AGB 2022.13 - The Hershey Company (HSY)

Market Leader in U.S. Confectionery

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The Hershey Company

Some may view consumer staples companies unexciting and expensive. However, the consistency of these businesses, especially during uncertain economic environments, calls for some attention to the best positioned companies. Hershey’s leading market share in U.S. confectionery results in excess cash flows that are currently being reinvested into savory snack brands. The current scale of the savory snacks segment is no where near the market leaders, but it does present a long future reinvestment avenue for the company.

Hershey is the leading confectionery company in the chocolate and mints categories in the U.S. (also #3 in gum and sweets). Founded in 1894, the company has a long history of growing the category through innovating, acquiring or licensing many of the well-known confection brands today. Hershey owns more than half of the top candy brands that generate over $500M in revenues annually in the U.S., which include Hershey’s, Reese’s, KitKat (licensed), Ice Breakers, and Kisses. The company sells almost 3B Hershey bars annually and 70M Kisses every day.

Other well-known confectionery brands under the Hershey umbrella in the U.S. are Jolly Rancher (licensed), Almond Joy, Brookside, Good & Plenty (licensed), Payday (licensed), Rolo (licensed), Twizzlers, Whoppers (licensed), York (licensed), Breath Savers and Bubble Yum. Almost all of Hershey’s chocolate and candy products are manufactured in the U.S., most of which (~60%) is from the company’s plants in Hershey, Pennsylvania.

Hershey’s brands are heavily skewed towards serving the U.S. customer. Globally, the company ranks #5 by revenues, after Mars, Ferrero, Mondelez and Meiji. Hershey manufactures and sells many of the same brands internationally as well as a few other market specific brands like Pelon Pelo Rico in Mexico. For 2021, the company’s international segment represented 8.5% of revenues and only 2.8% of segment operating income. Margins for the international segment are much lower than the North American confectionery segment because of the much smaller scale spread across many different geographies.

Over the past 5 years, the company has expanded into savory snacks by acquiring brands such as SkinnyPop, Pirate’s Booty, Dot’s Homestyle Pretzels and ONE Brands. The acquisitions into savory snacks have allowed the company to take the cash generated from the higher margin chocolate category and reinvest into the higher growth snack category. From 2017 to 2020, industry wide salty snacks category grew +6.1% annually while the chocolate category grew +3%. The frequency of snacking occasions for the U.S. Consumer has increased over the past decade as well and savory snacks represent almost 25% of the total snacking market.

Hershey sells its products mainly through retailers, which can be broken down to mass merchants (35%), grocery (25%), convenience stores (15%), drug stores (10%) and other (15%). eCommerce accounted for 2% of revenues prior to the pandemic, but now is ~5%. The company also operates a few of its own specialty retail locations called Hershey’s Chocolate World in Hershey, New York City, Las Vegas, Nigra Falls and Singapore.

As the largest confectionery company in the U.S., Hershey has favorable relationships with its retail partners. Leveraging these relationships to increase the presence of the company’s brands in the most valued shelf space is the name of the game. There are many factors that go into deciding which products get placed where (also there are nuances among the different retail concepts), but retailers will allocate the higher valued shelf space to brands that sell more and bring in traffic to the store. One of the key metrics to look at is sell-through by season. Retailers will often look at data from the prior season and allocate incremental shelf space to brands that are performing well.

From the company’s perspective, having shelf space is important but so are having the right products in place. There is a balance between having a high enough number of SKUs and profitability of those SKUs. In 2018, Hershey implemented SKUs rationalization to reduce complexity and costs since smaller product lines have lower margins. The company also divested a few underperforming brands like Krave (acquired in 2015, divested in 2020). Krave had peaked at $125M in revenue in 2016 but declined to $20M by 2019. Hershey has also pruned its international brands such as Shanghai Golden Monkey (acquired in 2014, divested in 2018) and Lotte Shanghai Foods (JV started in 2007, divested in 2021).

Advertising is a large factor in the success of a brand. Hershey spends 6%-7% of revenues on advertising. Recently, the company has refocused more on investing in its core brands like Hershey’s and Reese’s. Hershey has stated that lesser-known brands don’t benefit as much from advertising and are much more impacted by how they are placed on the shelves in stores. But well-known brands benefit more from advertising because customers come into the stores looking for those products, especially if there are new variations and extensions to the well-known brands. A brand like Reese’s has 55% household penetration vs. just 5% for some of the company’s lesser-known brands.

