Hershey Looks to Sweeten Edge With Judicious Investments in Its Brands and Manufacturing Network

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Consumers' penchant for confectionery and snacking fare has yet to fulfilled, as evidenced by the outsize organic sales growth Hershey has chalked up the past few quarters. But from our vantage point, 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 six 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 it lacks a competitive edge).

However, competitive and macro concerns abound, ranging from potential volume degradation as a byproduct of increased usage of weight-loss drugs to whether penny-pinching consumers could leave confectionery fare on the shelf in favor of more essential, daily products. Further, cocoa, sugar, and labor costs remain elevated (with management calling for high-single-digit cost increases this year) and could dent profits. Despite these looming headwinds, we surmise Hershey is playing from a position of strength, given its dominant standing (controlling around 45% of the U.S. 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 around 20% in the third quarter; 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 set to approximate 7%-8% of sales, outpacing the less than 5% average that has historically characterized the business), which we see as prudent. And with these investments 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. With its dominant share at home, leading brands, and sufficient resources, we believe Hershey is 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. As such, we expect the firm’s returns on invested capital to remain above its cost of capital over the next 20 years.

Hershey’s dominant position in the U.S. confectionery industry is illustrated by the fact that it holds about 45% share of the chocolate aisle compared with about 30% for its closest competitor, Mars/Wrigley, and just a low-single-digit share for private label (as cited by the firm, according to IRI). Further, Hershey has continued to build on its market-leading position, gaining a few hundred basis points of share since 2011 (which includes around a 100-basis-point boost to its chocolate share since 2020). Its outsize share extends across the U.S. confectionery space, where it controls approximately 31% of the category, up from 29% in 2011, versus Mars/Wrigley, whose share has eroded to 29% from more than 31% over the same period. We believe this shows that although Hershey’s niche is a category characterized by indulgent offerings, the firm remains a trusted brand with consumers, who are reluctant to sacrifice taste with an unproven supplier, and ultimately retailers. When combined with the resources Hershey invests behind its brands (allocating 6%-7% of sales toward research, development, and marketing on average over the past five years, or around $550 million annually) to drive customer traffic into outlets, we believe the firm's retailer relationships are stickier than those of its smaller, less-established rivals.

We contend that retailers prefer to stock brands that will drive traffic into their outlets and may be less inclined to expend shelf space on unproven suppliers that likely lack the resources to satisfy supply chain needs. As such, we believe the firm’s portfolio mix shift toward more on-trend categories, like healthy snacks following the acquisitions of Amplify and Pirate Brands, has been prudent, given these offerings align with consumer preferences for healthy and convenient fare. Prior to the pandemic, consumers were increasingly shopping the perimeter of the store at the expense of center-of-store categories, but we've been encouraged that Hershey has been working with its retail partners to ensure its products are in front of consumers where they are shopping, stocking its wares underneath checkouts, between self-checkouts, and at curbside pickups, which we view positively in light of the intensely competitive environment in which it plays. We think these efforts align with our contention that Hershey is poised to maintain its solid competitive positioning at home.

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. 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 25% the past five years. We forecast that ROICs will average a similar level over the next 10 years, supporting our stance regarding the firm's wide economic moat.

Questions have surfaced as to whether retail relationships will hold the same clout online, particularly in snacking, where impulse purchases are common and small, niche startups are also vying 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 more timely 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.

Earnings data Q1 2024

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