Hershey: Rich Valuation For A Fantastic Stock (NYSE:HSY)

Company overview:

The Hershey Company (NYSE:HSY) engages in the manufacture and sale of confectionery products and pantry items internationally. The company operates through three segments: North America Confectionery, North America Salty Snacks, and International. It offers chocolate and non-chocolate confectionery products.

The company provides its products primarily under the Hershey’s, Reese’s, Kisses, Jolly Rancher, Almond Joy, Brookside, barkTHINS, Cadbury, Good & Plenty, Heath, Kit Kat, Payday, Rolo, Twizzlers, Whoppers, York, Ice Breakers, Breath Savers, Bubble Yum, Lily’s, SkinnyPop, Pirates Booty, Paqui, Dot’s Homestyle Pretzels, and ONE Bar brands, as well as under the Pelon Pelo Rico, IO-IO, and Sofit brands.

HSY is a confectionery giant, leading the way in the US market. The business only generates c.8% of its sales from its international segment, choosing to focus primarily on the US.

Our view is that consumer goods (CG) businesses can be incredibly good investments during times of economic uncertainty / weakening. That is what initially sparked our interest in HSY, alongside what looks to be market leading growth.

Looking at HSY’s share price, it has performed incredibly well in the last ten years, with little sideways trading. This is a reflection of Management’s ability to corner what is a massive market, the US confectionery industry.

Within this paper, we will look to consider the attractiveness of HSY, looking to take a view on whether this will be a good investment in both the short and long term. We will do this by considering the current economic conditions, the confectionery market in the US and finally HSY’s financials.

U.S. Confectionery market size and outlook:

The US confectionery market is estimated to be worth over $38 billion, with growth driven by increasing consumer demand for sweet snacks and confectionery products. The market is expected to continue to grow in the coming years (in the region of 4-5%), driven by factors such as population growth, rising disposable income, and changing consumer preferences.

The industry is large and highly competitive, with a wide range of players, including multinational corporations, regional players, and small and medium-sized enterprises. The industry is characterized by a high degree of brand loyalty, with consumers often showing strong preferences for specific brands and products. This is very important during current macro conditions due to the risk of substitution, something we will touch on later.

The Hershey Company is a well-established player in industry, with a strong brand portfolio that includes iconic brands such as Hershey’s, Reese’s, Kit Kat, and Jolly Rancher. The business is marginally the largest player in the market, followed closely by Mars.

From our perspective, HSY is poised to sustain growth through organic measures as it capitalizes on its robust brand equity. The only area of concern is that this has not yet manifested internationally, compared to its rivals. While Hershey cannot match the global reach of candy products like the Mars or Snickers Bar, being the largest player in the US market is a highly profitable position that should not be overlooked. Additionally, this presents Hershey with the chance to further concentrate on expanding into international markets, which could drive growth beyond its current 4-5% level.

Transition towards healthy eating:

The US confectionery market is undergoing several key trends, including a shift towards healthier and more natural products.

As consumers become more health-conscious, they are increasingly seeking out products that are lower in sugar, fat, and calories. This has led to a growing demand for confectionery products that are made with natural ingredients and are free from artificial preservatives, sweeteners, and flavors. Businesses with traditionally “unhealthy” brands have either look to create healthier versions or are conduct M&A enter the segment.

Confectionery companies are also looking to position themselves as health-conscious brands by emphasizing the benefits of their products and promoting healthy lifestyle choices. This will ensure that their long-term brand image is not synonymous with an unhealthy lifestyle.

Further, Confectionery companies are investing in product innovation and brand building, as well as expanding into new and emerging markets. Mondelez (MDLZ), a competitor of HSYs, has committed to generating 50% of its revenue from healthy snacks and is spending 70% of its R&D budget in this area. HSY has a robust product innovation pipeline, with a focus on expanding its snack portfolio to better align with this transition. An example of this the launch of Sofit, a leading producer of plant-based protein products.

HSY has many brands which can be perceived as unhealthy and so seeing an active effort to expand into healthier options is key for the long-term viability of the business. Not to say that traditional chocolate is going away, but the key growth area is the healthier / natural side of things. We do not believe this to be a fad or short-term trend but a fundamental shift in the confectionery industry.

Macro view:

Consumer-led demand has slowed in 2022, as lockdown and post-lockdown spending naturally began to slow. Further, we have experienced the rise of inflation, which aggressively came into the forefront of economic consideration in 2022. A decade of lax monetary policy, rising energy prices and supply-side constraints have all contributed to this. Many companies have suffered with their cost of production increasing, as well as personnel costs. Consumers have seen their cost-of-living skyrocket, with many struggling to meet their basic needs.

