Theater-Flügels von Hershey — Terryfic3D/iStock Unreleased via Getty Images

Introduction

The stock of The Hershey Company (NYSE:HSY), one of the largest chocolate makers in the world, has significantly underperformed the broader market in 2023 and 2024. While it’s hard to overlook the fact that investors were overly optimistic about the company’s pricing power and growth prospects in 2022 and early 2023, HSY shares were trading for as much as $263, or a P/E ratio of 27 – things are very different today.

With historic cocoa price inflation, the emergence of weight-loss drugs potentially hurting demand, and inflation-ridden consumers, Hershey investors have taken an increasingly conservative stance. Since October 2023, Hershey shares trade in a range of $180 to $210, or a forward P/E of approximately 20. In my view, the market is underestimating the fact that Hershey is less affected by the rise in cocoa prices than some of its competitors, largely due to the comparatively low cocoa content in many of its products. It is quite possible that Hershey’s position and scale will enable it to emerge from this phase stronger than its competitors and further consolidate its leading position.

Of course, a P/E of 20 (Table 1) is by no means a bargain valuation, but given Hershey’s undoubtedly strong brand equity and conservative management, I think some premium is warranted. Having studied Hershey’s fundamentals, let me therefore share the three (and a half) reasons why I added HSY stock to my diversified and income-oriented stock portfolio.

The Hershey Company (<a src= — Table 1: The Hershey Company (HSY): Valuation metrics (Seeking Alpha)

Reason 1: Strong Profitability And Meaningful Investments In Future Growth

A high and low fluctuating gross margin is one of the most important characteristics of a well-positioned company. With a long-term average gross margin of 44.8% (Figure 1, blue), Hershey has plenty of room for advertising, administrative and interest-related expenses as well as – of course – shareholder returns.

Advertising spend has declined somewhat over the years, from 7.0% of net sales in 2016 to 5.4% in 2023, but what could be interpreted as underinvestment in the business to prioritize near-term operating margin improvement (Figure 1, red) should instead be viewed as appropriate advertising spend against a backdrop of the above-average inflation- but also demand-driven sales growth (Figure 2). Also, the operating margin improvement of more than 670 basis points in just eight years sounds spectacular, but keep in mind that the 2016-2017 period was a significant negative outlier and Hershey’s typical operating margin is around 20%. In any case, an increase by 2 to 3 percentage points compared to the long-term average is quite solid, especially against the backdrop of high inflation in 2022 and 2023, where many companies had to (temporarily) absorb a significant part of the increased input costs.

However, in contrast to the continuous operating margin expansion, Hershey’s adjusted free cash flow margin (FCF) has contracted in recent years after peaking at a very solid 18% in 2019 (Figure 1, gray). As always, I have adjusted FCF for working capital movements (three-year rolling average) and considered stock-based compensation as a cash expense. In the case of Hershey, I also took into account the recurring equity investments in tax credit qualifying partnerships (average of 7% of operating cash flow, OCF). The tax credits reduce Hershey’s tax expense, which is inherently included in OCF, and therefore I did not deduct the related write-down (see Note 10 on p. 80 of HSY’s 2023 10-K for more information).

In my view, the decline in free cash flow margin is not really a concern. Looking at the blue bars in Figure 3, which represent Hershey’s free cash flow before working capital adjustments, one can see that the unadjusted free cash flow margin would have been slightly lower in earlier years, resulting in a more favorable margin-related comparison. The current weak FCF margin is largely due to higher working capital accounts (inventories at 12% of net sales and ongoing increase in receivables), so I think it is reasonable to expect Hershey to see favorable cash flow-related effects in 2024 and thus a recovery in FCF margin.

I think it would be wrong to interpret this as a sign of poor working capital management. Quite the contrary, Hershey’s days payables outstanding ratio has been steadily increasing, reaching 60 days in 2023, while the days sales outstanding ratio has improved from 29 days to around 25 days in recent years. Admittedly, and probably as a result of the ongoing acquisitions, the inventory days ratio has had a negative impact on working capital efficiency (an increase from around 65 to 75 days since 2016), but overall working capital management is very solid and trends in the right direction, as evidenced by the decrease in the cash conversion cycle from 50 to 40 days over the last eight years.

