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Dismal Outlook For Hershey May Prompt Buyout

Posted: Jan 25, 2008 12:49 PM by Eugene Bukoveczky

Tickers in this Article: DB, CBY, WWY, HSY

Will relief ever arrive for the shareholders of legendary confectioner The Hershey Company (NYSE:HSY)? Since last April, the stock has moved in a steady, unbroken downtrend, losing more than one-third of its value along the way. Hardly the sort of thing that happens to supposedly safe, steady consumer staples stocks.

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Recent Earning Results Shock Investors
Judging by the latest earnings results, there's no reason to expect any sort of near-term recovery in the share price. Profit for the quarter ending December 31 was a paltry $54.3 million (24 cents per share), compared with $153.6 million (65 cents per share) one year earlier. That represents a year-over-year drop of 63%. Management now expects to report EPS of between $1.85 and $1.90, excluding one time charges, for 2008. Prior to the announcement, the consensus estimate for 2008 EPS was $2.11.

So, what's been the issue for Hershey?

Competition to Satisfy America's Sweet Tooth Heating Up
For starters, the chocolate business has gotten a lot more competitive as of late. Known for its straight up, tell it like it is opinions, bond rating agency Moody's (NYSE:MCO) summed up the situation with a downgrade of the company's long term debt to 'A2' from 'A1' and the assignment of a negative outlook.

According to Moody's, Hershey's brands, which include Reese's, Hershey's Kisses and KitKat, have been losing market share to other chocolate brands sold by larger more diversified competitors like William Wrigley (NYSE:WWY) and Mars, a division of the large Swiss food group Nestle. The loss of share has been particularly bad in the key convenience store channel. (For more on the importance of corporate debt ratings, check out Debt Reckoning.)

Lack of product innovation and sub-par marketing expenditures are seen as the main culprits behind the loss in market share. Hershey has also been slow to respond to the rapid growth in premium chocolate brands.

Shrinking Margins
At the same time, Hershey, along with the rest of the confectionery industry, is facing unprecedented increases in the cost of key inputs. As laid out in a recent report published by the brokerage division of Deutsche Bank (NYSE:DB), nonfat dry milk prices during the fourth quarter of 2007 were 93% higher than the same period a year earlier, and cocoa prices surged in December to $2,400 per metric ton, well above the long term average price of $1,600. Peanut prices were also up 23% on a year-over-year basis, and energy cost went up 51% on the same basis.

Board Shakeup May Not Be Enough
These factors suggests that fixing Hershey's business is going to require something more radical than the board shakeup which was engineered by the Hershey Trust last November. The Trust controls 78% of the voting rights to Hershey. A Wall Street Journal article published at the time hinted at the efficiencies the trust could see in a possible merger between Hershey and Cadbury Schweppes (NYSE:CSG).

The Bottom Line
With two of the world's biggest chocolate companies seriously underperforming and in need of a corporate makeover, the odds that they come to some sort of arrangement are pretty good in my estimation. I think the Wall Street Journal definitely picked up the scent last year regarding a possible deal. The rest is just a matter of timing and price. Based on its lackluster fundamentals, Deutsche's valuation is $38 for Hershey. If the company goes into play, I suspect we could see a deal premium above that level.

To learn more, see The Merger - What To Do When Companies Converge.

By Eugene Bukoveczky

Eugene Bukoveczky is a freelance writer and investment researcher. He holds a CFA designation and has spent several decades working in the investment business in places like Toronto, New York, London and Dubai. He currently resides in Nova Scotia, where, when not writing, he devotes his time to chopping wood, growing his own vegetables, riding his bike to the store, and thinking about other ways to reduce his carbon footprint.

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