Financial news

Hershey Will Outlive COVID-19 (NYSE:HSY)

By  | 

Via SeekingAlpha.com

The financial fallout from COVID-19 continues to build, as layoffs mount and many businesses face liquidity issues. The ensuing market turmoil has presented buying opportunities in a few high quality names. Hershey (HSY) briefly dipped below $110 per share on March 23 after having reached $160 as recently as March 4, and I took the opportunity to add to my position in the company. Hershey shares have rebounded to $140, but it pays to be ready in the event that market volatility provides another buying opportunity.

Hershey chocolate barThere is a reason why Hershey has been around since 1894…

Built to Last

Hershey has survived pandemics, wars, and the Great Depression in its 126 year history. Consumers have continued to buy candy and chocolate in difficult times, as these treats represent an affordable indulgence. If money becomes tight, Hershey and other consumer packaged goods companies can always resort to smaller packaging sizes to make their product affordable, and their shelf-stable products are well suited for this stay-at-home environment. There will be demand for Hershey’s products even in the toughest of times, and they have shown the ability to grow through U.S. recessions (gray bars in revenue chart).

ChartData by YCharts

Hershey is also on strong financial footing to survive the current economic disruption. The company has just under $2.4B in financial obligations for 2020 and $2.1B in current assets, including $493MM in cash and cash equivalents. Hershey generated over $1.7B in operating cash flow in 2019, so it would take a prolonged disruption to their supply chain to cause any major issues in the coming year.

Hershey financial obligations for 2020 and beyondHershey Liabilities from 2019 10-K, page 32

Hershey also has a $1.5B revolving credit line that it can use if needed. The revolving credit line would almost be enough to cover Hershey’s obligations for all of 2021 and 2022. Perhaps the biggest risk to Hershey is the forced closure of one or more of their production facilities for several months, particularly for their licensed products.

Kit Kat, Rolo, and Cadbury are among the brands that Hershey has a license to sell in the United States. In order to maintain these licenses, Hershey must achieve a specified sales volume for the year. In a worst-case scenario, Hershey might fail to achieve sales targets if production facilities are shut down for a prolonged period due to COVID-19. It is difficult to say how likely this scenario would be without knowing what the required volumes are for each product and what force majeure clauses might be in the contracts, but investors should be aware of such risks.

A Cash Generating Machine

Hershey generated over $1.45B in free cash flow in 2019, converting an impressive 18% of revenue into free cash flow. Free cash flow has been a major focus of the company, having increased more than 60% in the last three years. Hershey has allocated cash to a variety of uses, with varying degrees of value.

READ ALSO  Used Car Prices Offer Brief Respite After Plunging Below Forecasts Last Month

ChartData by YCharts

Hershey has used part of its cash to repurchased shares, and has retired 8.5% of their outstanding shares since 2010. The shares have largely been purchased at reasonable prices, including at $106.30 per share from the Milton Hershey Trust.

ChartData by YCharts

The company has also rewarded shareholders with increasing dividends in recent years. Common shares currently receive $3.09 in dividends per year, yielding 2.2% at a share price of $140. Hershey dividend increases have historically come during their May payment and the company can comfortably afford to increase the payment this year with a payout ratio of 53%; however, they may be conservative with the increase given macroeconomic conditions.

ChartData by YCharts

Historical Cash Sink

One weakness in Hershey’s capital allocation has been their use of cash in acquisitions. Hershey paid approximately $492MM for Shanghai Golden Monkey in two transactions, starting in 2014. Hershey derives only 16% of revenues from outside the United States, so the motivation to expand internationally made sense. However, to call the purchase of Shanghai Golden Monkey a disaster would be generous. Hershey sold the business just four years after the purchase, and took impairment charges of $280.8MM in Q3 2015 and $106MM in Q1 2017. Hershey finally gave up on the venture in 2018, selling the business and the Tyrrells chip product line for $167MM. Tyrrells came to Hershey through their purchase of Amplify Snack Brands, which paid $391MM for Tyrrells’ parent company in 2016.

Hershey paid $235.5MM for KRAVE Pure Foods in 2015 to establish a position in the premium jerky category, but they have struggled to compete against larger rivals. In discussing the $100.1MM impairment charge Hershey took for KRAVE during 2019 Q4, CEO Michele Buck stated that the acquisition failed due to lack of scale and the low margin nature of the business.

Driving Growth

Hershey has had more success with acquisitions since Buck took over as CEO in 2017. The company acquired Pirate Booty brand from B&G Foods (BGS) and Amplify Snack Brands in 2018. Pirate’s Booty showed 1.4% growth in Q4, with 4% growth in December (Q4 earnings call). Amplify’s main product, Skinny Pop, grew retail sales by over 13% during Q4. Amplify sales are not broken out in financial releases, but Hershey expected the unit to add $380MM of sales in the last eleven months of 2018 after the deal closed. Skinny Pop is the sixth largest product for the company, so the acquisition has played a significant role in Hershey’s recent growth.

