We've decided to give Hershey the old kiss-off from our food and beverage industry study. This may be somewhat surprising considering...
- Hershey is a quality business if there ever was one;
- Jeff consumes 85 pounds of Reese's Pieces each week, on average; and
- I grew up just a few minutes from Hershey, Pennsylvania, so saying anything negative about this company means I'll never be welcome in my hometown again.
Before tearing the company apart, however, we must say that Hershey certainly has a lot of things going for it that make it an attractive potential investment. Most importantly, the company's name brand, wide array of products, and nationwide appeal provide it with an impressive iron-clad competitive advantage over smaller candy makers and would-be rivals. As Warren Buffett might put it, the moat around Hershey's business is wide, deep, and full of alligators. We like those attributes, especially for companies in the food industry where change occurs with about the same frequency that Penn State changes head football coaches.
Hershey is also a value creator and has world-class business economics, qualities that we expect to find in most of the companies examined during this study. I calculated return on invested capital (ROIC) last year at 14% using the same assumptions used during my earlier analysis of Wrigley. Hershey itself reported a 17% figure in its 1998 10-K using different assumptions, while Jeff determined a 25% return earlier this week using data that was about as stale as a 1950s-era Almond Joy (actually, the number came from Hoover's -- so beware). We'll go with the 14% figure in the spirit of keeping things consistent.
A 14% return is not exactly the Hershey Kiss of death, but we're looking to invest in a company that can earn excess returns over an extended period of industry dominance. The industry dominance is there for Hershey, but calling the firm's returns over the past decade "excessive" is a bit... (ahem)... excessive. With ROIC at 14%, the company is likely beating its cost of capital, but not by very much. This may change in the future as Hershey hones its operational efficiency, but recent experience in this department has not been particularly encouraging.
Problems installing a new management information system from SAP (NYSE: SAP) will result in the chocolate maker missing some deliveries in the important Halloween candy season, wrecking any chance for earnings growth this year. The company will surely get its delivery problems ironed out, but the goof is not exactly a confidence builder for investors considering an investment in the firm for the first time. On the bright side, the loss of confidence has resulted in a currently low market valuation, which smells about as good to us as the permanently scented air that wafts down Chocolate Avenue from the company's main factory in Central Pennsylvania.
We require more than just a cheap price, however. We have absolutely no problem with the philosophy of buying stocks that may be out of favor in the short-term, so long as we can justify some contrary expectation that the market is not recognizing. But right now, it seems that the slow growth that is built into Hershey's valuation is dead-on accurate.
We don't see a near-term catalyst that is going to change that situation anytime soon. The business is not consolidating and no super-spiffy technologies are set to light a fire under the company. Judging from the company's proxy statement, Hershey already has a pretty aggressive performance-based management compensation system tied to metrics such as earnings per share, free cash flow growth, and ROIC. Perhaps tweaking that system and tying executive compensation even more closely to operational performance can provide the kinds of excess returns that we are looking for as long-term investors.
Until that happens, however, we're content to turn our attention elsewhere and focus on other companies. We admire Hershey a great deal and we will continue to purchase and enjoy its products, but we're craving something different. Maybe something a little more saucy, such as ketchup? We plan to start our look at another Pennsylvania company, H.J. Heinz (NYSE: HNZ), next week.
Until then, stay Foolish!
