Hershey (HSY) enjoys excellent brand power in its North American markets. But, it may see margin erosion with its move into salty snacks. It may be wise to take some profits. The shares are trading near all-time highs, and it is trading at a premium valuation compared to its average over the past five years.
Company’s New Operating Segments
In the fourth quarter of 2021, the company achieved net sales growth of 6.4%. About 2.2% of the net sales growth came from acquisitions. The organic net sales growth on a constant currency basis was 4%. List price increases drove this organic growth. Product volume was a 2% headwind for the quarter due to fewer shipping days. Until Q4 2021, the company used two operating segments – North America and International, and others – to report its operations. After completing the Dot’s Pretzel’s, LLC acquisition in December 2021, the company has reorganized its reporting into three segments – North America Confectionery, North America Salty Snacks, and International. Along with Dot’s, the company also acquired Pretzels – a co-manufacturer of pretzels and other salty snacks – with three manufacturing locations in Indiana and Kansas. Pretzels and Dot’s is expected to generate about $ 300 million in annual sales.
Insufficient Market Share in International Markets
Hershey derives a small percentage of revenues from outside North America compared to Mondelez (MDLZ). For instance, just two markets – China and India account for 22% and 19% of Mondelez’s revenue, respectively (See Exhibit 1: Mondelez Revenue from the Asia Pacific, Middle East, and Africa (AMEA)). Hershey derived 13.0%, 13.6, and 15.8% of total net sales from its international operations in 2021, 2020, and 2019.
Exhibit 1: Mondelez Revenue from the Asia Pacific, Middle East, and Africa (AMEA)
(Source: Mondelez’s CAGNY Presentation)
Mondelez derived 38.8%, 22.5%, and 9.8% of its total revenue from Europe, Asia Pacific, the 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 the North American market. Its brands do not have the same mindshare that it has in its home market – the US
AMEA markets are the growth engine for consumer products companies, and a lack of a strong presence there can hurt Hershey in the long run. Mondelez highlighted its strength in India, where its revenues and profits are increasing at a double-digit CAGR (See Exhibit 2: Mondelez’s Growth in India). India has a much younger population than Western markets and is seeing rising income levels. As populations age, they are likely to consume less chocolate, bringing growth headwinds for Hershey in North America. Hershey targets low single-digit growth (2% -4%) in sales and between 6% and 8% adjusted EPS growth (See Exhibit 3: Hershey Sales and Adjusted EPS Growth Estimate).
Exhibit 2: Mondelez’s Growth in India
(Source: Mondelez Investor Presentation, Author Compilation)
Exhibit 3: Hershey Sales and Adjusted EPS Growth Estimate
Hershey faces the difficult challenge of expanding into international markets where brands have gained a foothold over decades. However, gaining market share in global markets is not a priority for the company. Hershey’s focus is on expanding its market share in salty snacks in North America. The lack of a growing presence internationally is another risk factor that investors should consider before investing in Hershey.
Sector-leading Gross Margins
Hershey enjoys a huge gross margin of 45% compared to about 39% for Mondelez. This difference in margins may be attributed to Hershey’s brand strength in North America. The company has good pricing power, and the consumers have purchasing power given that per capita income levels are higher than other countries where Mondelez operates. Hershey also relies more on chocolate confections than Mondelez, and those snacks are more of an indulgence under various occasions throughout the day than biscuits. Mondelez generates 47% of its revenue from biscuits. Hershey had an operating income margin of 22% compared to 16% for Mondelez.
Dividend and Share Repurchase Program
The company operates a dual stock structure – Common stock and Class B Common stock. The Class B Common stock is not publicly traded. The company paid an annual dividend rate of $ 3.14 per share on its common shares and a quarterly dividend of $ 0.819 per share of class B shares for an annual payment 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 common stock count by 0.6% and its class B stock by 1.65% (See Exhibit 4: Hershey’s Outstanding Shares and Year-over-Year Change).
Exhibit 4: Hershey’s Outstanding Shares and Year-over-Year Change
(Source: SEC.gov, Author Compilation)
The company repurchased 2,876,644 shares during the fiscal year ending December 2021. However, 2,005,500 of those share repurchases were to eliminate the dilution caused by stock grants for incentive compensation. Nearly 70% of the share repurchases in 2021 went into eliminating the dilution that would have occurred from the stock grants for company executives.
Given the dramatic increase in share price over the past few months, Hershey’s dividend rate has dropped to 1.47%, which is barely higher than the 1.41% dividend rate of the S&P 500. The low dividend rate is another reason not to buy this company at current prices. If you will get the same dividend rate as the S&P 500, why not own the well-diversified index instead of investing in Hershey and expose your portfolio to the 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.GOV, Author Compilation)
Financial Performance and Valuation
Between 2017 to 2021, the company’s return on equity has averaged about 69%. Hershey’s return on equity is 5x more than that of Mondelez’s. Mondelez’s return on equity is about 13%. Hershey leads both JM Smucker (SJM) and Mondelez on return on invested capital with 20% (See Exhibit 6: JM Smucker, Mondelez, Hershey Return on Invested Capital [ROIC]).
Exhibit 6: JM Smucker, Mondelez, Hershey Return on Invested Capital [ROIC]
(Source: Seeking Alpha)
Hershey trades at a forward PE of 25.8x, above its five-year average of 22.8. For a long-term buyer, the company is overvalued at this time. Hershey faces the challenge of keeping up its stellar financial performance for the long term. The segment profit margins seem to point to lower margins and thus lower returns in the future. 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 salty snacks segment, its margins and financial returns may settle at lower levels than its confectionery margins. Given the prospects of lower returns in the years to come, it may be good to accumulate shares at 18x to 20x or lower PE multiple. The earnings estimate for FY 2022 is $ 7.94 per share. I would start building a position in the stock at $ 160, which would be about a 20x PE multiple.
Covered Call Strategy
The shares are trading near all-time highs, so if you own 100 or more shares and are sitting on good gains, it may be wise to take some profits or sell covered calls. The covered calls can generate a good income, and if the shares get called away, you would have sold near all-time highs. April 22, 2022, $ 205 strike price call last sold for $ 8.07 (See Exhibit 7: Hershey Covered Call Strategy for April). If one can sell a call at or above $ 6, a premium of 2.9% or more would be. I typically aim for about a minimum of 1% call premium when I sell covered calls.
Exhibit 7: Hershey Covered Call Strategy for April
One can collect $ 600 in call premium (subtract about $ 0.60 in broker fees per contract) for selling one contract. If the shares get called away, you would have increased your gains by 2.9%. On the flip side, you get to keep the premium if the claims do not get called away.
Hershey’s shares are trading near all-time highs. The company is expanding into salty snacks with lower profit margins than its North America Confectionery business. Its Asian business is small compared to its 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 may yield a reasonable premium at current prices. It may also be wise to sell some shares at current prices, book some profits, and patiently wait for a pullback before buying again.