The stepped-up investment in the business – which is of course welcome – is one reason why I expect free cash flow profitability to improve only gradually. While Hershey only invested around 3.5% of its net sales in the business in 2016 and 2017, relative capital expenditure exceeded 5% in 2020 and reached 6.9% in 2023 (adjusting for inflation, relative investments are even higher). For 2024, management is planning investments of $600 to $650 million, i.e. around 5.5% of expected net sales, which suggests a moderate positive effect on FCF. Another driver for the expected improved FCF profitability is Hershey’s “Advancing Agility & Automation Initiative”, which management expects to have a positive impact of $100 million in 2024.

The currently comparatively weak free cash flow is also the reason for the decline in the cash return on invested capital (CROIC, red bars in Figure 4). However, a CROIC of 14% is still well above any reasonable expectation for the cost of equity (the CAPM-derived cost of equity is currently 5.9%), which is very positive indeed. Furthermore, the current above-average investments should be seen as growth investments rather than maintenance investments, which is also reflected in the difference between ROIC (based on net operating income after tax, blue bars in Figure 4) and CROIC. In my view, a return to a CROIC in the high teens is a reasonable expectation and underlines Hershey’s continued strong shareholder value creation.

All in all, I consider the combination of a gross margin of almost 50%, a normalized CROIC in the high teens and solid working capital management to be a strong indication of a capable and long-term thinking management, prioritizing value creation and shareholder returns.

Reason 2: A Conservatively Managed Balance Sheet With Optionality

Hershey’s net debt increased from $2.7 billion at the end of 2016 to $4.4 billion at the end of 2023, mainly due to acquisitions. However, HSY’s leverage ratio, as measured by net debt to adjusted free cash flow, remained relatively flat during this period and at approximately 3x remains very manageable (Figure 5).

Knowing that adjusted FCF has not really grown in recent years, I see the continued reasonable leverage as a sign of financial prudence. This is by no means a given, considering how tempting it has been to increase leverage to buy back shares during the past low interest rate environment. Buying back shares naturally contributes to earnings per share (EPS) growth, but if funded with debt the positive effect is eventually negated by higher interest expenses, which, in the worst case, jeopardizes financial stability.

Share buybacks are regularly conducted at Hershey, but I would argue that they are carried out in a very disciplined manner. The number of fully diluted shares outstanding has declined by 10 million, or about 4.8%, since 2016. Put another way, share buybacks only contributed about 67 basis points to EPS growth on an annualized basis (11.7% p.a. since 2016, including buybacks).

Hershey’s interest expenses have naturally risen due to the increase in debt over the years and the rise in interest rates since the beginning of 2022. For 2024, management expects net interest expense to be in the range of $165-175 million, approximately 12% higher than in 2023, when the company paid 10% more than it did in 2022. This is certainly a significant increase, but interest expenses should be viewed in the appropriate context. An interest coverage ratio of approximately ten times free cash flow before interest is very solid, especially for a company with reliable and largely recession-resistant cash flows.

To some extent, the increase in interest expense is due to adjusting short-term borrowings (light blue bar in Figure 6), which by their nature (bank loans and commercial paper) and due to the inverted yield curve are more expensive than fixed-rate long-term debt. I expect Hershey to repay the $300 million 2.050% notes maturing in November. It is quite possible that the company will also redeem the very cheap 0.900% notes ($300 million, maturing on June 1, 2025) and instead refinance the – comparatively expensive but still cheap – $300 million 3.200% notes maturing next August.

