Hershey Investors Should Plan for Strong Returns

Anyone who has owned shares of Hershey (NYSE: HSY  ) for the last fifteen or so years has been very pleased. Since the turn of the millennium the stock has returned a total of 497% to shareholders, compared with 77% from the S&P 500.

Hershey competes in a favorable business environment, and I believe it has the competitive advantages necessary to get ahead and stay ahead of competition from Nestle (NASDAQOTH: NSRGY  ) and Mars.

The world's sweet tooth
An IBISWorld report on the candy and chocolate industry estimates that the industry has annual sales of $120 billion, which is a massive market. This also presents a large growth opportunity for Hershey, which posted annual sales of $7.1 billion in 2013. 

Unfortunately for us Hershey's largest competitor, Mars, is a private company, which makes comparisons difficult. However, the International Cocoa Organization reported that Mars had confectionery product sales of $17.6 billion in 2013.  Nestle, which is an international giant in the food industry, posted 2013 sales of approximately $11.1 billion in its confectionery category.

Hershey recognizes this large market, which it has barely tapped, and is currently working toward growing a larger international presence. According to the company's 2013 annual report, its sales in markets outside of the United States only represented 16.6% of its total sales.  It also stated that it is increasing its investments outside of the United States, mainly in Mexico, Brazil, India, and China, and it expects international sales to grow nearly 20% in the upcoming year.

Favorable environment
The packaged food industry in general is known to be highly competitive, which is normally not a good thing for investors in these companies. However Hershey has worked to grow an exceptional brand in the eyes of consumers. An overly simplistic, but effective way to see the brand power Hershey owns is the effect it has in making Hershey synonymous with chocolate to consumers. This is similar to the way people refer to a tissue as a "Kleenex" (of Kimberly-Clark) or refer to a soda as a "Coke" (of Coca-Cola).

This brand recognition is seen in the company's average net margin of nearly 9.5% over the last ten years. In Hershey's most recent quarter ended March 31, the company posted a net margin of 13.5%, well above the packaged-goods industry average of 8.3%.

Hershey also operates in an environment in which suppliers have little bargaining power, which also helps margins. Its main input, cocoa beans, is a raw commodity and as such suppliers are most likely to be price takers, not setters.

Lastly, another factor that will help Hershey's margins and growth as the company expands is the fact that its industry appears to have economies of scale. Economies of scale refers to the effect of falling unit costs as sales volume rises. This can be seen from the fact that in 2008 when Hershey's sales were $5.1 billion, its cost of sales and selling, marketing, and administrative expenses ate up 86% of these sales. Then in 2013 when Hershey's sales were much higher at $7.1 billion, the same charges only used up 81% of its sales dollars.

Growth prospects
Over the last five years Hershey has grown its sales and net income at compound annual rates of 6.8% and 21.4%, respectively. This compares very well with Nestle's confectionery segment, which has seen sales fall at a compound annual rate of -3.6% as operating income rose 0.1% per year. 

As stated earlier, Hershey's should see dramatic increases in international sales over the next few years as its investments abroad begin to mesh with its normal business operations.

Hershey expects its 2014 sales to rise by 5%-7%, with reported earnings per share rising to between $3.99-$4.08, or 10.5%-13% over its 2013 earnings per share of $3.61. I suspect -- for the reasons stated above -- that as Hershey continues to grow its international sales and become a bigger player in the market investors can expect it to reproduce these numbers year after year for the foreseeable future.

Fool's takeaway
Even though some may view Hershey as a large and mature company, investors can still jump in for plenty of growth. The company's stock is currently trading at around 21.5 times forward earnings, which is a bit hefty compared to the market's 17 times forward earnings valuation. However, considering that the company has grown earnings per share by nearly 14% per year over the last five years and may be able to make comparable gains over the next few years, this is a fairly reasonable price.

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