Description

Thesis

I think HSY is an attractive absolute/relative short due to its premium valuation, consensus estimates that now reflect an improved outlook and a more challenging comparison year ahead (e.g. shorter Easter, less cocoa/input cost benefit to gross margin compared to FY19).  Sentiment has also turned more positive with ~3 mm shares short compared to ~7 mm at the highs in 2018 and notable sell side bears upgrading to neutral.

HSY is a better business with a better industry structure than most packaged food peers but the company’s valuation now reflects these positives.  That was not the case 1-2 years ago when the stock traded at $90-100 and 16-18x EPS. The valuation then was at parity or even a discount to staples compared to a ~10% premium on average over the last 5 years.  The stock is now trading at 24x EPS and a ~20% premium to staples.

I do not see an enormous amount of risk to HSY’s numbers in FY20 but consensus already reflects a normal algorithm year (+2-4% sales growth, +6-8% EPS growth) thanks to announced pricing initiatives and management commentary.  So the thesis is more focused on multiple compression with more downside than upside risk to numbers. That said, one can make the argument there are potential cracks/questions related to the business as HSY has struggled to grow organically (until pricing last yr) and has resorted to reducing ad spend/SG&A to help drive earnings growth in the last couple years.  NA EBIT has also been relatively flat while international has driven the growth.

Business

HSY operates in an attractive category with chocolate accounting for 70% of its US mix.  The industry structure is also favorable with Hershey and Mars at 70-75% share of the US chocolate market.  Both announced material price increases in FY19. This is a clear point of differentiation relative to other packaged food companies and is in part due to lower private label penetration in the category (~2%).

Source: UBS

Fundamentals

HSY is +58% in the last 1.5 years compared to packaged food +14% and staples +23%.  The stock has re-rated on announced pricing initiatives, consistent execution post a challenging FY18 and a defensive bid (e.g. US exposure, strong balance sheet, better business visibility than peers).  Much of this has been now discounted in the valuation.

The second and most recent pricing announcement was this past summer.  See below from 2Q conference call. Cons is now modeling FY20 pricing at +2% so there is less upside risk outside of further price announcements.  The CEO also discussed +2% pricing for FY20 on the 3Q call.

“As we have previously discussed, price realization is a strategic focus area for us. The price increase we announced last summer remains on track and the final portion is implementing now as we execute our Halloween program.  Additionally, last week, we announced a new price increase on our confection instant consumables business. These

products represent roughly one-third of our overall sales, and they were priced high single digits contributing to an estimated 2 points of pricing to our overall portfolio.” -2Q conference call

In addition, consensus is modeling FY20 on algorithm with sales +3% y/y and EPS +7% y/y.  This is right in the middle of HSY’s long term financial algorithm. It’s also worth noting the below algorithm implies +1.5-3.5% organic revenue growth.  HSY has been trending well below this level since FY14 while M&A has been a larger driver.

Source: CAGNY presentation

HSY organic revenue growth has been sub-1% since FY14.  The company has also reduced ad spend as a % of sales by 150-200 bps in the last 5 years though it remains well above peer spend levels.

HSY consistently missed its gross margin guidance in FY18 due to inputs including freight/logistics.  The initial FY18 guide was for flat gross margin y/y while the actual was closer to -160 bps y/y. The shortfall was offset by reduced SG&A and marketing spend (advertising was -11% y/y or -$60 mm in the context of EBIT +$50 mm for the year).  The company has been more consistent in FY19 and consensus estimates have been revised higher over the year (for FY19 and FY20). This is unique among food companies where earnings estimates have generally been revised lower. Cocoa, estimated at ~1/3rd of COGS, has been a significant tailwind to gross margin in FY19 and not likely to repeat.  The company does not provide perfect clarity on its hedging/pricing strategy but has noted favorable cocoa pricing from late 2016 and 2017 has helped FY19 due to 12-24 month contracts.

“Hedging gives us some visibility. I think probably the biggest takeaway across that group is that as we talked about in the prepared remarks, we've got a tailwind this year on cocoa. But if you look at cocoa prices today versus the last 12 to 24 months, they are higher. And so at a minimum, we're not likely to have a tailwind in 2020 that we've been able to enjoy this year on cocoa.” - 3Q conference call

In summary, favorable pricing and a helpful input/commodity dynamic has helped HSY’s performance in 2019 and its valuation re-rating.  Going forward, the favorable pricing is reflected in consensus estimates and the gross margin comparison will be more challenging (+100 bps in FY19 after -160 bps in FY18).  In addition, the company will face a shorter Easter period in FY20 (April 12 in 2020 compared to April 21 in 2019).

Valuation

HSY is almost trading at 24x 2020 EPS.  The company’s 10 yr average is 20x EPS. Peak skepticism was mid-2018 at <18x EPS.

The company is trading at almost 17x EBITDA.

Risks

HSY is still better positioned than peers and can continue to benefit from its defensive characteristics (pricing visibility, balance sheet, US mix, etc.).  HSY is an attractive asset and there is some M&A risk through likely lower at this valuation/size. There was speculation in mid-2016 with MDLZ but the stock was trading at $100 then (https://www.reuters.com/article/us-hershey-m-a-mondelez-intl/hershey-rejects-23-billion-mondelez-takeover-offer-idUSKCN0ZG24O).  The timing of this call might be early as pricing should still be strong for the next 1-2 quarters.

Catalyst

Earnings, pricing/gross margin commentary.