed food, I believe Hershey is somewhat insulated from this due to the fact that chocolate is a treat, rather than a meal. Chocolate is chocolate; you know what you’re getting into. In addition, a new study has found that a little chocolate may actually be good for you. This seems to concur with what I’ve long understood about chocolate. And I think this plays out in their results: HSY has seen solid increases in volume lately, even while they’ve increased prices along the way.
One other exciting aspect is “Project Next Century”. Announced in 2010 as a measure to improve the supply chain and cost structure, the firm also moved production from a century-old facility in Hershey, PA to one across town that was built in 1992. The spending associated with the four-year project completed in 2014, which means cash flow should improve moving forward.
Finally, the company has incredible shareholder alignment through the structure of executive pay. The vast majority of executive compensation is tied to business and stock performance.


Although HSY maintains a dominant position in the domestic market, competition remains fierce. In addition, HSY is finding difficulty in growing abroad, especially in China. The company noted in its first quarter results that sales in China fell 47% YOY.
Input costs regarding raw materials fluctuate, which can cause oscillating profit and cash flow. The recent changes regarding ingredients will very likely add costs, and it remains to be seen how that will play out in the market and pricing strategy.
Recent acquisitions add execution risk, though HSY remains conservative regarding its acquisition strategy.
Finally, there is currency risk, though that’s not as strong for HSY since most of their business is still domestic.


The stock’s P/E ratio is 24.15, which is just below that of its five-year average. Most other metrics are more or less in line with the five-year average as well. HSY is a stock that consistently trades at a premium against the broader market.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7.5% long-term dividend growth rate. That growth rate is well below that which the dividend has increased over the last five and ten years, but it’s also just above the EPS growth over the last decade. It’s perhaps a bit on the aggressive side, but I’m factoring in the moderate payout ratio, international growth potential, recent acquisitions, and what I see as low risk. The DDM analysis gives me a fair value of $92.02.


Overall, I see this as a high-quality, low-risk, easy-to-understand business that operates in a great industry that just doesn’t change all that much. Hershey dominates the domestic chocolate market as well as the domestic breath freshener mint market via great products with well-known brand names that occupy significant shelf space. And I see plenty of growth potential yet ahead, especially abroad. Although the company is having some issues figuring out their strategy in outside markets, I’m confident they’ll resolve that out via the right combination of organic growth and acquisitive growth.
The stock appears to be trading at roughly fair value here after falling more than 10% YTD, which I see as an opportunity to pay a fair price for equity in a high-quality business. I’ll never shy away from an opportunity like that. Although I’m somewhat lukewarm on HSY’s near-term potential, especially after recently reduced guidance for FY 2015, I think the next 10-20 years could be pretty exciting. And I certainly see the dividend as one that’s sustainable and very likely to continue growing at a rate well above that of inflation. The company should be announcing its next dividend increase in late July, though I think it’ll be somewhat modest due to near-term challenges.
This purchase adds $32.10 to my annual dividend income, based on the current quarterly $0.5350 dividend.
I’m going to include current valuation opinions from other analysts below, which I use to concentrate my reasonable valuation estimate:
Morningstar rates HSY as a 4/5 star valuation, with a fair value estimate of $102.00.
S&P Capital IQ rates HSY as a 3/5 star “hold”, with a fair value calculation of $94.70.
I’ll update my Freedom Fund in early July to reflect this recent purchase.
Full Disclosure: Long HSY.
What do you think about this business? Like the fundamentals and prospects? Why or why not? 
Thanks for reading.

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