The 2019 purchase of ONE Brands for $397MM, $325MM net of tax benefits, represents the latest effort to expand into the healthier snack market. Hershey is starting to develop a legitimate nutrition bar portfolio with ONE Brands’ line of low sugar, high protein bars complementing the Oatmega protein bar brand that they obtained as part of the Amplify purchase. Hershey disclosed that the ONE Brands product line was realizing high double digit growth, including 35% growth through traditional sales channels (Q4 earnings call). Page 18 of the 2019 10-K states that they expect ONE Brands to generate $100MM in sales for the year. While paying 3.3x sales is a fairly steep price, it may pay off if Hershey is able to drive high double digit growth for a few years. Hershey expects that the deal will be “slightly accretive” to EPS in 2020.

READ ALSO  US may introduce new sanctions against Russia’s Nord Stream 2 as gas project approaches final stage

Hershey saw combined sales growth of 5.8% in Q4 for Mexico, Brazil, India, and China. This growth came despite spending 11% less on international advertising and marketing. Income from international markets has increased by $125MM over the last three years, and the company should have plenty of runway for further growth given the relative small size of the international operations.

Valuation

As noted above, Hershey repurchased class B shares from the Hershey Trust in 2018 for $106.30 per share. The trust’s board has a fiduciary responsibility to protect the trust, so it is reasonable to assume that they received a fair value for the shares. The class B shares can be converted to common stock at any time, but the trust would risk losing voting control of the company since class B shares hold 10 times the voting rights of the common stock. Common shareholders are compensated for their reduced voting rights by being entitled to 10% higher dividend payments.

Since the payout ratio is ~ 50%, we can apply a premium of 5% to the common shares to get a rough estimate of $111.62/share in value back in 2018. This likely underestimates the current value given the company has continued to grow in the 18 months since the last purchase of trust shares.

The company provided 2020 earnings per share guidance of $6.04 to $6.20 in their Q4 earnings release. Hershey stated during the Q4 conference call, that they expect to spend between $475MM and $525MM on capital expenses in 2020, although it wouldn’t be surprising if this is revised downward sometime during the year if revenues are significantly impacted by the fallout from COVID-19.

Using a CAPM formula and assuming a 7% market return, Hershey’s current working average cost of capital is only 2%. This is driven in part by the minuscule 0.62% yield on 10-year bonds as of this writing; Hershey’s 3.3% average interest rate on debt and low beta (0.2) also play a major factor in the low cost of capital. Given these unprecedented interest rate conditions, a variety of scenarios need to be contemplated in order to generate a range for the intrinsic share value.

READ ALSO  Google postpones Android 11 unveiling amid U.S. protests

In scenario 1, free cash flow declines by 2% per year before eventually returning to GDP-level growth, while the cost of capital rises to 7%. By no means a worst-case scenario, these numbers seem plausible in the event of a prolonged recession.

In scenario 2, free cash flow is flat for several years before returning to GDP-level growth with the cost of capital rising to 5%.

In scenario 3, free cash flow continues to grow at GDP levels indefinitely while the cost of capital rises to 4%. In this case, Hershey is able to continue to grow despite economic headwinds and the cost of capital remains relatively low.

FCF

Growth Rate

years 0 to 5

FCF

Growth Rate

years 5 to 10

FCF

Growth Rate

years 10 to 15

FCF

Growth Rate

years 15 to 20

FCF

Growth Rate

years +20

WACC

Intrinsic Value

Discounted FCF model

Scenario 1 -2% 0% 2% 2% 2% 7% $97
Scenario 2 0% 2% 2% 2% 2% 5% $178
Scenario 3 2% 2% 2% 2% 2% 4% $261

We can see that even this narrow range of scenarios generates a fairly wide range of outcomes for shareholders. I believe that the COVID-19 crisis has the potential to drag on for a year or more and will have far reaching consequences for the U.S. economy, including unemployment and bankruptcies. Given this belief, I think Hershey will experience something in between Scenarios 1 and 2, with the current share price almost exactly in the middle of the valuations for those two scenarios. Hershey will likely survive regardless, but I would like a larger margin of safety when purchasing additional shares and will wait for an opportunity to buy shares at or below the recent low of $110.

Conclusions

Hershey is a great company that is built to survive in a variety of economic environments. Consumers have historically been willing to spend money on small indulgences, even in trying economic times. Shares were recently trading at a fair value and I will likely purchase additional shares if the price falls below $110 again, which may happen given the recent market volatility.

Disclosure: I am/we are long HSY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to promote thought and discussion, and should not be considered investment advice. Please carry out your own research and take your own situation into consideration before considering an investment in the company.




Print Friendly, PDF & Email

Latest from finanz.dk