Dueling Fools
Hershey My Way
August 25, 1999
The Bull Rebuttal
By
Poor, misguided and curmudgeonly Bill. I suppose I should thank him for the opportunity to argue for a company that exemplifies the best that corporate America has to offer. Here's a firm that has done nothing but benefit both its shareholders and society as a whole, and Bill is stuck with the unenviable task of arguing against it. Given what little he has to work with, I think he did a fairly good job, but not good enough to convince me that Hershey is anything but an excellent company to hold for the long term.
Bill points out that Hershey's margins haven't improved over recent years. Is that glass half empty or half full? I'll counter with the observation that Hershey's margins have been rock steady over the past dozen years. For the past 12 years, net margins have been in a fairly tight range, around 5-10%, and typically near 7%. I think I'll call that glass half full.
My fellow Fool then makes the point that the candy and food industry is lackluster. I would have to agree with him here. But like I said earlier, the food industry as a whole is extremely defensive. What it lacks in growth it more than makes up in safety and predictability.
Then there's the issue of Hershey's global brand. I'll agree with Bill that Hershey is an American brand that has minimal market penetration overseas. The fussy Germans may not palate the Americanized chocolate well, but it really wouldn't be that hard for Hershey to tweak its manufacturing process to better serve the international markets. I'll see the glass half full again and say that there is literally a world of growth opportunities out there for Hershey.
Bill then points to Hershey's "substantial" debt as a reason to be cautious. First of all, the average public company, according to Media General, has a debt/equity ratio 1.4x, a number that Hershey is not out of line with. Plus, Hershey has more than enough cash flow to finance the debt. In the first six months of the year, Hershey had operating income of $459 million and net interest expenses of $35 million. In fact, a seasoned financier would say that a little bit of debt in Hershey's capital structure is a good thing. It's a relatively cheap source of capital for Hershey, protects operating earnings from taxes, and serves to boost the company's return on equity.
The bearish argument then goes on to imply that Hershey is overvalued at 25x trailing earnings. I think Bill would see differently if he actually went ahead and did a discounted cash flow analysis. Using the conservative assumptions that Hershey will earn $2.60 next year, will grow earnings 7% per year beyond that, and then discounting back those cash flows at an 11% discount rate, the present value of Hershey's stock is just below $65 per share. Not a huge discount to today's price, but still mildly undervalued.
I also think that the assumptions I made above are extremely conservative. For instance, the 11% discount rate is probably a tad on the high side. The company has, in addition, grown its earnings 18% annually over the past five years, but I'm only assuming 7% growth going forward. More importantly, even with absolutely flat net income, the company can significantly boost its per-share earnings down the road by using its copious amounts of free cash flow to continue both slowly retiring debt and keeping up its share repurchase program.
Awesome products, strong domestic brand, healthy and predictable profits, and a corporation that at its core is intent on helping those in our country who need it most. Yes, I love Hershey more than I love chocolate. And if you, dear Fool, take some time to look at the company more in-depth, I think you'll love it, too.
Next: The Bear Responds