Hershey%27s Report

7/27/2019 Hershey%27s Report

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The Hershey Company

The Hershey Company was incorporated in 1927 as a successor to a business founded

by Milton S. Hershey in 1894. Hershey’s is the largest chocolate producer in North America and

a global leader in chocolate and confectionery products. Hershey’s principal product groups

include chocolate and sugar confectionery products; pantry items (such as baking ingredients,

toppings and beverages); and gum and mint refreshment products. The company operates as a

single reportable segment in manufacturing, marketing, selling and distributing its products

under more than 80 brand names including some of well-know brands such as Reese’s, Jolly

Rancher, Kit Kat, Rolo and Twizzlers.

Its three operating segments are broken up geographically into the United States, the

Americas (Canada, Mexico, Brazil, Central and South America, Puerto Rico) and Asia, Europe,

the Middle East and Africa (“AEMEA”). Hershey’s products are marketed and sold in

approximately 70 countries worldwide. By far, the largest revenue-earning segment is the

United States, accounting for 84% of sales. The AEMEA operations represent less than 10% of

consolidated revenues but are growing quickly, especially in India, the fastest growing chocolate

consuming country in the world (with annual growth averaging 15% from 2008 to 2012).

The Hershey Experience arm of the company manages the company's retail operations

globally, including Hershey’s Chocolate World Stores in Hershey (Pennsylvania), New York City,

San Francisco, Chicago, Shanghai, Niagara Falls, Dubai, and Singapore. Hershey’s two

strategic business units are the chocolate business unit and the sweets and refreshment

business unit. These strategic business units focus on various components of the company's

product line and are responsible for building and leveraging the company’s global brands, and

putting best demonstrated practices around the world into place.



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and reporting practices that allow for results in line with or better than predicted targets) will be

kept in mind throughout the analysis and report.

Global Chocolate Industry (Present and Future)

The global chocolate industry has been growing moderately for last five years. While the

worldwide estimated growth in CAGR is 2.7%, in Asia CAGR is expected to grow at 4.3%. 1 In

emerging economies such as China and India, chocolate has started to be used as a functional

food, which presents a great opportunity for global chocolate companies. In 2011, BRIC

countries accounted for 55% of global confectionery retail growth. According to Hershey’s

investor update, 2012, BRIC countries will represent $26 billion in sales (out of estimated global

sales of $98.3 billion2) by 2017. According to government officials and KPMG’s report, the

fastest growing chocolate countries are India (15%), China (9%), Russia (6%) and Mexico

(3.8%). Hershey’s says by 2017, 25% of its sales revenue will come from international sales3.

Growing segments among chocolates are organic chocolate and “fair-trade chocolates”.4

While chocolate buying is seen primarily as an impulse purchase, KPMG’s report states there

are 3 distinct types of chocolate purchasers. Convenience buyers are those who want to grab

a chocolate bar from a local store or throw a multi-pack into a trolley during a weekly shopping

trip. Thus, chocolate in bar form became quite important and global companies like Mars

innovated in areas of packaging and marketing to attract consumers. Value buyers are

especially important in emerging economies. Luxury buyers are a niche segment of the market

and companies like Godiva and Lindt are prominent players in this market. According to US

chocolate sales numbers, luxury chocolate sales are up, year-over-year. The sensitivity of these

buyers to price is difficult to determine, however seeing as how Hershey has increased their

prices by nearly 10% in recent years. Last year the increase in volume accounted for only a

0.3% increase in net sales (outside of the Brookside acquisition) indicating that consumers may

in fact be sensitive to price and Hershey’s strategy of increasing prices may not be sustainable,



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especially in times when cocoa prices are low, and thus the price increases are not justifiable to

customers.

There are 4 main pillars driving current and projected future growth in the global

chocolate industry: Sustainability, Innovation, Health and Events. Sustainability is having a

major impact on the chocolate industry, particularly the US market, which is the largest

chocolate market in the world. Consumers are becoming increasingly aware of “fair trade”

programs. Hershey’s recently announced that, for its Bliss brand chocolates, it will import cocoa

specifically using a fair trade program. Innovation in packaging is next big trend in chocolate.

Many of Hershey’s competitors, such as Nestle and Wrigley’s, have recently introduced new,

custom packaging. Thus, in order to accurately predict Hershey’s future cash flows, it is

important to consider possible capital expenditure in innovation and packaging, as well as

possible new machinery to produce customized products. Health is becoming an increasingly

important area of focus, even in the chocolate industry. Obesity is driving many governments,

like that of the UK, to introduce new regulation for food and chocolate companies. Hershey’s

must consider increased regulation and the wider focus on health if it is to succeed in continued

future growth. Events is the final pillar and plays an important role in chocolate sales. In the

United States, Easter season chocolate sales were $4.9 billion in 2010. Easter is equally big

business in Brazil, where chocolate sales see annual highs around this time of year. In China,

more than half of the chocolate purchased is done so as gifts, with New Year and Lunar New

Year being peak buying times. Product innovation and additional marketing campaigns by

Hershey’s competitors during these peak seasonal selling times could have a significant

adverse on Hershey’s sales volume.

Finally, it is worthwhile to note that the youth population (in almost every country in

which Hershey’s operates) has a huge effect on the future of chocolate sales. For example,

although Japan is now the world’s 3rd largest chocolate market, its aging population makes the

growth prospects for chocolate less attractive than a country such as Mexico. In Mexico, 52% of



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the population is under age of 20, which presents a huge opportunity for global companies to

expand and attract new, younger customers to drive future growth.

