The Motley Fool: Dueling Fools, Dell Bear's Den

Dueling Fools
August 25, 1999

Hershey My Way
Bear Argument

By Bill Barker (TMF Max)

Make no mistake about it -- Hershey Foods is on the short list of companies that absolutely every American should be rooting for. The story of Milton Hershey -- the company founder who left controlling interest in the company to a school for orphans -- is one of the least publicized but most compelling acts of generosity ever to come out of American capitalism. (If anyone out there knows of a needy child who would like a free boarding school education in rural Pennsylvania, contact the Milton Hershey School for more information. The school has an endowment of over $5 billion, more than all but five universities in the country.)

The generosity and ingenuity of Milton Hershey, as further described in the highly recommended The Emperors of Chocolate, make for compelling reading. Few companies can lay claim to being a more intricate part of 20th century Americana. But while disliking anything at all about Hershey certainly qualifies as downright un-American in my book, the stubborn and continued unwillingness of most of the world to go ahead and just be Americans is the big problem for Hershey shareholders. Hard as this may be to believe, most of the world thinks that "The Great American Chocolate Bar" is simply inedible.

Let's review the positives for Hershey, because, like the Hershey bar itself, they're pretty simple. On the domestic front, the company makes nice, steady progress. Hershey is the leading producer of confectionery in the United States, currently capturing nearly 35% of the domestic market, easily outdistancing major rival Mars, which has a 22% share of the market. At $4.2 billion in annual sales, Hershey's top line is up about 50% from where it was in 1991 -- meaning sales have been growing about 5% annually.

Hershey, to put it kindly, has never been known as a particularly efficient manufacturer. It's no surprise that margins haven't improved at all over the decade, though candy-making technology has improved quite a bit. Hershey has taken on a fair amount of debt (the debt/equity ratio is a hefty 0.84), which has essentially funded the buyback of 40 million shares. This helped Hershey grow its earnings from $1.21 per share in 1991, to a level of about $2.34 this year. Not bad, but the share buybacks have masked the measly growth in net income -- about 5% a year, in line with revenue growth. Hershey also puts out a dividend of 1.9%.

That's the good news for Hershey. In a prolonged period of near-perfect economic conditions, the company has been able to grow sales just slightly better than the rate of inflation. By inflating its price from an early 1991-1993 range of 13-16x earnings to today's P/E of about 25x current year's earnings, Hershey has been successful in almost, but not quite, keeping up with the market's average returns over the last 10 years.

The bear argument comes in as we take a look at the international scene; Hershey is no global powerhouse. According to a recent ranking of the top 60 global brands, Hershey is nowhere on the list. In fact, though it pains me to point this out, it's not an exaggeration to say that, internationally, Hershey is one of the least respected brands anywhere. Because Hershey's chocolate is made through a process that chemically sours the condensed milk, to foreigners more accustomed to a sweeter taste, Hershey's tastes like "barnyard" chocolate. Consider these quotes from The Emperors of Chocolate:

"The list of Hershey's international failures goes on and on... Whenever Hershey has tried to introduce its chocolates abroad, foreigners have rejected the Hershey flavor."
"The Germans couldn't believe Americans would eat it. They were tasting the candy and spitting it out."
"The world out there eats Hershey chocolate and goes, 'Yuck.'"
"Hershey is not a player. Nobody on the world scene gives Hershey a second thought."
[And from Hershey's former CEO in reference to global expansion] "I think we have to label it as a goal... but it's going to be difficult. It will take us maybe a quarter of a century [to get our foot in the door.] We can be a very successful company in North America without being in Europe."

So it should come as no surprise that less than 4% of Hershey's total revenues come from international sales. Hershey's main assets -- the distinctive taste of its chocolate and its brand name -- are actually global negatives. In determining Hershey's future, one must assume that global tastes are not about to radically change.

And that means Hershey is stuck in an industry that's truly lackluster. Total domestic candy sales are up only 2.7% over the last 12 months. True, Hershey has been able to expand market share by buying up rival brands such as York Peppermint Patties and Reese's peanut butter cups. But by buying up the competition, Hershey has already achieved a large chunk of the growth it can expect. Having limited itself to a purely U.S. strategy (Hershey isn't even successful in Canada or Mexico), this company is working in an awfully tight space.

Hey, I love the fact that a controlling percentage of the company is owned by an orphanage, and that when you buy a Hershey bar a significant percentage of the profit goes to help needy kids. But Hershey has largely found itself orphaned by the rest of the world. While its U.S. customers aren't going to switch loyalties anytime soon, the growth prospects here are quite limited. I just don't see how anybody can be bullish about a company with substantial debt and 5% annual growth, selling for 25 times earnings.

Next: The Bull Responds