Advertising is also important support for its retail partners. Hershey can increase the sales velocity of its products on its partners’ shelves with a successful advertising campaign. And typically, when there are price increases, customers react negatively by purchasing lower volumes. So in the first year or so of the price increase, customers get used to the higher price and volumes come back. With an increase in advertising, customers typically convert to the new price quicker, which helps Hershey as well as its retail partners.

Hershey also works with its retail partners for its seasonal products. The main seasonal products are sold near Valentine’s Day, Easter, Halloween and the winter Holidays. About a third of the company’s revenues come from seasonal items (Halloween alone makes up 10% of the company’s revenues), and these items tend to have higher price points because of the increased demand and the limited nature of the products. Easter chocolate is 12%-18% more expensive than the company’s other chocolate products. When it comes to seasonal products, many retailers have promotional activity around these times. Hershey commits to these pricing promotions in advance by 6 months or more.

The company’ market share in the U.S. is 46% (#1) of the chocolate category. Hershey has 35% (#1) of the mint category, 13% (#3) of gum and 8% (#3) of the sweets category. Within savory snacks, the company has 20% (#2) of the popcorn category and 31% (#2) of better-for-you puffs.

The growth formula for the company is 2%-4% annual revenue growth, which can be broken down to 1.5%-2% from the confection business, 0.5% from snacks, and 0.5%-1% from international (where does the other 0.5% come from?). This growth rate was reduced in 2017 from 3%-5%. The company expects margin leverage from corporate expenses and other SG&A to achieve 6%-8% earnings growth. Hershey has one of the highest gross margins within the food category, given its high concentration on chocolate confection, especially around its core brands.

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Why is it a good business?

Hershey benefits from scale economies in the company’s confectionery segment. With production centralized mainly within the U.S., Hershey maintains a cost advantage vs. smaller competitors. This is manifested in both lower unit costs and distribution costs. Hershey has one of the highest EBITDA/manufacturing facility (by a wide margin) when compared to the rest of the food category. Furthermore, the company has 5 brands that make up most of the segment (70+%), which means marketing dollars are spent more efficiently.

Scale also benefits Hershey with respect to its customer relationships. Retail partners will give Hershey brands and products high consideration for the best shelf space in store. Because the company’s leading brands help attract foot traffic to the store, Hershey can request favorable shelf space for some of its smaller and newer brands as well. Sales strategies around seasonal promotions are planned in advance of many months and because Hershey has strong relationships with its retail partners, the company can get priority for its own brands vs. smaller competitors.

The company and the large peers in the confectionery category benefit from the lack of private label competition. As we know from studying good retailers like O’Reilly Automotive, Home Depot and Tractor Supply, private label products tend to be priced below that of a comparable branded product in the range of 20%-40%. Furthermore, retailers that achieve significant scale tend to prioritize private label products over the branded ones due to the higher margins.

While consumers will be more inclined to purchase the branded good with the right advertising, this doesn’t work as well during a weak economic environment. Private label for the food category saw declines in 2020 and 2021 but the trend has reversed in 2022. This was partly because companies with branded products likely benefited from a more robust supply chain during the pandemic lockdowns, and partly because the consumer had excess cash from the government stimulus packages and changes in spending patterns from services to goods.

Food as a category has roughly 22% private label exposure but the sub-categories have varying exposures. Chocolate has the lowest exposure at ~2.5% and savory snacks are a bit higher near 10%. Hershey as a company has private label exposure of 4%, given that North American savory snacks and international made up 6% and 8% of revenues in 2021, respectively. Hershey’s private label exposure is the lowest among the mid to large sized consumer goods companies.

The company also benefits from its recent entry into eCommerce. Hershey has been slow to foster this channel because the traditional retail channel is so profitable for the company. Hershey has developed new bundle sizes and packaging specific for eCommerce so that its products can stand out on a retail partner’s website or app. The results have been good, with 1.2x-3.5x higher average selling prices and 1x-3.5x larger basket sizes when compared to brick and mortar purchases. Margins are still below that of traditional retail by 1%-1.5% points on gross margin. These figures are from 2019.

