Why Hershey Won’t Sweeten Your Portfolio

Source: https://www.flickr.com/photos/mikebarry/

Source: https://www.flickr.com/photos/mikebarry/

Who would have thought that a boring candy company could generate the returns that it has over the past few years? Shares of Hershey (NYSE:HSY) have nearly tripled since bottoming out during the depths of the financial crisis. The company has done a stellar job of raising its revenues and cutting costs, and this has led to the company growing its earnings by over 60 percent in the past four years.

However, I think that it is time to talk profits as the risks have begun to outweigh the reward. These risks are threefold. The first is that Hershey is richly valued. The shares trade at over 26-times trailing earnings and at 23 times 2014 earnings expectations. For a stable company that has shown signs of growth over the past few years, this may not seem like such a rich valuation.

One could justify investing in Hershey shares as an alternative to bonds, but the problem is that the company’s most recent quarter was a major disappointment. The company’s EPS growth was about 5 percent, and revenue growth was just 2.4 percent. This is a sign that the company’s growth is slowing, and if it continues to slow, it could turn negative. This is not a good state of affairs for a company that is trading with a valuation that anticipates growth.

The second issue is the potential for rising commodity prices. Hershey has to buy a lot of cocoa, sugar, and corn (to make corn syrup.) Corn and sugar prices have weakened as of late, but cocoa has been soaring and trades at a 52-week high. In fact, the iPath DJ-UBS Cocoa Subindex ETF (NYSEARCA:NIB) is up over 13 percent for the year. Furthermore, I’m not sure that corn and sugar prices will remain low. Corn appears to be making a base, and while the price is down on hopes of a strong crop, it is still up slightly; any weather that hurts the U. S. corn crop can send the commodity flying. Sugar is also declining, but about 40 percent of the world’s sugar is grown in Brazil where there is a drought. This can send sugar flying as well.

So, while we could see continued weakness in sugar and corn, the potential benefit to Hershey is outweighed by the risk that they spike higher.

Third, Americans and Europeans are becoming more health-conscious, and this doesn’t bode well for a candy manufacturer. This hasn’t been an issue for Hershey in the recent past, as the company as strong brand power, but other players in the industry have languished (E.G. TOOTSIE ROLL (NYSE: TR).) This isn’t a trend that is going to severely eat into Hershey’s profits immediately, but it is something that will slowly erode the company’s growth away over a period of several years. This could be, in part, the explanation of the company’s decelerating growth.

Ultimately, Hershey shares have more risk to the downside than they have upside potential. If these three concerns turn out to be unfounded, then Hershey is probably fairly valued, and it can probably generate 6 percent – 8 percent returns per year. This is fairly mediocre, and I think that there are lower risk ways to get this sort of return. If I am right, however, we can easily see Hershey shares trade with a non-growth price to earnings multiple, and this would be somewhere in the teens. If the stock were to trade down to a 15 P/E multiple, for instance, the stock would have more than 40 percent downside. That is a lot of risk to take in order to earn a relatively lackluster return.

Thus if you like the idea of owning shares in a company that generates free cash-flow from an iconic brand, at the very least wait for a better entry point.

Disclosure: Ben Kramer-Miller has no position in Hershey or in any of the securities mentioned in this article.

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