With the above analysis in mind, looking to the future of chocolate industry, we expect

that Hershey’s business will be significantly affected (both negative and positively) by a wide

variety of factors. Innovative packaging, health benefits, youth population, personalized orders,

distribution channels, rising of the middle class and input prices are going to significantly affect

the chocolate industry, and Hershey’s success largely depends heavily on how they adapt to

those market changes.

As well, with increased opportunity comes increased risk. The global chocolate industry

is facing two major threats currently. Counterfeit products are a major threat to global

chocolate companies. Other companies are making low quality products and imitating the

packaging of companies such as Hershey’s, in order to mislead consumers and garner sales,

this may become more of a factor if the price of Hershey’s product continues to increase. The

Obesity Epidemic is another major concern for chocolate companies and, as discussed, many

governments are in the process of implementing rules and regulations to overcome it, including

stricter regulation on the sale of products containing an excessive amount of sugar.

Hershey’s Specific Analysis

Now that we have discussed the global chocolate industry as a whole, we will look at

Hershey’s, specifically, and discuss a few programs/initiatives that Hershey’s is implementing

and will have a significant effect on the company, moving forward.

Project Next Century

In 2010, Hershey’s announced “Project Next Century” in order to create operating

efficiencies and a more competitive cost structure. The company believes that shifting

significant company production to the West Hershey facility will give them significant



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advantages for in their supply chain. They estimate they need to spend somewhere between

$190 million and $200 million for the project. As part of this project, Hershey’s projects they will

be able to save $60 million to $80 million per year, moving forward, which will enable them to

further re-invest in brand building and global capability increases.5 The project was completed in

2012 within the cost estimates.

Global Supply Chain Transformation Program

In 2009, Hershey’s finished a 3-year long Global Supply Chain Transformation Program.

This was a well-planned and accurately timed project that increased efficiencies in Hershey’s

operations and helped them in their pursuit of international expansion. Through this program,

the company introduced an advanced inventory management system, improved consumer

relations and reduced overall cost structure. As part of this program, they also opened a new

manufacturing facility at Monterrey, Mexico to support the booming market in Latin America,

including Brazil and Mexico6.

Managing Revolving Consumer Dynamics and Regulatory Standards

In the previous section, we discussed about the changing market dynamics and evolving

regulatory standards that are driving global chocolate industry. Hershey’s has responded to

those changes. For example, to attract the value buyers, Hershey’s introduced KitKat Mini

version. To attract the Luxury Buyers, Hershey’s introduced Hershey’s Premium first in Brazil

and then launched the product worldwide7. To combat with the obesity challenge, Hershey’s

introduced new ‘Sugar Free’ product line. Those products are moderately lower in calories (by

about 20%) though similar in fat content, i.e. richness in test to the original versions.

Expansion program in emerging economies

As discussed in the Global Chocolate Industry section, emerging economies, such as

BRIC countries, provide significant opportunities for Hershey’s to expand. Keeping up with the



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pace of these economies, Hershey’s is expanding in these markets via Greenfield Projects,

exports and acquisitions. In countries like Brazil, Hershey’s started its own manufacturing facility,

whereas in other regions like Central America and Puerto Rico, it mainly sells product it has

exported from the United States. For Hershey’s, the majority of its sales volume (84.5%) still

comes from US, so there is tremendous opportunity for the company to expand into these new

markets. On the flip side, the margin will not be as high as the US market in those emerging

economies (where the price of chocolate and other confectionary goods is far lower), so

Hershey’s will need to make its money from bigger sales volume and innovation in new products.

Hershey’s is now expanding in Europe using a new strategy. It is initially expanding with well-

known brands: Kisses, Reese's, Hershey Ice Breakers and Jolly Rancher 8. Hershey’s states

that it will be able to meet the increasing sales volume through its improved production facility in

West Hershey (Project Next Century) and a new production facility in Brazil. Hence, we expect

in short-run Hershey’s need not to make any acquisition to support its international growth.

Strategy for expansion

Hershey’s seems to have a very well thought out strategy for expansion into emerging

economies. In Mexico, they started with Greenfield Operations because they had existing

product/market knowledge in Latin America. But for other countries like India and China this was

not the case. In India and Brazil they bought a 51% stake in Godrej Beverages & Foods Limited

and Pandurata Netherlands B.V., respectively. Once they learned about operating in India and

saw huge potential, they then acquired the remaining 49% of the company. As well, in China,

they entered into an agreement with Lotte Confectionary Ltd. to produce and market Hershey’s

products. This shows that Hershey’s is extremely strategic in its decision-making and completes

significant and tested due diligence before implementing any strategy, which can only serve to

benefit shareholders moving forward. Since Michele Buck was appointed as the Chief Growth

Strategy Officer of Hershey’s, she has invested more money (up from 2% to 8%) in advertising



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campaigns and customer insights research programs. Hershey’s is already seeing a significant

return on those investments.

Brookside Foods Ltd. (“Brookside”) Acquisition

Hershey’s has traditionally been looking to acquire companies that have complementary

skills, facilities and products. In 2012, they acquired all of the outstanding stock of Brookside

Foods Ltd., a privately held confectionary company based in British Columbia, Canada.

Brookside was doing approximately $90 million in annual revenue prior to the acquisition. By

acquiring Brookside, Hershey’s was able to expand its product offering to include chocolate-

covered fruit and real fruit juice in its portfolio. Hershey’s also acquired two production facilities

located in British Columbia and Quebec as part of the acquisition.