In my view, Hershey’s treasury department is doing an excellent job of managing debt maturities (Figure 6), and I do not expect the weighted-average interest rate to increase materially even if interest rates remain at current levels for the foreseeable future. With post-dividend free cash flow of $500 million to $700 million per year – implying a payout ratio of 50% to 60% in terms of FCF – Hershey theoretically has plenty of room to pay down debt if it chooses to do so. However, with a leverage ratio of well below four times free cash flow and a long-term credit rating of A1 with stable outlook, I would argue that there is no need to deleverage.

Reason 3: Dividend Safety Reinforced By Hershey Trust Company Ownership

As mentioned above, Hershey’s dividend payout ratio is a healthy 50-60% of adjusted free cash flow. Combined with the company’s solid long-term growth, there’s plenty of room to raise the dividend. Granted, Hershey did not increase its dividend during the Great Recession, but the dividend increases since then (Figure 7) have more than made up for three years of dividend stagnation, which I personally view as a sign of financial prudence in a very difficult economic environment. Hershey will pay its 377th consecutive dividend on its common stock on June 14. So, so assuming a quarterly frequency since inception, it now has an unbroken streak of 94 years.

I believe the combination of a starting dividend yield of 2.8% and a five-year average growth rate of 10% (which is in line with the long-term average) is a compelling opportunity for long-term and income-oriented investors looking to protect (or grow) the purchasing power of their income. The “secret” to why I believe Hershey’s dividend is not only very safe, but will continue to grow at a respectable pace, lies in the company’s capital structure.

Hershey has two classes of stock, common and Class B shares. The latter have 10 votes per share, while the former have one vote per share and are entitled to elect one-sixth of Hershey’s board (p. 38, HSY 2023 10-K). Conversely, common shareholders receive a 10% higher dividend than Class B shareholders – for example, $4.456 versus $4.050 in 2023 on an annualized basis.

Unlike the common stock, the Class B shares are not publicly traded and through them, the Hershey Trust Company (HTC) retains voting control over Hershey. HTC, which was founded by Milton Hershey in 1905, is the trustee of the Milton Hershey School Trust, among others, and its purpose is to “house and educate an indefinite class of poor children” with a perpetual time horizon. In my view, HTC is thus very well aligned with long-term shareholders in general and income-oriented investors in particular.

I consider an investment in Hershey to be adequately hedged to preserve (and grow) the purchasing power of the income generated – not only because of its capital structure, but also because of its market-leading position, focus on “everyday treats” (where price/inflation play less of a role) and solid growth prospects.

Reason 3.5: International Expansion – A Lot Of Potential But With A Question Mark

Hershey’s market share in the U.S. is likely to be well over 30% (figures from statista for 2021 can be found here). Considering that Mars Inc. (private) controls around a quarter of the market and Chocoladefabriken Lindt & Sprüngli AG (OTCPK:LDSVF, OTCPK:COCXF, OTCPK:CHLSY) and Ferrero International S.A. (private) each control around 8%, it can be argued that the U.S. market is already highly consolidated. At the same time, Hershey’s leading share is a clear indication of the company’s scale and therefore its potential for growth through increased profitability.

The U.S. chocolate market is expected to grow at a compound annual growth rate of 5.2% in the coming years, and I would argue that it will not be difficult for Hershey to fully participate in this growth. However, it should be borne in mind that a large part of this growth is probably due to expected inflation, so it will not necessarily fully translate to bottom-line growth. In this context, I believe Hershey’s stepped-up investments and cost savings program are the right measures to ensure continued solid earnings growth, in part by taking market share.

Hershey remains focused on North America (Figure 8), where it generates more than 90% of its sales and income, thereby indicating significant potential for international expansion. However, considering that both the North America Salty Snacks business and the International business are still less than half as profitable as the North America Confectionery business (approximately 15% vs. 30% operating margin), I would argue that there is also ample room for growth through margin expansion in these segments.

