Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
It's been nearly a year since Amazon.com (NASDAQ:AMZN) announced it was buying Whole Foods Market, inspiring a wave of terror among investors in grocery store chains. One year later, the knock-on effects are continuing to be felt as retailers reposition their business models to compete with the new entrant upon their turf -- and this morning, it's shares of Hershey (NYSE:HSY) that are getting knocked.
Here's what you need to know.
Bright and early Wednesday morning, analysts at Credit Suisse announced they're downgrading Hershey stock to underperform, and while Amazon wasn't named as a prime mover in the decision, it's pretty clear who's to blame here.
Amazon isn't just a new owner of Whole Foods, after all. It's also new management that's cutting prices at the store often referred to as "Whole Paycheck" to make it more competitive with rival grocers. It's an online grocer delivering non-perishable (and more and more frequently, perishable) groceries right to your door. And it's the inventor of an entirely new way of buying groceries -- one without checkout counters or cashiers. In multiple ways, Amazon is shaking up the grocery industry, and forcing its competitors to make changes to keep up.
Credit Suisse attributes its pessimism about Hershey to this "shift in shopping patterns to more convenient methods like online and click-and-collect" that it's seeing in grocery retail lately, as explained in a note today on StreetInsider.com (subscription required). More and more often, grocery shoppers are assembling their shopping lists from the comfort of their homes, then either heading to the store to pick up their groceries already bagged (a la Kroger's new ClickList option) or having orders delivered to them (via Instacart, for example).
Either way, you know what part of the grocery store business model gets left out? Impulse buying.
Hershey no longer an "impulse buy"
By strategically positioning small-dollar-value candy and gum (and magazines, batteries, and so on) right next to the checkout counter, grocery stores try to entice customers to add just one more thing to their carts while waiting their turn in line. (This works even better when shoppers bring pleading children in tow.)
Impulse buying helps grocery stores separate shoppers from a few extra quarters each shopping trip. But according to Credit Suisse, impulse buying is even more important to candy companies like Hershey. As the analyst explains, once you separate shoppers from the physical checkout line, you're going to "materially reduce the number of impulse purchase occasions for confectionery products merchandised at traditional checkout aisles."
Now, Credit Suisse doesn't place a specific number on how "materially" it expects phenomena such as online ordering and ClickList to affect Hershey. But the analyst believes "Hershey's operating margin [will] head lower over the next two years" because of the need to increase its own "investment spending" as it devises ways to offset this challenge to its sales. At the same time, the banker warns that the cost of cocoa is rising, and Hershey is struggling to pass on the added cost of its raw materials to its customers.
Result: Higher input costs without commensurately higher selling prices are going to squeeze Hershey's profit margin -- and this is on top of the company's troubles in the checkout aisle.
How much should this stock cost?
Now, all of this might not matter so much to investors if Hershey were a demonstrably cheap stock with an anticipated high rate of earnings growth. Problem is, that's not the case.
Valued on its trailing-12-month net income, Hershey stock currently sells for a P/E ratio of 19.4. Factor in the effect of the $4.1 billion in net debt on Hershey's balance sheet, though, and the stock's debt-adjusted P/E is something closer to 23.6.
Analysts who follow Hershey stock, meanwhile, see the company growing earnings at less than 9% annually over the next five years. Given the market dynamics that Credit Suisse is describing today, I wonder if that rate is attainable. But even if it is realistic, well, 23.6 times earnings, divided by 9%, would give Hershey stock a PEG ratio of 2.6 -- or more than twice what value investors ordinarily consider a bargain price.
This suggests that Hershey is overpriced today at a share price of more than $90. In announcing its underperform rating, Credit Suisse set a target price of $80 on the stock. If you ask me, though, this stock could go even lower than that.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.