Hershey (HSY) enjoys excellent brand power in its North American markets. But, he may see margin erosion with his shift to salty snacks. It may be wise to take some profit. The stock is trading near all-time highs and is trading at a higher valuation compared to its five-year average.
New operating sectors of the company
In the fourth quarter of 2021, the company achieved net sales growth of 6.4%. Approximately 2.2% of net sales growth came from acquisitions. Organic net sales growth at constant currency was 4%. Catalog price increases fueled this organic growth. Product volume was a 2% headwind for the quarter due to fewer shipping days. Until the fourth quarter of 2021, the company used two operating segments – North America and International, and Others – to report its activities. After completing the acquisition of Dot’s Pretzel’s, LLC in December 2021, the company reorganized its reporting into three segments: Confectionery in North America, Savory Snacks in North America, and International. Along with Dot’s, the company also acquired Pretzels – a co-manufacturer of pretzels and other savory snacks – with three manufacturing sites in Indiana and Kansas. Pretzels and Dot’s is expected to generate approximately $300 million in annual sales.
Insufficient market share in international markets
Hershey derives a small percentage of its revenue from outside of North America compared to Mondelez (MDLZ). For example, only two markets – China and India account for 22% and 19% of Mondelez’s revenue, respectively. (See Appendix 1: Mondelez Revenue in Asia Pacific, Middle East and Africa (AMEA)). Hershey earned 13.0%, 13.6 and 15.8% of total net sales from its international operations in 2021, 2020 and 2019.
Exhibit 1: Mondelez revenue in Asia Pacific, Middle East and Africa (AMEA)
(Source: Presentation CAGNY of Mondelez)
Mondelez derived 38.8%, 22.5% and 9.8% of its total revenue from Europe, Asia-Pacific, Middle East, Africa (AMEA) and Latin America. Essentially, Mondelez generates 71% of its revenue outside of North America. Hershey has struggled to gain market share outside of the North American market. Its brands do not have the same notoriety as in its home market – the United States
AMEA markets are the engine of growth for consumer products companies, and the lack of a strong presence there may hurt Hershey in the long run. Mondelez highlighted its strength in India, where its revenue and profit are growing at a double-digit CAGR (See Exhibit 2: Growth of Mondelez in India). India has a much younger population than western markets and is experiencing rising income levels. As populations age, they are likely to consume less chocolate, which hinders Hershey’s growth in North America. Hershey targets low single-digit growth (2% to 4%) in sales and between 6% and 8% growth in adjusted EPS (See Exhibit 3: Hershey’s Adjusted EPS Growth and Sales Estimate).
Exhibit 2: Growth of Mondelez in India
(Source: Mondelez investor presentation, authors’ compilation)
Exhibit 3: Hershey’s adjusted EPS growth and sales estimate
Hershey faces the difficult challenge of expanding into international markets where brands have established themselves over decades. But gaining market share in global markets is not a priority for the company. Hershey is focused on expanding its market share in salty snacks in North America. The lack of a growing international presence is another risk factor investors should consider before investing in Hershey.
Gross margins among the best in the industry
Hershey enjoys a huge gross margin of 45% compared to around 39% for Mondelez. This difference in margins can be attributed to the strength of the Hershey’s brand in North America. The company has good pricing power and consumers have purchasing power as per capita income levels are higher than in other countries where Mondelez operates. Hershey also relies more on chocolate confections than Mondelez, and these snacks are more of an indulgence on various occasions throughout the day than cookies. Mondelez generates 47% of its turnover with biscuits. Hershey had an operating margin of 22% compared to 16% for Mondelez.
Dividend and share buyback program
The company operates a dual share structure – common stock and class B common stock. Class B common stock is not listed on the stock exchange. The company paid an annual dividend rate of $3.14 per share on its common stock and a quarterly dividend of $0.819 per Class B share for an annual payout of $3.276 per share. The company paid $686 million in cash dividends in 2021 and $640.7 million in 2020. The company reduced its number of common shares by 0.6% and its Class B shares by 1.65% . (See Exhibit 4: Hershey shares outstanding and year-over-year change).