We have seen interest rates rising globally, with the view that cooling demand will bring inflation back under control. The problem with this is that much of the contributing factor to inflation is supply-side issues, which are less responsive to interest rates. This has contributed to inflations slow decline, as it still remains above 5% in Jan23.

Looking ahead at 2023, our view is that it will be more of the same, with interest rates likely ticking up marginally higher. This should finally bring inflation under control, likely in late 2023, at which point interest rates will likely follow. Between now and then however, many businesses and consumers will struggle. The Conference Board estimate the risk of a recession to be 96%.

This has brought negative market sentiment and many businesses have experienced slowing growth. The value we see in consumer goods is that they are able to keep demand sticky. The reason for this is relative inelasticity in demand. Consumers either must continue to purchase the good, because they require it as part of their life (such as toothbrushes) or are willing to continue purchasing it (potential because it is a small part of spending). A chocolate bar fits into that second category. If the price of a bar increases from £/$1 to £/$1.1, it has a very small impact on an individual’s life.

The risk with this comes from consumers who are looking to save money where they can, thus choose to substitute for cheaper alternatives. Our view is that this is less likely the cheaper the good is, which is the case for most confectioneries. Further, as we have established, brand value is high in this industry.

In HSY’s case, they have been able to increase prices a net 8%, with volume growth still remaining strong at 4%. This suggests that they are able to execute on price hikes successfully without impacting volume. This has contributed to a 16% increase in sales between FY21 and FY22.

Another challenge arising from the current economic climate is the supply-side challenges that are leading to rising operational expenses. The company’s GPM has experienced a decline, going from 45.1% to 43.2%, due to increased costs for raw materials and transportation.

Overall, our position is that the business has navigated economic conditions well so far, margins have contracted but revenue growth has more than compensated for this.

Financials:

Despite facing weakening market conditions, HSY’s recent financial performance has been impressive with growth across all segments and a 6.7% increase in net income.

Although operating and net income margins have decreased (1.1% and 0.7%), the margin contraction is smaller as we move down the P&L. This indicates the greatest impact on margin contraction is inflationary pressure on production costs, with some efficiency gains having been made following.

HSY’s balance sheet remains strong with improved inventory turnover and decreased CCC, indicating improved efficiency in tough trading conditions. This is one of the first examples we have seen of such improvements, with the vast majority of businesses experiencing widening of these metrics.

Despite having a high debt to equity ratio, we believe HSY is conservatively financed as net debt only represents 1.6x EBITDA. Therefore, we consider there to be no credit risk.

Overall, we are very impressed with HSY’s financials as they are driving healthy growth and steady margins, while having a strong balance sheet. This leaves investors to enjoy a ROE of 54%.

Outlook:

Analysts are forecasting much of the same with 3% CAGR in revenue and NI. Margins will remain relatively flat, as we surmised, with scope for growth beyond inflation likely coming from M&A activity.

Peer group comparison:

Presented above is HSY’s key financials compared to a peer group of other food and beverage businesses. HSY performs extremely well, with greater than average EBITDA-M and FCF-Y. Further, growth has exceeded their peers in the last 5 years, cementing the level of outperformance.

On a head-to-head basis, HSY does very well as no business has the combination of growth and FCF that HSY offer.

Valuation:

HSY is currently trading at a 20x EBITDA and a 29x P/E ratio, a market-leading valuation comparable to that of Nestle and Mondelez. We believe this position is reasonable, as HSY allows investors to benefit from both growth and profitability. With Nestle and Mondelez, you would be sacrificing profitability but receive greater diversification in product offering.

The question remains as to how high valuations can go. It is difficult to envision a value higher than 20/22x, as beyond this point the valuation would surpass all future cash flows. Consumer goods are trading at a premium, as they should be, due to the inflation hedge they offer, which investors have recognized.

Taking these factors into consideration, we arrive at a valuation of 21x, with an upside potential of 7%. Given the margin for error and the current market sentiment, this growth potential is not sufficient to justify recommending this stock as a buy.

Conclusion:

The Hershey Company stands out as a rare case of a consumer goods business that has achieved both market-leading profitability and growth exceeding inflation. This is a testament to Management’s clear focus and ability to execute its strategy effectively.

The company has proven its resilience despite economic difficulties and is expected to maintain strong performance in 2023. Its financials are strong and it has a prudent financing approach, making the current levels of dividends and buybacks sustainable in our view.

Our only reservation regarding the business is that our valuation (supported by analyst consensus numbers) indicates that the stock is trading at its fair value, with limited upside potential. Given this, we classify the stock as a hold.