Wednesday, December 27, 2006

Hershey - This milk chocolate will melt in your hand

On December 27th, 2006, I have shorted Hershey (HSY) at $50.60 per share. This is the first stock that I have decided to short which is mainly driving by the following:

- Canada plant shutdown with a material product recall

- Lowered guidance twice in the last 6 months

- Poor financial trends with increasing debt position to buyback shares

- Lowering advertising budget from 4.0% in 2002 to an estimated 2.5% in 2006

- Future risk of goodwill/intangible impairments with any additional decreases in revenue

Company Background:
The Hershey Company engages in the manufacture, distribution and sale of confectionery, snack, refreshment, and grocery products in the United States and internationally. It principally offers confectionery and snack products in the form of bar goods, bagged items, and boxed items; refreshment products in the form of gum and mints; and grocery products in the form of baking ingredients, chocolate drink mixes, peanut butter, and beverages. The company sells its products primarily to wholesale distributors, chain grocery stores, mass merchandisers, chain drug stores, vending companies, wholesale clubs, convenience stores, and concessionaires through sales representatives, food brokers, and retail sales merchandisers. It also offers chocolate products in Brazil under the brand name 'HERSHEY'S'. The company was founded by Milton S. Hershey in 1894. The Hershey Company is based in Hershey, Pennsylvania.

5 Year Financial Trends
Nothing exciting when looking at the 5 year financial trends chart for HSY. The revenue line is growing at a rate of 3.7% from 2002-2006 and net income is growing at 7.4% within the same period. The recent guidance from the company is pegging top line growth at ~2.4%. Core business is declining partially offset by the new product lanches. Hershey has been experiencing some gross profit erosion due to product mix and raw materials increases. The management has been able to offset these expenses with reductions in the SG&A areas of the business, potentially cutting too much of the advertising expenses.

Stock performance
Investing $10,000 in HSY at the end of 2001 would be worth approximately $16,400 today (12.26.2006). This represents a 10.4% annual rate of return, 2.4x higher than the S&P 500 benchmark of 4.3%. The stock has captured the majority of the gains in 2003 and 2004, with marginal declines from 2005 through Dec 2006.

Value scorecard
My value scorecard highlights the balance sheet concerns that are supporting my short decision:

- Increasing debt position over the last 5 years from $880 Million or 64% of book value in 2002 to $2.3 Billion or 275% of book value as of Q3 2006. $190 Million or 15% of the $1.3 Billion in long-term debt is due in 2007.
- The current market cap of $11.7 Billion is approximately 12.6 multiple from the book value of $830.3 Million as of Q3 2006.
- The current ratio has been steadily decreasing over the last 5 years from 2.3x in 2002 to 1.0x in Q3 2006
- Goodwill and Intangibles assets account for 76% of the book value. If sales performance declines, there is a potential exposure of additional asset impairment charges.

Growth Potential
When deriving a price target for HSY, using a straigh P/E multiple calculation might not truly reflect some of the liquidity risks that are currently in the stock. HSY has been increasing debt to buyback shares to improve the reported EPS results. For my price target, I am using the dicsounted cash flow method resulting in an enterprise value of $9.5 Billion or $40.94 per share. Here are my assumptions:

- Revenue annual growth of 3.5% to $5.7 Billion in 2010 (consistent with management long-term rates and analyst consensus)
- Free Cash Flow as a % to Revenue of 15%. HSY has averaged approximately 9.4% from 2002-2006.
- Weighted Average Cost of Capital of 10%
- Terminal Growth Rate of 4%
- Q3 2006 Net Debt of $2.2 Billion

Understanding that my price objective is based on a few assumptions, I have provided a two-way sensitivity analysis on FCF % to sales vs. terminal growth rate to provide some additional safety.

Disclosure: Author is short Hershey (HSY) stock

Company website
SEC online for 10-K and 10-Q reports
Yahoo Finance


www.BradReese.Com said...

Future asset impairment charges are right on the money.

Page 70

Mr. Lenny loaded-up Goodwill and Trademarks from the Mauna Loa and Grupo Lorena acquisitions.

Ditto for the Scharffen Berger and Joseph Schmidt acquisitions.

Page 72


Brad Reese

Bill Smithy said...

Thanks for shorting HSY. I will buy all I can from you at this price.

Anonymous said...

Your discount rate may be too low. Remember Candy companies are among the safest consumer companies along with tobacco margins. Please post your discount rate.

ETStockideas said...

the discount rate that I am using is 10%, which is reflective of HSY capital strucutre.

Scott Granowski said...

I like the frankness of your blog and want to share a couple of thoughts. While your short on HSY may ultimately work, your analysis of the "balance sheet concerns" appears to overlook a couple of factors. First, while debt has definitely increased, to measure as a % of book value may be misleading as the share count has declined significantly. This causes book value to be a less significant measure. I would recommend using some multiple of cash flows. (By using such a metric, debt levels have not risen significantly.) In the same light, the increasing ROC is probably overstated, creating an excessively positive outlook. Second, goodwill and intangibles growth (and impairments) are a necessary function of an acquisition strategy. As such, "asset impairment charges," in my experience, don't typically create investment opportunities. Thanks for your blog.

Burt said...

One thing to watch out for on HSY is the ownership. Control is currently in the hands of the Hershey charitable foundation. This group wants to diversify its holdings, but has not been able to. If the stock gets into real trouble, the foundation will undoubtebable consider offers. There will probably be many; HSY is worth much more to a large diversified PG or Nestly than it is alone. The street knows this story.

Do you use stops? If so, what is yours on HSY?

ETStockideas said...

Thanks Burt. I do use stops, specifically on short trades. My stop is at 10% loss, which results in a stop at $55.66 per share

Anonymous said...

I must remain a HSY long, so forgive me if I don't wish you well with your opposing position.

In spite of the fact that I am seeing Hershey as a good value play at precisely the same time you find it a short, I know without a doubt that you are a financial genious without peer.


Oh, how do I know of your genious? The Hershey ad, my friend! It's right on top of your summary in support of your position to short Hershey stock. Whenever I think I've seen it all...I will remember this.

Scott Granowski said...

As I read this morning's news, I thought about your short position. It appears that HSY has a developing set of problems which were not reflected in the price of the stock. Good work.