Rampant Cocoa Cost Inflation Unlikely to Dull Wide-Moat Hershey's Financial Prospects or Edge

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Consumers' hunger for confectionery and snacking fare has yet to be fulfilled, as evidenced by Hershey's outsize organic sales growth the past few years. But from where we sit, this isn't merely a byproduct of a favorable demand environment. Rather, we applaud the strategic focus CEO Michele Buck has brought to bear over the past seven years--ramping up investments in its core domestic brands while pulling back in its international arm (high-single-digit percentage of total sales, where we surmise its competitive position lags its global peers).

However, competitive and macro concerns abound, ranging from potential volume degradation stemming from increased usage of weight-loss drugs to whether penny-pinching consumers could leave confectionery offerings on the shelf in favor of more essential, daily products. Further, cocoa (which is up more than threefold this year), sugar, and labor costs remain elevated (with management calling for high-single-digit cost increases this year) and could dent profits. Despite this, we surmise Hershey is playing from a position of strength, given its dominant standing (controlling more than one-third of the US chocolate space, versus just low-single-digit marks for lower-priced private-label offerings) combined with the robust resources it maintains to ensure its lineup continues to evolve with consumer trends.

In this context, we’re encouraged that Hershey is firm in its commitment to funnel resources toward its brands, with advertising spending up at a double-digit clip over since Buck took the helm; we think Hershey will expend a high-single-digit percentage of sales (nearly $1 billion) toward research, development, and marketing annually over the next 10 years. And even though management has been forthright that its innovation pipeline was a bit scant in fiscal 2023, this coincided with stepped-up spending to build out its capabilities and capacity (with capital expenditures of about 7% of sales, outpacing the less than 5% average that has historically characterized the business), which we see as prudent. And with these investments largely in the rearview, we think Hershey intends to flavor its mix over the coming quarters.

Business Strategy & Outlook

In our view, Hershey's solid intangible assets and cost advantage warrant a wide economic moat rating, underpinned by its dominant market share position on its home turf, array of leading brands, and vast resources to invest to support its brand standing and expand and enhance its capacity. We believe these factors have resulted in Hershey being a critical partner for retailers that are reluctant to risk out-of-stocks with unproven suppliers, supporting the intangible asset source of its wide moat. When taken together, we expect the firm’s returns on invested capital to remain comfortably above its cost of capital over the next 20 years.

Hershey’s dominant position in the US confectionery industry is illustrated by the fact that it holds about 36% share of the chocolate aisle, which outpaces the 31% share held by its closest competitor, Mars/Wrigley, and just a low-single-digit share for private label (according to Euromonitor). Further, Hershey has continued to build on its market-leading position, gaining more than 300 basis points of share since 2014 (which includes around a 100-basis-point boost to its chocolate share since 2020). These share gains have been driven by its namesake, which now controls nearly 13% share of the US chocolate market, up from less than 12% in 2014, as well as the number one US chocolate brand, Reese’s, which now holds more than 17% of the market, up from 12% in 2014. We believe this shows that consumers aren’t willing to sacrifice taste, and thus prefer to stick with trusted brands, particularly when they are looking to indulge.

In addition, we maintain that retailers would rather stock leading brands that are able to aid in their efforts to drive traffic into their outlets, versus unproven suppliers that likely lack the resources to satisfy supply chain needs. As such, we believe the firm’s portfolio mix shift to include more on-trend categories, like wholesome snacks following the acquisitions of Amplify (Skinny Pop), Pirate Brands, and Dot’s, has been prudent, given these offerings align with consumer preferences for healthy and convenient fare. We surmise Hershey’s brand prowess, retail relationships, and vast resources have been a catalyst for the market share gains these acquired brands have been able to chalk up. In that context, Skinny Pop now controls more than 27% of the US popcorn aisle, versus just 11% in 2017, when it was a standalone business. Further, Dot’s has grown to become the second-leading player in the US pretzel category with more than 11% share, which is up from just 1% in 2018 and less than 6% in 2020. 

Beyond the stout retail relationships that have afforded opportunities for expansion from a distribution perspective, we also think Hershey’s ability to hold and grow its share is a byproduct of the extensive resources it directs to support its brands, with around 6%-7% of sales being funneled annually to research, development, and marketing on average over the past five years, or about $575 million. This not only helps bring excitement to the aisles in which it plays, but also serves to keep its brands and products top of mind for consumers that have an array of alternatives to meet their snacking needs.

We also contend that Hershey maintains a cost edge, which should ensure it can fund investments to support its leading brand mix and retail relationships to a greater extent than new entrants with limited budgets, ultimately leading to a barrier to entry. This scale manifests in production and distribution advantages across its expansive network. We believe this creates a virtuous cycle, starting with scale that affords manufacturers a mutually beneficial relationship with retailers, through which the vendor becomes an important retail partner rather than a mere supplier by developing sales strategies to maximize volumes and retailers’ margins, while also prioritizing its own brands. With a broad domestic manufacturing and distribution network, we think Hershey operates with lower unit and distribution costs, as well as greater supply chain efficiency and an enhanced ability to leverage brand spending, than smaller peers. Further, we think that as a result of these cost advantages, Hershey can replicate competitive products and ultimately offer it to retailers at a lower cost than its smaller peers. This stands to limit the potential shelf space (and scale) new entrants can amass. 