Exhibit 4: Outstanding shares of Hershey and year-over-year change
(Source: SEC.govAuthor’s Compilation)
The company repurchased 2,876,644 shares in the fiscal year ending December 2021. But, 2,005,500 of those stock repurchases were to eliminate the dilution caused by stock awards for incentive compensation. Nearly 70% of share buybacks in 2021 were used to eliminate the dilution that would have occurred with stock awards to company executives.
Given the dramatic rise in the stock price over the past few months, Hershey’s dividend yield has fallen to 1.47%, which is barely above the S&P’s 1.41% dividend yield. 500. The low dividend rate is another reason not to buy this company at current prices. If you get the same dividend yield as the S&P 500, why not own the well-diversified index instead of investing in Hershey’s and exposing your portfolio to single-stock risk.
Hershey’s payout ratio is higher than that of Mondelez – its closest competitor in the US and international markets, but the payout ratio is within manageable limits (See Exhibit 5: Hershey, Mondelez, JM Smucker Payout Ratio).
Exhibit 5: Hershey, Mondelez and JM Smucker Payout Ratio
(Source: SEC.GOVAuthor’s Compilation)
Financial performance and valuation
Between 2017 and 2021, the company’s return on equity has averaged around 69%. Hershey’s return on equity is 5 times that of Mondelez. Mondelez’ return on equity is approximately 13%. Hershey leads both JM Smucker (SJM) and Mondelez on ROI with 20% (See Exhibit 6: JM Smucker, Mondelez, Hershey Return on Invested Capital [ROIC]).
Exhibit 6: JM Smucker, Mondelez, Hershey Return on Investment [ROIC]
(Source: Search Alpha)
Hershey is trading at a forward PE of 25.8x, above its five-year average of 22.8. For a long-term buyer, the company is currently overvalued. Hershey faces the challenge of maintaining its strong financial performance over the long term. Segment profit margins seem to indicate lower margins and therefore lower returns going forward. For example, the North America Confectionery segment has a profit margin of 32.2%, while its North America Salty Snacks segment and its International segment have 18.13% and 10.1%. As the company expands further into the savory snacks segment, its margins and financial returns could settle at lower levels than its confectionery margins. Given the outlook for lower returns in the coming years, it may be good to accumulate stocks at a PE multiple of 18x to 20x or lower. The profit estimate for the 2022 financial year is $7.94 per share. I would start building a position in the stock at $160, which would be a multiple of 20 times the PE.
Covered call strategy
Stocks are trading near all-time highs, so if you own 100 or more stocks and are sitting on good gains, it may be a good idea to take profits or sell covered calls. Covered calls can generate good income, and if the stock is called, you would have sold near all-time highs. April 22, 2022, strike price of $205 last sold at $8.07 (See Exhibit 7: Hershey’s Covered Buy Strategy for April). If one can sell a call at $6 or more, a premium of 2.9% or more would be. I generally aim for around a minimum of 1% call premium when selling covered calls.
Exhibit 7: Hershey’s covered call strategy for April
One can collect $600 in call premium (subtract approximately $0.60 in brokerage fees per contract) for the sale of a contract. If the shares were redeemed, you would have increased your earnings by 2.9%. On the other hand, you can keep the bonus if the claims are not canceled.
Hershey’s shares are trading near all-time highs. The company is expanding into savory snacks with lower profit margins than its confectionery business in North America. Its Asian business is small compared to competitors like Mondelez. But, future growth may be in Asia, but Hershey may not benefit from it. The prospect of lower growth, lower margins and lower returns on invested capital make the stock overvalued at current prices. Selling a covered call can earn a reasonable premium at current prices. It may also be a good idea to sell some stocks at current prices, take profits, and patiently wait for a pullback before buying again.