McLane Company Inc. – Hershey’s Biggest Customer

Hershey’s biggest customer by a significant margin (accounting for 22.2% of Hershey’s

revenue) is McLane Company Inc. (“McLane”). If McLane does not renew its contract once the

current deal expires, this will have a significant adverse affect on Hershey’s sales volume. We

see this as unlikely due to the long-standing relationship. As well, because McLane is the

company’s biggest consumer, it makes up the majority of Hershey’s accounts receivable. If

McLane encounters cash flow problems Hershey’s the quality and days to collect of Hershey’s

accounts receivables will suffer. It should be noted that McLane is wholly owned subsidy of

Berkshire Hathaway, and it is itself a $28 billion and highly successful supply chain company.

Voting model & Milton Hershey School

The company’s largest shareholder is the Hershey Trust Company, resulting in a dual

class capital structure with unequal voting rights. Hershey’s Class B stockholders (which include

the Hershey Trust Company) have 10 times more voting power than the common stockholders.

Furthermore, the common stockholders are only entitled to select one out of the six members on



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the Board Of Directors. Milton Hershey School, the school founded by Milton Hershey, has three

members on the Board Of Directors of the company, including the Chairman of the Board.

Inherent with this type of capital structure, there is often a greater opportunity for corruption,

unfair Board of Director practices and the potential for earnings management/creative

accounting to occur without proper oversight.

SWOT ConclusionIn conclusion, by looking first at the global chocolate industry and then at Hershey’s

specifically, we believe that Hershey’s has significant strengths in areas such as successful

investment in efficiency improvement programs, well thought out expansion into new product

lines and growing markets (often through acquisition) and solid recognition of emerging trends

such as the health conscious consumer. Their major weakness currently is the company’s

limited presence outside US. Clearly, major opportunity for Hershey’s lies in expansion into

emerging economies and the huge potential offered there. It also has the opportunity to further

diversify its product portfolio and expand its presence in other segments of the confectionary

business. A threat to Hershey’s continued success lies in the global chocolate industry threats

(such as the obesity epidemic, certain aging populations, etc.) as well as strong competition

from other global chocolate players like Mars, Russell Stover and Nestle. In the premium

chocolate segment, the company also faces competitive threats from companies like Lindt,

Godiva, Ferrero Rocher, etc. Mars has a very strong portfolio of chocolate brands in Europe and

Nestle has a strong presence worldwide. Hershey’s strong focus on innovation, smart

expansion and its recent increase in marketing effort, lends to the conclusion that the company

will be extremely successful in the international marketplace, moving forward.

Commodities — Price Risk Management and Futures Contracts

Introduction to Cocoa



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As a company that’s main products are largely chocolate based, cocoa is, by far, the

most significant raw material used by Hershey’s and will be examined the most thoroughly in

this report. Taking a look into the prices and supply of cocoa beans is crucial, as this will have a

direct impact on the company’s COGS and, thus, bottom line. Less significant inputs such as

sugar, milk and peanuts will not be discussed in detail in this report, as they are simply far less

relevant to Hershey’s bottom line.

Supply

Hershey’s cocoa products are purchased directly from third-party suppliers, who mainly

source the cocoa beans from countries such as Ghana and The Ivory Coast (as West Africa

accounts for approximately 70% of world’s supply of cocoa beans). See exhibit 3. Historically,

the main factors that adversely affect the cocoa crop (and thus increase the price of the

commodity) in these countries, have been adverse weather, crop disease, and political unrest.

However, Hershey’s believes that if there is a marked disruption in any individual country, cocoa

from other producing countries and from current physical cocoa stocks in consuming countries

would provide a significant supply buffer until the issue is resolved. Thus, the general ability for

the company to obtain cocoa is not significantly at risk in the near future.

Current Price

In early 2011, cocoa prices reached 37-year highs (over $3,800 per metric ton), but by

the end of 2012, cocoa prices were nearing record lows of around $2,200 per metric ton (See

exhibit 4). This goes to show the extreme volatility in the price of Hershey’s main input, but it

should be noted that Hershey’s stated costs (across many of its raw materials, including cocoa)

do not necessarily reflect market price fluctuations because of the company’s forward

purchasing and hedging practices.



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Future Price Predictions and Anticipated Effect on Hershey’s

As of March 2013, the price of cocoa was $2,153 per metric ton. According to a director

at Singapore-based Petra Foods, a worst case scenario could see global cocoa prices more

than double by 2020, rallying to a level last seen 36 years ago of over $5,000 per metric ton, if

production fails to catch up with demand. Raobank, a financial services group in Asia, has a

less pessimistic view and expects prices to return to the 5-year average of around $2,750 per

metric ton in the near to mid-term. While it is very difficult to accurately forecast the future price

of any commodity, it should be noted that most experts are in agreement that cocoa is near its

floor price and is only likely to increase in price in the years ahead. How much this will increase

and how Hershey’s will hedge this risk will be crucial to the company’s future performance. Our

findings, however, show that due to hedging, as well as important strategic moves such as price

increases and varying the level of chocolate in their products as commodity prices rise, the

company is not as susceptible to the world swings in cocoa price one might expect. Couple this

with the efficiency programs and there are several years, recently, when cocoa and sugar prices

are rising and Hershey’s COGS are falling. (see exhibit 5). This fits with the company's reporting

objective of income smoothing and is consistent with Hershey’s public image as a stable and

growing company.

