Empire of Chocolate (Bore Port) January 20, 1999

<THE BORING PORTFOLIO>
Empire of Chocolate
A Look at Hershey

By Dale Wettlaufer ([email protected])

Alexandria, VA (Jan. 20, 1999) -- What's on the radar? Well, that's something we've talked about before, but we're going to put a little something in motion today. As we've discussed in the past, we will always look at a company extensively before buying it -- and we're price sensitive. So just because we like something doesn't mean we like it at the current price. But we like things at certain prices. So we have to get our research done on a number of companies and then wait for opportunities.

These are going to be kind of free-form looks at whatever. Alex can certainly engage in the same thing here. And rather than keeping our research notes on our company targets on my standard yellow pad, I've decided to put them here. So today, I'm entering Hershey Foods Inc. (NYSE: HSY) on the list.

This has been on the list from day one, but I just finished a fascinating book on the confectionery industry and I feel like I have had a good introduction to things. I highly recommend the book I read. It's titled The Emperors of Chocolate: Inside the Secret World of Hershey and Mars and was published in January of this year. I guess I hit on this book pretty early. Here's a link to the book at Amazon.com, but you can, of course, buy it elsewhere. If you do click the link above and buy the book, we get a commission on the sale, just to let you know what the relationship is there.

One vital point I picked up from this book is the fact that the Hershey bar and any confection with Hershey's milk chocolate in it stand little chance of picking up significant market share in Europe or any other country where European tastes have had a substantial influence on local palates. That's because Hershey's chocolate tastes sour to non-American palates. It's called "barnyard chocolate" by the rest of the industry because of its taste (Who knew, huh? I love it, personally). This definitely shapes my opinion on the company. When you think of Marlboro, you think "international brand." When you think of Coca-Cola, you think "international brand." If you think of a traditional American icon, the Hershey's bar, and think "international brand," you'd miss a vital point of investing in the company.

Not that all markets will reject Hershey's milk chocolate. For instance, I would think Hershey's chocolate stock keeping units (SKUs) will have a better chance in inland China than in coastal provinces where British tastes would have a larger influence on things. You can pretty much forget huge chunks of the Indian subcontinent and the British Commonwealth countries, as Cadbury and more caramel and sweet chocolates have mindshare and "mouthshare." These issues are key in thinking about investing in Hershey Foods. Figuring out how they're doing in international markets with respect to individual brand SKUs would be pulling teeth, by the way, given the highly secretive nature of the confectionery industry.

However, Hershey's not totally chocolate, either. In reading The Emperors, I found out that it's darned hard to come up with new products in the confectionery industry. Consolidation has been a major theme, and Hershey has had an advantage here because its main competitor, Mars Inc., has traditionally been less eager to buy and more eager to build. Take a look at some of Hershey's non-chocolate brands and some of the products you might not recognize as being from Hershey. These are North American brands, by the way:

Almond Joy candy bar
Cadbury's Creme Eggs candy
Cadbury's Dairy Milk chocolate bar
Cadbury's Fruit & Nut chocolate bar
Cadbury's Krisp chocolate bar
Cadbury's Mini Eggs candy
Cadbury's Roast Almond chocolate bar
Caramello candy bar
5th Avenue candy bar
Heath toffee bar
Hershey's classic caramels
Hershey's Cookies 'n' Creme candy bar
Hershey's Cookies 'n' Mint chocolate bar
Hershey's Golden Collection almond
Hershey's Golden Collection solitaires
Kit Kat wafer bar
Krackel chocolate bar
Milk Duds candy
Mounds candy bar
Mr. Goodbar chocolate bar
Reese's crunchy cookie cups
Reese's NutRageous candy bar
Reese's peanut butter cups
ReeseSticks wafer bars
Rolo caramels in milk chocolate
Skor toffee bar
Whatchamacallit candy bar
Whoppers malted milk balls
York peppermint pattie
Amazin' Fruit gummy bears
Amazin' Fruit Super Fruits candy
Chuckles candy
Good & Plenty candy
Good & Fruity candy
Heide jujubes
Hershey's jellybeans
Hershey's classic caramels
Jolly Rancher bubble gum
Jolly Rancher candy
Jolly Rancher Jolly Jellies candy
Jolly Rancher Jolly Beans jellybeans
Jolly Rancher gummis
Jujyfruits candy
Luden's throat drops
Mexican Hats candy
Nibs candy
PayDay peanut caramel bar
Rain-Blo gumballs
Reese's Pieces candy
Sixlets candy
Sour Dudes candy
Super Bubble bubble gum
TasteTations candy
Twizzlers candy
Twizzlers Pull-n-Peel candy
Wunderbeans jellybeans
Zagnut candy bar
Zero candy bar

That's pretty exciting. Here's a link to Hershey's total brand lineup, available at the company's website at www.hersheys.com. Hershey is still the North American leader in the confectionery market, but the thing to think about when you look at classic American brands is their potential around the world. In looking at Hershey in the future, this is what we will want to ask the company or find or for ourselves.

Finally, the company has two major initiatives underway that interest me very much. First, it's still implementing SAP R/3 enterprise resource planning application software, which I see as a major positive. By the way, SAP (NYSE: SAP) was down another $1 5/16 to $29 11/16, touching a new 52-week low today. We love that.

Second, the company is finishing its first year of operations with Economic Value Added (EVA) principles to help determine management compensation. I see this as a major positive because implementing EVA is one thing while tying management incentives to EVA is a whole different ballgame. Telling management you're going to measure EVA but tie bonuses to earnings per share growth is probably going to get you EPS growth. Tying management compensation to EVA is probably going to get you to create more EVA and get everyone thinking about the real economics of the business. We'll have to ask how this went in 1998.

As usual, we have a spreadsheet for you. Here's the Excel 97 version and here's the Excel 5.0/95 version. This is a basic look at the company's financials. I've also done a little valuation work on it. The point of that valuation work is not to try to guess at what I think the market can do, but to try to figure out what kind of expectations are built into the price of the company. Our job is to see whether we think those expectations are realistic and then we can go on to modify those expectations.

But for now, we don't have a fully formed idea of whether these goals can be reached. What I will say is that both the SAP and EVA implementations get people thinking about the right ways to increase shareholder value while protecting the value of the franchise. Sometimes shareholder enhancement programs get people thinking more about short-term values than long-term value.

Have a good night. We hope to see you on the boards.

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