Investment Thesis

Data supports that chocolate consumption has a “lipstick effect” during the recession. However, The Hershey Company (NYSE:HSY) was not immune to the decline during the last recession in ’08-’09. This time around, it seems Hershey is not only facing similar pressure but is in a more vulnerable position susceptible to the downside. The market price is too rich for the stock’s valuation.

Company Overview

The Hershey Company, incorporated in 1927 in Delaware, was a successor to a business founded in 1894 by Milton S. Hershey. It is a global confectionery leader of making chocolate, sweets, mints and other snacks. The company markets, sells and distributes products under more than 100 brand names in approximately 80 countries worldwide. Its reportable segments are North America Confectionery, North America Salty Snacks, and International.

Strength

Although Hershey has made efforts to diversify its revenue stream, such as its recent acquisition of Pretzels, its most important sales still came from its loyal customers in North America with a sweet tooth for confectionery. Essentially, it is still a chocolate company, as most of us think of it when we see its more than 100-year-old brand. As we can see from the chart below, North America Confectionery accounted for over 81% of its total net sales. Salty snack consumption in North America is growing fast but still made less than a 10% contribution in total. And we can see since the pandemic; its sales have had healthy growth in all segments.

There is a so-called “lipstick effect” that when facing the stress of economic challenges, consumers would still treat themselves to “affordable luxury” such as chocolate while cutting back on other consumption. Chocolate consumption is part of the affordable luxuries for average consumers. With the looming recession, we want to investigate how resilient the company might face challenges.

On top of its long-established brand and reputation, in recent years, Hershey has great balance sheets and cash flow statements to attract investors. Its revenue and gross profit have been at their strongest in its long history. Looking at this chart with history dated back to 1988, we can see that during the last recession of 2008-2009, the company’s revenue almost didn’t take many hits, but its gross profit was dented. Could Hershey be recession-resilient this time?

Broadly speaking, in the US, candy consumption during the last recession actually did not go down but went up.

So it means the consumption of chocolate indeed has recession-resilient power. How much will it translate into Hershey’s recession-resilient earnings power?

For the US consumer market, chocolate is the largest share of confectionery, according to Hershey’s custom database. Hershey should stand to benefit from this chocolate consumption inelasticity.

But during and after the great recession, even though its revenue remained strong, its earnings and margin were all adversely affected. In particular, it took almost a decade for its net margin and free cash flow margin to recover steadily above its pre-2008 level. And similarly, it took about four years for its stock price to recover. The latest data shows that these margin numbers, although still at or above average levels, recently dropped, starting from its gross profit margin.

And the company’s account payables have decidedly exceeded its account receivables. Looking back at what pulled down its operational cash flow during 2008, it cited higher account payables due to “higher costs of goods and services”. Sounds familiar? Because it was indeed similar to our current situation with a high inflation rate that pushes up the cost of both goods and services. Unlike in 2008, though, its account payables were still well below average account receivables. In this regard, the company is worse off than last time.

In fact, the difference between the two is deep in the red at the lowest level it has been recorded.

To investigate further the constraints that Hershey might face, we compare the cost of sales it incurred in 2008 with 2022. We see that the cost of sales increased by 5.9% in 2008 compared to 2007 and was primarily due to higher input and energy costs, high acquisition costs and offset by favorable supply chain productivity and lower business realignment charges. While looking at 2022, the cost of sales increased by 20.3% compared with 2021. They were driven by higher supply chain inflation costs of logistics and labor costs, plus $40 million in losses from its derivatives hedging positions, and were offset by favorable price realization and supply chain productivity. To compare 2008 with 2022, on the negative side, if we take out the odd items such as acquisition cost, and hedging losses, what’s left is remarkably similar: higher costs in material and labor, but added logistics inflation in 2022. While on the positive side, if we take out the one-time lower business realignment spending, they both have higher supply chain productivity, but this time it also has higher price realization.

In other words, the company faced similar challenges in 2008 but is more critically in need of higher prices now. That might be the one thing we could see coming down gradually due to the inflation-reducing efforts from the Fed. While its gross margin still increased in 2008 YoY, it declined in 2022. The price didn’t rise high enough to offset the higher cost in 2022. Looking ahead, the “lipstick effect” could probably maintain the sales volume, but perhaps not so much on the price front. So does it mean the company has to sell the sweets at a lower price and higher cost? It is probably so if it has a historically high inventory, similar to how it was at its highest level then before 2008. And chocolates are perishable. This will bring down the inventory as it did after ’08-’09, but probably with a lower profit margin.

On top of the higher inflation of labor and raw material costs, another exogenous factor is its supply chain risks. Over 80% of its raw material, cocoa bean, was sourced from West Africa. A recent default concern in Ivory Coast caused potential supply risks, and cocoa bean prices jumped back up to their higher levels during the early pandemic at $2738 per ton. Hershey could face higher production costs going into recession, further pressuring its earnings and margin.

We think the recession-resilient power of sweet chocolates probably cannot fully translate into recession-resilient earnings power for Hersey.

Financial Overview

Valuation

What’s interesting is Hershey’s stock price was actually falling for about two years before going into the 2008 recession, so the drop in prices from ’08-’09 was not dramatic. But this time, its price is at its all-time high. This essentially makes the company’s stock price more susceptible to a downside correction.

As we showed earlier, its earnings have been stable to a mild upward trend; on the other hand, its price has taken off on a tear. What it ended up with is its PE ratio started to diverge from its PB and PS ratio. The market price seems to be chasing the top line and sales more than earnings. As we can see, its earnings could fall by a large portion when the recession hits, even though consumers’ indulgence in chocolate did not decrease. When that happens, the stock price fall could be more severe than in the last recession.

At the same time, its return ratios are mostly flat to declining, notably a continuous downward trend for return-on-equity ratio.

Using all our analysis above, we assess Hershey’s fair price with a ten-year projection forward with our proprietary models. In our bullish case, Hershey has flat to negative growth in margin for ’23-’24, while regrowing with momentum afterwards; it was valued at $213.26. In our bearish case, the company has to face a few more years of fluctuation in margin growth as it continues to balance the prices and costs but returns to a robust growth trajectory, valued at $182.41. In our base case, it has negative growth in margin for ’23-’24 but returns to solid growth afterwards; it was valued at $201.39. The current price is higher than our top estimate.

Conclusion

To be clear, we are not here to argue against chocolate’s incredible power of stress release and delicious taste. The “lipstick effect” generally works for chocolates but is not necessarily enough to help Hershey’s bottom line, especially this time. We found the company is facing a similar situation as before ’08-’09 with rising costs but less buff and more elevated stock prices. For one of the largest chocolate producers in North America, Hershey still needs to tighten the belt to brace for some storms ahead. We think the current valuation is too rich, and recommend HSY stock a sell at this level.