Forwards and Hedging Strategy

Hershey’s attempts to minimize the effect of future price fluctuations related to the

purchase of major raw materials, primarily through forward purchasing to cover future

requirements, generally for periods from 3 to 24 months. The company enters into futures

contracts and other commodity derivative instruments to manage price risks for cocoa products,

sugar and dairy products, among other things. By using futures and options contracts and other

commodity derivative instruments in combination with forward purchasing of these raw inputs,

the company tries to reduce the risk of future price increases and provide visibility to future



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costs. This is directly in line with management's reporting objectives of earning stability and

predictability and the ability to consistently make a profit and pay out a stable dividend. However,

the use of hedging and futures also limits the company’s ability to take advantage of decreases

in the prices of these commodities. As well, these instruments create a time lag such that

current commodity prices are not necessarily reflected in the financial performance of the

company at this point in time, creating the potential for current numbers to seem either under or

overstated depending on the direction of future commodity movements. The important thing for

Hershey is to keep hedging itself to a level similar to its competitors so as not to give them a

competitive advantage in the case of commodity price fluctuations. Keeping an eye on the

fluctuations in these commodities and how Hershey’s manages them is absolutely key to

understanding the company.

Financial Statement Analysis of Hershey’s

Recasting of Financial Statements

As previously discussed, there are several non-recurring expenses as well as a large

concentration of sales by one buyer. Both of these factors have implications on Hershey’s

financial statements and performance. We have divided these factors into two scenarios –

Normal and Worst – and have analyzed the financial performance under each scenario.

Financial statements and ratios for both the scenarios are given under exhibits (see exhibits 6

and 7).

Normal Scenario

Hershey’s financial statements have been recast to give a true picture of the business

under normal operating conditions. Thus, the company’s financial statements (income statement

and balance sheet) as at December 31, 2012 have been adjusted to reflect what we believe to

be the true picture of the company. The items adjusted under the recast statements are as

follows:



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Income Statement

Business realignment and impairment charges: In 2012, total cost for “Project Next Century”

was $76.3 million. Since this is one time transition, we do not expect this cost to occur in

normal business operating expenses. Therefore, we will deduct $76.3 million from expenses.

In 2012, company took an impairment charge of $7.5 million on Tri-US. Tri- US decided to

cease its operations and dissolve the company. Since Hershey’s had an equity stake in that

company, it had to write-off its partial equity contribution of $7.5 million. Since this is also an

exceptional situation, we don't expect these charges to be reflected in normal course of

business. Total of $83.7 million was recorded as business realignment and impairment

charges.

Brookside Foods Ltd. Acquisition: Hershey’s recorded expenses of $12.7 million as the

integration costs for Brookside. Furthermore, the company’s short-term debt and interest

expenses also increased to finance the acquisition. We believe that these costs are one-time

expenses and hence will not occur in normal business operations. Thus, the company’s interest

expenses can be assumed to be closer to the 2011 interest expenses in case of normal

business practice. Overall, by taking all of the above into consideration, recast net income

of the company will increase by around $68 million (after tax).

Balance Sheet

Hershey’s hasn't provided detailed information on inventories and receivables to

determine the actual value of both of these asset classes. In the company's annual report, it has

not given details on the aging of receivables and inventory and it’s therefore not possible to

determine the proportion of receivables that are likely to be collected or the inventory that may

not be sold. The company uses the LIFO method for the majority of its inventory policy, whereas

remaining inventories are priced at the lower of FIFO cost or market. As on December 31, 2012,

the company accounted for $331.7 million inventory using the LIFO method, whereas the



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remainder was accounted for using the lower of FIFO cost or market. Hence, we believe that

half of the company’s inventory is not priced at market, however as per information provided in

the financial statements its not possible to truly determine the actual market value of inventory.

Hershey’s MD&A report mentions that 22% of its sales are made to McLane Company,

which is by far the largest buyer of the company’s products. However, in an accounts

receivables note, Hershey’s states that 19.6% of its receivables are attributable to Wal-Mart and

17.9% of its receivables are attributable to McLane Company. Since McLane Company is the

primary distributor of Hershey goods to Wal-Mart, we believe that a total of 37.5% of Hershey’s

receivables are either directly attributable to or originally passed through the McLane Company,

which represents a massive credit risk. In order to smooth this number and appear less risky,

the company has mentioned Wal-Mart as its debtor but it may indeed be an indirect debtor,

while the company’s direct debtor in this regard is likely the McLane Company. Certainly, in line

with being seen as a stable and low risk company, this makes sense from a management

perspective, but should be viewed with caution from a shareholder’s perspective.

In summation, in terms of inventories and receivables reporting, we find that company

has used creative accounting to distort the true picture of its credit risk and fair value of its

receivables and inventory. As far as the company’s market value of fixed assets are concerned,

Hershey’s hasn’t provided enough information to determine the market value of plant, property

and equipment, and due to management objectives, it may be wise to keep this in mind moving

forward.

Worst Scenario

Income Statement and Balance Sheet

Loss of Revenues from McLane Company: In case McLane Company decides not to

distribute Hershey’s goods, Hershey will lose total revenue of USD 1.45 billion based on 2012

statements and net income of approximately USD 145 million.



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Bankruptcy of McLane Company: Though McLane Company has a very good credit rating, in

case of bankruptcy, we expect the receivables from McLane company to go bad and Hershey

may have to take USD 77.9 million as bad debt expense, thus reducing the net income by same.

