Introduction
I own one company in the consumer staples sector. That company is PepsiCo (PEP), which, as most know, is the parent company of brands like Lay's, Doritos, and Pepsi.
As much as I love that investment, I'm somewhat breaking an investment rule by consistently adding to it, as it's not necessarily a business that makes our lives better.
Don't get me wrong, I love most of its products - maybe a bit too much.
And that's the problem. While PepsiCo has a defensive business model, it does not produce products that are essential to society. As tasty as its chips are, humanity could go without them. For some people, it would even be better.
However, the same applies to cigarettes, bungee jumping, fast cars, french fries, sports betting, and so many other things.
Or, as Cosmopolitan put it more than ten years ago:
It also applies to the Hershey Company (NYSE:HSY).
Founded in 1894, this chocolate/snack giant is still a total return star.
In addition to tasty but unhealthy snacks, it has produced a lot of gains for its shareholders.
Including dividends, since the year 2000, HSY has returned 1,350%. The S&P 500 has returned roughly 460% during this period, which isn't bad either!
However, over the past ten years, HSY has lagged the S&P 500 by roughly 70 points, which is mainly due to its most recent stock price decline, triggered by factors like consumer weakness, inflation, and a massive surge in cocoa prices.
The good news is that (some) declines come with opportunities.
- Hershey has strong pricing power thanks to established brands. This protects it against consumer weakness.
- The company has a terrific dividend growth track record and an attractive valuation thanks to recent weakness - this tremendously improves the risk/reward, even if inflation remains elevated.
- Despite the rebound in cocoa prices, the company is well protected.
Poor harvests in West Africa have led to deep cocoa shortages, sending prices soaring to nearly $12,000 per ton in recent weeks. In response, companies like Hershey have been raising prices on their products to deal with the fallout in the short term.
[...] Buck said Hershey has taken steps to ensure its cocoa supply and doesn’t expect volatility to affect its outlook for the year. - Bloomberg
My most recent article on Hershey was written on November 5, when I used the words ">14% Annual Return Potential" in the title.
Since then, HSY shares have returned 7%.
While it's below the S&P 500's impressive 21% return, it's a good start, supported by strong earnings and a great valuation.
So, let's dive into the details!
Resilience When It Matters Most
In the lengthy intro, I quoted Bloomberg, which made the case that Hershey is well-protected against the surge in cocoa prices.
- It benefits the company's pricing.
- HSY stuck to its full-year outlook.
A big driver of this is brand recognition. The company has a highly diversified portfolio of brands that have achieved a five-year CAGR of roughly 7%.
Two of these brands generated more than $2 billion in sales last year.
This helped the company in the first quarter, when its net sales grew by 8.9%, driven by base business growth of roughly 2% and an additional 7% from higher inventory levels in expectation of the company's ERP (enterprise resource planning) implementation.
ERP changes come with elevated risks, as Lamb Weston (LW) found out the hard way when issues with its system change caused its supply chain to break down - causing customers to go to competitors.
By increasing inventories, HSY is lowering operational risks.
It also needs to be said that the company's performance was 3-4 percentage points higher than it expected.
Even better, the company aims to quickly reduce inventory again and sticks to its full-year outlook of 2-3% net sales growth.
Speaking of sales growth, the company keeps proving that in addition to hiking prices, it's still seeing strong demand.
For example, in its North American Confectionary segment, which includes Reese's, it saw 10.4% net sales growth, including 6% higher prices and 4.5% higher volumes.
It truly helps that the chocolate business in North America has shown consistent growth, growing by 4% annually to become a $26 billion business last year.
Having a strong footprint in this market has turned into one of Hershey's biggest tailwinds.
The company also believes that innovation is a key driver of its success.
Please note that "innovation" in this segment isn't what you may be used to in other segments, like the invention of a new computer chip, advanced software, or a new high-powered aircraft engine.
When companies like Hershey's discuss innovation, it's mainly finding new products that go well with current consumer trends.
It may not be a high-tech innovation, but it certainly is an important innovation to keep brands attractive.