Hershey’s international expansion holds considerable potential, but naturally comes with a big question mark. Mars Inc. likely has generated sales of $22 billion from confectionery in 2023. Taking into account the market shares mentioned above, the company probably generates around a third of its sales from confectionery in the U.S. There’s no doubt that Mars – which has been in the candy business since 1920 – has done a phenomenal job of expanding internationally. But of course, that doesn’t mean it’s impossible for Hershey to succeed internationally as well. It won’t be easy, however, especially considering that many of Hershey’s brands are known for their distinctive flavors, which are difficult to establish in the European market and probably in Asia as well. Reformulating the flavor of the iconic Hershey’s chocolate to appeal overseas consumers would be a big mistake in my eyes. However, with the company’s increasingly diversified brand portfolio and also certain distribution agreements, I think there is still a lot of potential without jeopardizing the reputation of the core brand. That being said, with a slow and steady rollout and skillful marketing, I wouldn’t rule out international success for Hershey’s chocolate in Europe and Asia.

Summary And Conclusion – Why HSY Stock Is A Buy Now

In stark contrast to about a year ago – when HSY shares were hitting new all-time highs and trading at a P/E in the high twenties – investors seem far less optimistic about the chocolate market leader in the U.S. today. As a result of fears of weight-loss drugs impacting consumption, cocoa price inflation and consumers turning to discount brands in the face of structurally elevated inflation, HSY shares are trading at a valuation that warrants a starter position, in my view.

Of course, at $195, my discounted cash flow model for HSY stock still implies a perpetual growth rate of 3.6% at an expected cost of equity of 7.0% (Figure 9), which itself represents an equity risk premium of only 2.35% (over the 30-year Treasury). However, there are several reasons why I believe it is worth paying up for quality here.

Hershey’s is undoubtedly a well-run company operating in a rather recession-resistant sector, selling products that have the advantage of being low-cost everyday treats. That’s not to say that Hershey’s is cheap chocolate, of course – it’s the kind of everyday treats that even inflation-ridden consumers are unlikely to resist, much like a bag of Lay’s chips (PepsiCo, Inc., PEP) or a Coke (The Coca-Cola Company, KO), for example.

As a result, the company has strong pricing power, which is underlined by the excellent sales growth of recent years and the ongoing margin expansion. The focus on chocolate with a relatively low cocoa content also reduces the impact from the volatile and recently exploded cocoa price. Hershey’s free cash flow margin, and therefore cash return on invested capital, is currently negatively impacted by comparatively high working capital and increased investment in the business. However, the long-term trend in related metrics suggests sound working capital management and that free cash flow will eventually recover. I am also confident that Hershey’s current above-average investments will pay off. The company has a history of disciplined and sustainable growth without engaging in excessively large and therefore risky acquisitions.

Despite the currently stagnating free cash flow, Hershey’s leverage remains very manageable, and its interest coverage ratio continues to be solid (10x free cash flow before interest). The company’s treasury department is doing an excellent job of managing debt maturities and interest rate exposure (weighted-average interest rate of only 3.4%). If Hershey suspends share repurchases in the coming years, it could easily repay its debt as it comes due. Of course, this thought experiment should only serve as an illustration of management’s financial prudence and not point to the need to reduce debt.

Long-term oriented buy-and-hold investors with an emphasis on income-generating stocks will certainly appreciate the company’s capital structure. The Hershey Trust Company’s voting control protects the company from hostile takeovers and aligns management very well with the interests of the Milton Hershey School Trust and therefore long-term common shareholders.

Finally, I believe that Hershey’s international expansion could represent a solid growth opportunity well beyond what the already quite consolidated U.S. market has to offer, which is expected to grow in the mid-single digits in the coming years. At the same time, Hershey’s scale as a market leader in the domestic market offers the potential for continued margin expansion and thus solid earnings growth despite structurally higher inflation.

I recently bought a starter position in Hershey shares, which currently represents 0.25% of my portfolio value. I intend to add to this position slowly or more quickly depending on how HSY stock performs in the coming months and expect it to eventually make up 2% of my portfolio, making it one of my larger positions.

Thank you very much for reading my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there’s anything I should improve or expand on in future articles, drop me a line as well. As always, please consider this article only as a first step in your own due diligence.