Impairment of Goodwill: In case company is not able to run the acquired companies well as it

is planning and due to above events or due to unfavorable circumstances, Hershey may have to

take impairment of its goodwill and intangibles. Hershey’s have approximately USD 803 million

of goodwill and intangibles and hence company may have to take impairment of the same.

Revenue Recognition

Hershey’s recognizes revenue when the following requirements are met (as stated in the

company's annual report).

1) A valid customer order with a fixed price has been received

2) The product has been delivered to the customer

3) There is no further significant obligation to assist in the resale of the products

4) Collectability is reasonably assured

However, net sales are calculated net of trade promotions and other sales incentives,

which may inflate this number and serve to make the company’s top line performance appear

better than it actually is.

Financial Analysis

Our analysis of Hershey’s financial performance is largely based on historical ratios for

the past 10 years data. Auditors have provided a clean opinion on all the financial reports and

thus the reports are considered reliable for financial analysis. We believe looking back to 10

years of data regarding the financial information will provide a good insight on their financial

performance and will help us to outline some financial indicators that may affect their financial

performance in future.



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Profitability

Revenues: During the last 10 years, Hershey’s average 10-year growth increased from 1.81%

in 2003-2004 to 2.93% 2011-2012. The increase in revenues has been primarily brought about

through the following important factors:

1) Increase in prices of Hershey’s products

2) Increase in volume sold

3) Company’s expansion in international markets (primarily India, China and Brazil)

4) Moderate growth in US market.

84% of the company’s revenues are from the US and the remaining 16% are from

international markets. Hershey’s major strategy is to grow its sales volume through expanding

into international markets by acquisitions. Acquisitions give Hershey’s both product diversity and

new market opportunities, thereby resulting in higher sales volumes. Hershey’s is trying to

capture significant value through acquisitions. As discussed, quite often, its equity investments

are initially fairly small, followed by the full acquisition if the business model is successful. The

company’s investments in China and India are currently valued at more than the company

initially paid. Hershey’s investments in growing markets indicate that the company's revenues

will continue to increase in international markets, however these markets are more price

sensitive than US and far less brand conscious. How much the company will be able to translate

the increased revenues into higher EPS will depend on its cost cutting measures, supply chain

productivity and ability to transfer the cost increases that come with expansion, to end

consumers.

Margins: During the last 10 years, the company has made significant investments to improve its

both its productivity and its margins. In 2007-2008, the company made an investment of $530

million in a supply chain transformation program to enhance its manufacturing, sourcing and

customer service capabilities. As a result of this investment, company’s profitability was lower in



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both 2007 and 2008. However this investment ultimately enabled the company to improve its

operating and net profit margins substantially. In 2012, the company recorded 43% gross

margin versus 39% in 2003. In 2010, the company implemented its “Next Century Program” as

an ongoing effort to improve its supply chain and create a more competitive cost structure. The

total cost of this implementation was around $200 million, which included transfer of significant

production into a newly expanded facility. Apart from investing in acquisitions and productivity

improvements, Hershey’s is also leveraging its higher margins to invest heavily in marketing and

selling expenses. As a result, the company’s SM&A expense as a percentage of sales

increased from 19.57% in 2003 to 25.64% in 2012, thereby reducing operating profit margin

from 19.1% in 2003 to 16.7% in 2012. Overall, due to substantial growth in margins and

moderate growth in revenues, Hershey’s has been able to increase its EPS from $1.73 in 2003

to $2.89 in 2012, and this growth is expected to continue well into the future.

It is pertinent to mention that the company’s profitability is highly dependent on prices of

cocoa, peanuts and dairy, which will be discussed in more detail below. However, as discussed,

the company has been able to mitigate some of the risk of commodity price volatility by booking

future contracts (generally from 3 to 24 months). By booking future contracts, Hersey’s is able to

determine its cost of production in advance and, thus, transfer the impact of higher costs to end

consumers smoothly, although not without some lag. This is directly in line with their reporting

objectives of showing stability, smooth profits and continued growth. Any significant cost input

increases will be passed on to end consumers with little impact to overall profitability. Similarly,

the company has a policy of booking future contracts in a variety of the currencies it deals in,

which also mitigates the currency risk arising from international operations (which are expected

to be an increasingly important aspect of Hershey’s operations moving forward).

By taking a macro view of company’s operating performance, we can see that company

is enjoying very healthy margins on it products currently, and reinvesting the money into

international expansion, cost cutting measures and marketing expenses. This investment will



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help the company to increase its revenues in the long run, without compromising its margins,

and thus will contribute to it continued EPS growth and long term objective of returning top

notch shareholder value.

Balance Sheet

Liquidity: Hershey’s current ratio during the past 10 years has decreased from 1.93x in 2003 to

1.44x in 2012, however it is still at a level at which it can pay its current liabilities. Furthermore, it

is not uncommon for growing firms to reflect lower current ratios, especially when the return on

assets is increasing. The company’s return on assets has increased from 12.96% in 2003 to

14.42% in 2012. The company has being able to negotiate better trading terms with its suppliers

and buyers. Hershey’s days payables has increased dramatically, from 18.41 in 2003 to 41.57

days in 2012, which allows them to use the cash they are delaying paying for other purposes in

the interim. At the same company’s receivables days has decreased from 34.05 days in 2003 to

23.65 days in 2012. Overall company’s cash conversion cycle has reduced from 87.08 days in

2003 to 43.91 days in 2012. These are all positive signs for the company.