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Returns on incremental capital?

Over the past 10 years, Hershey spent 39% of its capital on capex, 56% on M&A + equity investments, and 5% on R&D. Capex is mostly related to expanding the company’s manufacturing capacity and distribution centers. During the pandemic, due to the increased demand in the take home category, Hershey was capacity constrained for some of its core brands like Reese’s, Payday and a few gummy products. Over the past 3 years, the company spent $800M to increase capacity by 15%.

Capex had ranged between 3.5%-5% of revenues for the 8 years prior to 2020, but that number moved higher to 5.5% in 2021 and is expected to be 6% in 2022. The expectation is that capex as a percentage of revenues will come down to 5%-6% for 2023 and 2024 and then back to the normalized level of 4% after that. Some of the investments around supply chain and the new ERP system will come off after next year and the company’s recent investments into manufacturing capacity should last a few more years.

Over the past 5 years, Hershey has made a concerted effort to grow in the savory snack category, mostly through acquisitions. Amplify, which owned the SkinnyPop brand, was acquired in 2017 for $1.6B, or 14.8x 2017 adjusted EBITDA including $20M in assumed synergies. That’s a high multiple considering that Hershey itself was trading at 13x-14x EBITDA during that time period. The company quickly sold off Amplify’s international operations, which contributed $125M in revenues and no earnings. Net of the divestiture, Amplify did ~$250M in revenues and ~$85M in EBITDA in 2017. Amplify held 15% of the ready-to-eat popcorn category at the time of acquisition.

After the acquisition, Hershey decided to place better-for-you savory snacks (including future acquisitions) under the Amplify team in Austin, Texas. In 2018, the company acquired the Pirate’s Booty brand from B&G Foods for $420M or $360M net of tax benefits. Amplify took over selling responsibilities after the acquisition was completed. Revenues for Pirate’s Booty and other brands 2018 were ~$100M.

And in 2021, Hershey acquired Dot’s and its co-manufacturer Pretzels for $1.22B or $1B net of tax benefits. These two acquisitions generated revenues of $275M and ~$75M in EBITDA, which implies a multiple of 17x. Again, this is a high multiple paid but the growth rate may have made it more palatable. Dot’s had 13% market share of the pretzels category and was responsible for a majority (55%) of the growth of the category in 2020/2021.  

Hershey made a few other smaller acquisitions and divestitures during this time period. The company acquired ONE Brands in 2019 for $397M. ONE Brands makes low-sugar protein bars. Hershey also acquired Lily’s Sweets, a maker of better-for-you confections in 2021 for $425M. Lily’s is on pace to do $100M of revenues in 2022.

We estimate that Hershey generated returns on incremental capital between 15%-25% over the past 4 years. Since Hershey’s CEO joined in 2017, the returns have improved due to (1) better growth in the North America segments (both confectionery and savory snacks), (2) higher operating margins from cost cutting initiatives and (3) a lower tax rate from the Tax Cuts and Jobs Act. Some of the growth was attributable to price increases at the company starting in 2019.

The company announced a “Margin for Growth” initiative in 2017, which aimed to cut costs of $150M-$175M by 2019 from workforce reduction, supply chain optimization and reducing non-allocated administrative expenses. A lot of these cuts were part of the international segment, which had been a large drag to margins for many years. International margins are still much lower than the other two North America segments, but at least the margins are now positive.

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Reinvestment potential?

Hershey’s growth formula is 1.5%-2% from core confection, 0.5% from U.S. savory snacks and 0.5%-1% from international. For the confectionery and savory snacks segments, growth comes from price increases and innovation. Hershey has taken more prices increases in recent years, with increases of 1.7%, 2.3% and 3.1% for 2019-2021. Prior to that, the only meaningful price increase were in 2012 and 2015.

In the past, Hershey’s pricing strategy was mainly cost and commodity price driven, meaning price increases were mainly to offset input costs. However, in recent years, the company has applied more strategic elements to their pricing, using elasticity models to predict how much pricing consumers are willing to accept depend on the brand, product line, sales channel, etc.