To be specific, the company launched Reese's Medals for the upcoming Olympics, new gummy brands, and new Dot's Pretzels flavors.
On top of that, the company is focused on further improving profitability.
In 1Q24, it reported an adjusted gross margin of 44.9%, which was higher than expected due to strong shipments. However, it was 170 basis points lower compared to 1Q23 due to higher commodity prices, which offset price realization and productivity gains.
The good news is that the company's AAA initiative is expected to deliver an incremental $100 million in savings this year, mainly coming from division and corporate expenses.
Savings by 2026 and beyond are expected to be roughly $300 million, most of it coming from the North American Confectionary segment and corporate.
So, what does this mean for shareholders?
Shareholder Value
When HSY wins, its shareholders win.
In the first quarter, the company paid $273 million in dividends, which is 31.8% more than it paid in 1Q23.
This includes a 14.9% dividend hike on February 8, 2024, and a 15.1% dividend hike on July 27, 2023!
Currently, HSY yields 2.8%, which comes with a sub-50% payout ratio and a five-year CAGR of 12.2%.
Hershey has hiked its dividend for 14 consecutive years and aims to maintain a 50% payout ratio.
It also helps that HSY has an A-rated balance sheet, which allows it to prioritize shareholders.
On a long-term basis, it aims to maintain a sub-2x leverage ratio, which is its third capital priority behind growing its dividend in line with earnings and disciplined capital spending.
All of this also bodes well for +10% annual returns.
Why?
That's because the company expects to maintain 6-8% annual adjusted EPS growth, supported by its product pipeline, pricing, commercial growth, and ongoing investments in new capabilities.
Knowing that a company's total return consists of capital gains and dividends, we get a likely path to 9-11% annual returns.
Assuming the company's P/E ratio remains unchanged, we are dealing with 6-8% annual EPS growth and a dividend yield close to 3%. That's how I arrive at a 9-11% annual return outlook.
However, the cherry on top is that HSY is trading below its normalized P/E ratio, which improves the longer-term risk/reward.
Using the FactSet data in the chart below, HSY is trading at a blended P/E ratio of 20.6x, which is below its two-decade normalized P/E ratio of 22.7x.
With regard to EPS growth, analysts expect 0% growth this year (in line with guidance), potentially followed by 4% and 6% growth in 2025 and 2026, respectively.
While this is below the company's long-term guidance, it makes sense, given the pressure on the consumer right now.
However, combining its valuation with subdued EPS growth, we still get an annual return outlook of 10%, which I expect to last if the company is able to maintain 6-8% annual EPS growth beyond 2026.
The only reason why I don't own HSY is my investment in PEP.
Given my concentrated 21-stock portfolio, I am not yet looking to add more similar stocks.
Takeaway
Investing in companies like PepsiCo and Hershey poses an interesting dilemma.
While they don't necessarily produce essentials, their strong brand recognition and pricing power make them (very) resilient, even in challenging economic times.
Hershey, the star of this article, has shown impressive returns, outperforming the S&P 500 for many years despite recent struggles due to cocoa price hikes and inflation.
With a solid dividend growth track record and a valuation that's become more attractive, Hershey offers a promising path for long-term investors, potentially offering 9-11% annual returns for many years to come.
Pros & Cons
Pros:
- Strong Brand Recognition: Hershey's well-known brands provide the company with consistent demand and pricing power.
- Impressive Dividend Growth: HSY has a decent dividend yield, elevated dividend growth, and a healthy payout ratio.
- Attractive Valuation: Trading below its normalized P/E ratio, the company has an attractive long-term risk/reward profile.
- Resilient Business Model: Despite economic pressures, Hershey maintains steady sales growth and profitability.
Cons:
- Non-Essential Products: While they are very popular, Hershey's products aren't essential (and largely unhealthy), which can be a downside in tougher economic climates.
- Commodity Price Volatility: Rising cocoa prices can impact margins despite Hershey's efforts to mitigate the effects.
- Moderate EPS Growth: Expected EPS growth is modest, especially in the near term, which could keep a lid on its stock price performance.
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