Improving cash cycle conversion along with higher revenues and better margins has

helped the company to increase its free cash flow per share from $1.42 in 2003 to $3.58 in 2012.

As of December 31, 2012, the company had cash and equivalents of approximately $730 million.

This cash is enough for the company to honor its payment on its long-term debt obligation of

$257.7 million in 2013. Even if the company makes acquisitions equivalent of its cash balance in

2012, it has revolving credit facility of $1.5 billion available to meet working capital and debt

payment requirements. If needed, the company could easily raise additional debt capital since it

has a very favorable credit rating from both Moody’s and S&P.

Overall, we believe that the company is in a very healthy liquidity state and can easily

meet its working capital needs and honor its debt obligations.



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Leverage: The company’s financial leverage during the past 10 years has increased from 2.80x

in 2003 to 4.59x in 2012. Furthermore, company’s debt/equity ratio has increased from 0.76x in

2003 to 1.48x in 2012. Even though company’s debt burden has increased, it is important to

note that the debt taken has helped the company to significantly increase its revenues and

margins. The following are the reasons that high leverage is not a serious concern for Hershey’s.

1) Hershey’s has high credit ratings from Moody’s and S&P, indicating the company can easily

pay its debt obligations (and likely raise additional capital if need be) and hence shareholder

value will not be compromised.

2) The company’s interest coverage ratio as at December 31, 2012 was 11.31x, indicating that

company’s operating cash flows can easily service the company’s debt and, in order to service

its debt obligations, the company will not need to take on any additional debt.

3) Through 2016, the company has long-term debt payments that will be around $1 billion. As

per the information provided by the company, Hershey’s has not indicated any near-term major

acquisitions or unusually large Capex in coming years. Hence we can assume the company’s

operating cash flows will be used primarily to pay its debt obligations, which, as a result, reflect

the fact that company’s leverage and debt to equity ratio will likely decrease in coming years.

Comparison of Hershey financial performance with Industry and Global

Players:

Name P/E Curr Ratio Interest Coverage Financial Leverage Gross Margins ROE (%) ROA (%)

Average 29.88 1.89 274.52 2.58 34.71 19.71 7.59

HERSHEY CO/THE 26.79 1.44 11.09 4.84 43.04 69.79 14.43

MONDELEZ INTERNATIONAL INC-A 13.64 1.05 2.93 2.51 37.34 8.98 3.58

KELLOGG CO 18.86 0.75 5.94 6.44 38.28 45.60 7.09

TOOTSIE ROLL INDS 36.63 3.25 507.15 1.30 33.34 7.90 6.10

LINDT & SPRUENGLI AG-REG 36.17 2.50 92.95 1.53 16.25 10.59

SNYDERS-LANCE INC 26.59 2.07 9.99 1.88 33.29 6.93 3.68

J & J SNACK FOODS CORP 24.47 3.78 1,163.93 1.27 30.11 11.92 9.38

WANT WANT CHINA HOLDINGS LTD 35.12 1.92 52.37 2.25 39.54 37.86 16.82

ORION CORP 40.82 1.21 6.86 2.67 43.06 16.29 6.10

BARRY CALLEBAUT AG-REG 19.60 1.73 4.86 2.66 13.93 11.04 4.16

M DIAS BRANCO SA 19.83 2.24 11.86 1.47 40.13 21.31 14.51

LOTTE CONFECTIONERY CO LTD 28.59 1.91 6.69 1.51 36.62 3.50 2.31

ULKER BISKUVI SANAYI AS 25.71 1.98 2.73 2.97 21.48 17.04 5.73

PETRA FOODS LTD 79.34 1.29 56.54 3.63 31.91 8.31 2.29

CALBEE INC 28.31 2.11 2,449.40 1.40 42.31 9.58 6.83

GENERAL MILLS INC 17.69 0.96 7.02 2.92 36.29 22.99 7.88



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Return on Equity & P/E: Hershey’s return on equity is highest among its industry peers.

Hershey’s ROE as of December 31, 2012 was 70% versus an average of 19% for the industry.

Again, the robust ROE is a result of the long-term investments the company had made to gain a

more competitive cost structure. Considering the company is expanding aggressively into

overseas markets, its return on equity may get compromised in the near term, but we believe it

will still be above its peers in the industry, due to its massive current advantage. The company’s

P/E ratio is 26.45 (December 31, 2012) versus an industry P/E ratio of 29.78. Its stock price is

currently $72.22 (December 31, 2012). The P/E will be discussed in more detail a little later.

Overall, Hershey’s has better gross margins, profit margins and a higher return on equity

than its industry peers. However, it is falling behind in liquidity and leverage. Considering the

company will be paying the majority of its long term debt in the next four years and, at the same

time, expanding aggressively into international markets, we believe that Hershey’s liquidity and

leverage ratio should come into line with the industry average. However as a result of its better

profitability and returns, its stock price and associated valuation may increase, assuming the

company maintains its average historical P/E ratio in coming years.