For Hershey, innovation usually means tweaks in packaging, changes in formfactor or collaborations between their core brands. In 2018, the company combined Hershey’s and Reese’s Pieces in a bar form. Hershey also introduced holiday-flavored Kisses that same year. In 2019, the company introduced Reese’s Thins which were 40% thinner than the original cup and individually wrapped. That same year, Kit Kat Duos: Mint + Dark Chocolate was also introduced. The company expects on average for innovation to contribute 1% to annual revenue growth.

While Hershey is mainly a U.S. confectionery company, there are opportunities to expand in savory snacks and internationally. From a market share perspective, Hershey’s savory snack segment generated $555M in revenues in 2021. Compare this to the North American leader, Pepsi, whose Frito-Lay division generated $19.6B in revenues for 2021.

International may be a steeper hill to climb, given Hershey’s prior lack of success for the segment. In 2013, Hershey had plans to grow the international segment from $800M in revenues in 2012 to $1.5B-$2B by 2017. A lot of that growth was expected to come from China, where Hershey had JV operations like Lotte Shanghai Foods and Shanghai Golden Monkey. By 2017, the company’s international segment only generated $894M in revenues with operating margins in the single digit percentages. The company ended up selling its stakes in both JVs in recent years.

Hershey only ranks 5th in global confection market share, after Mars, Ferrero, Mondelez and Meiji. Whether the company’s flavors are best suited according to American taste or it just takes years of investments in brand advertising, the international market has been difficult for Hershey to gain traction. Looking at the different confectionery markets (this is 2017 data), Western Europe is the largest market at $53B, followed by the U.S. at $34B and China at $16B.

With a reinvestment rate between 35%-55% and a return on incremental capital between 15%-25%, we estimate that Hershey has increased its intrinsic value between 8%-9% annually over the past 4 years. Hershey’s higher incremental returns in recent years have been mostly reinvested back into the business in the form of M&A, keeping reinvestments rates level with prior years. While the deals have been expensive, in the mid-to-high teens EBITDA range, they weren’t so large as to dilute returns from the growth in the core business.

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What else is important?

Can the company hold onto Covid related gains?

During the initial Covid related lockdowns, the company experienced slowdown in certain channels such as foodservices and travel retail, which experienced declines of 75%-80%. Convenience stores and drug stores were also negatively impacted as consumers were not frequenting these stores as much. And the company’s mint and gum categories experienced weakness as people were less inclined to purchase these items with social distancing measures in place.

On the positive side, families were at home more so the take-home category (typically 1/3 of the business) did see a boost. Families had more movie nights and were making more smores at home. The company responded to the shift in demand by focusing ads around smores for families rather than larger community and friend gatherings. According to NPD, chocolate consumption was up 9% during the first year of the pandemic. The take home category still remains elevated compared to pre-Covid levels. eCommerce saw a boost going from 2% to 5% of revenues. As the country reopened at the end of 2020, eCommerce started to decline but still remains elevated.

The company gained market share from its competitors due to its strong positioning in the seasons category and superior manufacturing and supply chain capabilities. While Hershey was capacity constrained at some of their core brands, the company did relatively well to have products in stock. Some of the gains also came at the expense of private label (though very private label is small for the confections category).

Looking ahead, a favorable view for Hershey would depend on whether the company can maintain these recent share gains. Hershey gained 500bps of share in the seasons category, and also did well in take-home. The company, as of 3Q 2021, has retained 75% of the share gains from seasons and 50% overall.

Inflation vs. Pricing

Similar to other consumer products companies, cost inflation has become an issue in 2022. Gross margin guidance for 2022 was adjusted lower by 60bps-80bps after 1Q 2022 and are now expected to be down 120bps-140bps for 2022. 80% of this decline is from inflation of key raw materials, packaging and logistics costs. The other 20% is from incremental costs to service higher volumes.

To offset the cost, the company is implementing price increases again in 2022, which should have the most impact in 2023. Remember that these price increases lag by 6+ months depending on the category. It remains to be seen whether these price increases will result in a meaningful decline in volumes and/or share losses.

Optionality

M&A will be the biggest source of optionality for the company. While we know that international will be a challenge to scale, the savory snacks segment does have potential to reach critical mass with a few meaningful acquisitions. With the segment under already under the umbrella of the Amplify team, the company should see continued margin leverage as the segment grows.

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