Despite disparate disclosures, we’ve attempted to home in on direct operating costs (manufacturing and distribution), while removing discretionary operating costs such as advertising and research and development, noncash costs including depreciation and amortization, and nonrecurring expenses to gauge the firms best positioned to overcome customer acquisition costs. In this context, we find that Hershey touts above industry average direct operating margins (32% versus 25%) relative to the rest of our packaged food coverage universe. As further evidence of the strength of its competitive position, returns on invested capital, including goodwill, have consistently exceeded our 7% weighted average cost of capital estimate by 3-4 times, averaging 24% the past five years. We forecast that ROICs will average a similar level (25%) over the next 10 years, supporting our stance regarding the firm's wide economic moat. 

Although much consternation continues to swirl around the impact of anti-obesity drugs on the demand for the indulgent snacking and confectionery fare within Hershey’s product suite, we see the effect as muted. More concretely, we think the high out-of-pocket price tag and unfavorable side effects could limit the uptake of the drugs over a longer time horizon. Further, we surmise Hershey’s vast resources and plethora of data and analytics should enable it to tweak its portfolio to adeptly align its mix with evolving consumer trends, rendering any volume hit minimal.

Questions also surround whether retail relationships will hold the same clout online, particularly in snacking, where impulse purchases are common and small, niche startups intensely vie for share. In this context, we surmise Hershey has been working with its retail partners to tether its online and offline strategies, an essential undertaking, given that three fourths of the time consumers dedicate to a search online is spent on retailer websites. And we believe that the firm understands the necessity of investing to build out this area of its business. For one, the firm's innovation efforts have included updated packaging to appeal to online shoppers, with a focus on ensuring product and quantity are clearly visible on website images of the item. Further, Hershey sells full-size bar variety packs to appeal to the impulse purchaser and indulger online. Importantly, it is bringing these innovations to market in a timelier fashion, with some of its recent endeavors taking just 12 weeks to move from concept to shelf. These efforts have bolstered average selling prices online, which approximate 1-4 times the level Hershey derives across its portfolio in brick-and-mortar outlets. But management stressed that it isn’t abandoning efforts to help retailers drive traffic in physical stores, which we view as prudent in light of our expectations that an omnichannel approach stands to best cater to consumers’ evolving needs.

Wide

Economic Moat

Hershey

The Hershey Co. engages in the manufacture and marketing of chocolate, sweets, mints and confectionery products. The firm operates through the following geographical segments: North America and International and Other. The North America is responsible for the traditional chocolate and non-chocolate confectionery market position of the company, as well as its grocery and snacks market positions, in the United States and Canada. The International and Other segment includes the combination of all other operating segments, including those geographic regions where the company operates outside of North America. Its brands include Hershey's, Reese's, and Kisses. The company was founded by Milton S. Hershey in 1894 and is headquartered in Hershey, PA.

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Hershey reports strong Q4 earnings, eyes growth through strategic investments

Hershey's strong performance in Q4 2022 sets a positive tone for 2023, with a focus on growth and margin improvement.
Strategic investments in marketing, capacity, and talent aim to drive market share gains and sustained growth.
Challenges such as inflationary pressures and margin variability require careful management and strategic planning.
Opportunities for growth through new product launches, core brand focus, and distribution optimization are key focus areas.

Hershey reports strong Q1 performance with international growth and margin expansion

Hershey's Q1 performance reflects strong international growth and gross margin expansion driven by pricing strategies and operational efficiencies.
The company faces challenges in navigating tough comparisons and supply chain dynamics but is strategically positioned for sustained growth.
Opportunities lie in international expansion, distribution optimization, and margin accretion strategies to capitalize on market trends and drive profitability.
Overall, Hershey's performance showcases resilience and strategic foresight in addressing market challenges and leveraging growth opportunities for long-term success.

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Hershey navigates competitive confectionery markets with a focus on managing costs, driving revenue strategies, and addressing challenges in Salty Snacks. The company anticipates a strong Halloween season and aims for profitable growth despite competitive pressures.

Hershey anticipates growth in 2024 despite inflation challenges

Hershey's 2024 outlook is positive with anticipated strengths in capacity growth, new products, and distribution. Inflation and retailer dynamics present challenges, but pricing and productivity measures are in place. The focus on consumer value and innovation positions Hershey well for growth opportunities.

Hershey anticipates growth amidst inflation challenges and market adaptations

Hershey's 2024 performance is driven by pricing actions to manage inflation, with net sales growth and gross margin expectations outlined for the year.
Challenges include elevated commodity costs and the popcorn category slump, countered by cost-saving initiatives and strategic marketing efforts.
Opportunities lie in distribution expansion, capacity investments, and adaptive pricing strategies to navigate market dynamics and drive growth.

Hershey reports solid Q1 performance, eyes growth amidst challenges

Hershey's Q1 performance met expectations with strong market share gains and innovative products. Despite challenges like cocoa volatility and inflation, the company is well-positioned for growth through strategic partnerships and cost-saving initiatives.

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