Financial Forecast

AssumptionsIn order to understand our financial forecast, we must first understand what assumptions

we have made when estimating the various line items:

1) The net sales for the previous 3 years have grown by between 7.0% and 7.2%, except for

last year when it was 9.3%, which was inflated due to the acquisition of Brookside that added

1.9% to top line sales. To project the net sales growth in the future we have broken down the

sales into two segments US and international. The US chocolate market is projected to grow at

3% annually, however we expect Hershey to benefit from an additional 2% due to the

diversification of its portfolio, due in part to the Brookside acquisition, and a modest increase in

sales of its current products, dropping to the market growth rate of 3% in the long-term. We



27

7) To estimate the future share price we use the EPS, which we have calculated using the

assumptions stated above and multiply it by the projected P/E ratio. The current P/E ratio of

29.93 (April 11th 2013) is more than 2 standard deviations (Exhibit 10) from the average as well

as being the historical high. This tells us that the P/E ratio is well outside what could be

considered normal for Hershey’s. This can be explained in part from the recent improvement in

margins and the increase of almost 10% in prices in recent years. This is further illustrated by

the fact that Hershey’s share price has doubled the performance of the S&P 500 since the

recession of 2008, although it has a historical Beta of 0.25 (according to Google finance).

However these improvements are not sustainable and we expect the P/E to return to the

historical average of approximately 21 in the long term as Hershey’s growth begins to decline.

This is a reasonable assumption since it represents the historical value investors have been

willing to pay for earnings from Hershey’s. These high P/E ratios are also present in Hershey’s

competitors and might be explained by the recent low cocoa prices leading investors to believe

the chocolate industry will see increasing profits in the near term. In Hershey’s case this is

further compounded by the anticipated growth related to the recent improvements in margins

due to investments in supply chain productivity.

Future Outlook

Based on our financial forecast we predict that Hershey’s will continue its stellar performance.

Based on these results we expect the EPS to be $3.64 at the end of 2013. At the current P/E

ratio of 29.93 (April 11th 2013) this would represent a share price of $ 108.95. Since the current

share price is $86.61 (April 11th 2013) this would initially seem to indicate that Hershey would be

a good investment. However, as stated above, this level of performance is not sustainable and

we anticipate that it will return to historically normal levels within the next five years. Using the

historical average P/E (since 1986) of 21 as a long term target, we come to a price of $101.89

by the end of 2013. Looking to our sensitivity analysis on the P/E we look at a P/E of between



28

25 and 31 for 2013, giving us a price range of $90.98 to $112.81. Since the current price is

$86.61 (April 11th 2013), this leads us to the conclusion that Hershey’s is currently a buy, which

is further corroborated by the fact even in the worst case scenario we still forecast the price of

the stock to increase, although moderately in years to come. The outlook is significantly better in

our current estimations and best case scenarios.

Sensitivity Analysis

As stated above, the biggest risk to Hershey’s bottom line is the cost of sales. In the last

five years, the cost of sales has been between 57% and 66% although, with the completion of

the Next Century Program, we ultimately expect this to improve to 56%. Since the cost of sales

is difficult to predict due to constant improvements in efficiency by Hershey and fluctuating input

prices, we have performed a sensitivity analysis in the exhibits looks at the effect of cost of

sales (with a range of 54% to 57% to represent expected cost of sales after improvements) on

the EPS and share price. Looking at the EPS for end of year 2013, we expect it to be $3.64.

With a cost of sales of 54% it would be $4.05, which would be a 11% improvement; however

with a cost of sales of 57% it would be $3.40, a drop of 7%. As expected, the EPS is highly

sensitive to the cost of sales. Consequently, the share price is also highly sensitive to variation

in the cost of sales. Based on the financial model, the estimated share price with a cost of sales

of 56% is $101.89, at 54% cost of sales it is $113.34, at 57% cost of sales it is $96.17. Finally

looking at the prices sensitivity to P/E, with a P/E of 28 in 2013 the price would be $101.89;

looking at the best case with a P/E of 31 the price would be $112.81, which would be an 11%

improvement; however with a P/E of 25 the price would be $90.98, a drop of 11%. Naturally the

P/E used in our valuation model affects the share price, however this gives us a range of $90.98

to $113.34 for the share price at the end of the year, which makes Hershey a definite buy.



29

Conclusion

In conclusion, Hershey embodies operational excellence demonstrated by their industry leading

gross margins; this competitive advantage allows Hershey to thrive in the chocolate industry.

Their long history points to reporting objectives that emphasize stable growth, thus when

reading their financial statements we must beware of possible income smoothing and other

creative accounting policies. Hershey uses financial instruments to hedge itself against

commodity and currency fluctuations. Their continued investments in supply chain efficiency

have made them a major force in the US chocolate industry, and their expansion into

international markets provides growth opportunities for the future. Through our recasting of the

financial statements we have determined that even in the worst-case scenario, Hershey’s

business operations are sustainable and they will remain the industry leader in gross margins.

Although, at a first glance a P/E of almost 30 might seem high for a consumer staple company,

investors believe in the future growth of the chocolate industry, which is demonstrated by the

high P/E of Hershey’s competitors. Looking at the forecast for the future it becomes clear that

from an equity perspective Hershey is a sound investment and should provide stock growth in

the future. We estimate Hershey’s share price to be $101.89 by the end of 2013. However, do to

the sensitivity of the model to the cost of sales and P/E, which are difficult to predict, we expand

our confidence interval to $90.98 to $113.34 by the end of 2013, in all cases a significant

improvement over Hershey’s current share price of $86.61.



30

Appendix

Exhibit 1:

HSY Stock Price (1996 to 2013):

&&

Exhibit 2:

HSY Dividend History (1996 to 2013):

&



31

Exhibit 3:World Supply of Cocoa Beans (69% from West Africa - Ivory Coast, Ghana, Cameroon, Nigeria)

Exhibit 4:World Cocoa Prices (2006 - 2012)



32

Exhibit 5:

Hershey’s Cost of Goods Sold vs. Raw Inputs (2008 - 2012)

&



33

Exhibit 6: (Normal Scenario)&

&

&

in#millions 2012 in#millions 2012

Income*Statemet Balance*Sheet

Net#Sales 6,644#####

Cost#of#Sales 3,745##### Current#Assets

SG#&#A 1,691##### Cash#and#Equivalents 796#########

Business#Realignment#Charges D########## Accounts#Receivables 461#########

Income*Before*Interest*and*Income*Tax 1,207##### Inventories 633#########

Interest#Expense 92########### effered#Income#Taxes 122#########

Income*Before*Income*Tax 1,115##### Prepaid#expenses 168#########

Provision#for#Income#Taxes 387######### Total*Current*Taxes 2,181#####

Net*Income 728######### D##########

EPS 3.18######## Property#Plant#&#Equipment 1,674#####

Dividends*Paid Goodwill 588#########

Retained*Earnings Other#Intangibles 215#########

effered#Income#Taxes 12###########

Other#Assets 152#########

D##########

Total*Assets 4,823*****

D##########

Current#Liabilities D##########

Accounts#Payables 442#########

Accrued#Liabilities 651#########

Accrued#Income#Taxes 2##############

Short#Term#ebt 118#########

Cu rre nt#P orti on #of #Lon g#te rm#de bt 258#########

Total*Current*Liabilities 1,471#####

D##########

Long#Term#ebt 1,531#####

Other#Long#Term#Liabilities 669#########

eferred#Income#Taxes 36###########

D##########

Total*Liabilities 3,706#####

D##########

Stockholders#Equity D##########

Total#Stock#Holders#Equity 1,116#####

D##########

Total*Liabilities*and*Equity 4,823*****



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Exhibit 7 (Worst Case Scenario)

Ratios& Now& Normal& Worst& Industry&Average&Now&

P/E$ 26.45$

$$$$$$$$$$$

24.04$$

$$$$$$$$$$$$$$$

+$$$$ 29.88$

ROE$ 69.79%$ 65.23%$ +37.69%$ 19.71%$

Current$Ratio$ 1.44$ 1.48$ 1.38$ 1.89$

Interest$Coverage$ 11.09$ 15.38$ 2.51$ 274.52$

Leverage$ 4.84$ 3.32$ 22.10$ 2.58$

Gross$Margin$ 43.04%$ 43.63%$ 43.05%$ 34.71%$

Net$Profit$Margin$ 9.95%$ 10.96%$ +1.22%$ 7.84%$

ROA$ 14.42%$ 15.10%$ +1.63%$ 7.59%$

&

in#millions 2012 in#millions 2012

Income*Statemet Balance*Sheet

Net#Sales 5,194######

Cost#of#Sales 2,958###### Current#Assets

SG#&#A 1,410###### Cash#and#Equivalents 728#########

Business#Realignment#Charges 848########## Accounts#Receivables 383#########

Income*Before*Interest*and*Income*Tax (22)*********** Inventories 633#########

Interest#Expense 75############ Deffered#Income#Taxes 122#########

Income*Before*Income*Tax (97)*********** Prepaid#expenses 168#########

Provision#for#Income#Taxes (34)########### Total*Current*Assets 2,036*****

Net*Income (63)***********

EPS (0.28)####### Property#Plant#&#Equipment 1,674#####

Dividends*Paid Goodwill ##########

Retained*Earnings Other#Intangibles ##########

Deffered#Income#Taxes 12###########

Other#Assets 152#########

Other#items#on#Income#Statement,#ones

that#are#not#effected#from#recasting#are Total*Assets 3,874*****

calculated#as#per#percentage#of#sales

Current#Liabilities

Accounts#Payables 442#########

Accrued#Liabilities 651#########

Accrued#Income#Taxes 2##############

Short#Term#Debt 118#########

Curre nt#P orti on#of #Long#te rm#debt 258#########

Total*Current*Liabilities 1,471*****

Long#Term#Debt 1,531#####

Other#Long#Term#Liabilities 669#########

Deferred#Income#Taxes 36###########

Total*Liabilities 3,706*****

Stockholders#Equity

Total#Stock#Holders#Equity 168#########

Total*Liabilities*and*Equity 3,874*****



36

Exhibit 9:

!$#

!$1.00

!$2.00

!$3.00

!$4.00

!$5.00

!$6.00

!$7.00

2010 2011 2012 2013 2014 2015 2016 2017

E P S

Year

Sensitivity.of.EPS.to.Cost.of.Goods.Sold

Best!Case

Worst!Case

Current

!$#

!$20.00

!$40.00

!$60.00

!$80.00

!$100.00

!$120.00

!$140.00

2010 2011 2012 2013 2014 2015 2016 2017

S

h a r e

P R i c e

Year

Sensitivity&of&Share&Price&to&Cost&of&Goods&Sold

Best!Case

Worst!Case

Current



37

Exhibit 10:& Normal distribution of Hershey’s historical P/E ratio shows that at current levels occur less than

0.13% of the time, well outside the norm.

&$&&&&

&$20.00&&

&$40.00&&

&$60.00&&

&$80.00&&

&$100.00&&

&$120.00&&

&$140.00&&

2010& 2011& 2012& 2013& 2014& 2015& 2016& 2017&

S h a r e P R i c e

Year$

Sensitivity$of$Share$Price$to$P/E$in$2013$

Best&Case&

Worst&Case&

Current&

Hershey%27s Report

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