Iconic US chocolate maker Hershey Foods is in the midst of a transformation process. Its aim? To diversify into the snack food market in order to expand beyond its core chocolate business. With new products and even a new name in the pipeline, could this herald a new era for the company? David Robertson reports.

Hershey, the iconic chocolate maker, is in the process of transforming itself into a snack-food conglomerate, and in doing so the company has become one of the star performers of the US food industry.

For much of the 1980s and 90s Hershey did little to stand out in the crowded snack and confectionary business. Its share price was lacklustre and its products, 80% of which are chocolate-based, were barely known outside the US. But the arrival of Richard Lenny as chief executive in 2001 has been something of a catalyst for revival.

Last year Hershey's share price went over US$50 - the first time it has hit this mark in twenty years (split adjusted) - and the stock is currently trading at around $59.
Sales grew 6% in 2004 to over $4.4bn and analysts are forecasting that 2005 sales will rise at least another 6%. As a result, Hershey has been the best performing stock in the US packaged food sector (along with Kellogg), which is a considerable achievement considering the chocolate maker came within a whisker of being auctioned off in 2002.

Bidding war

The company's majority shareholder, The Milton Hershey Trust, which runs a school for disadvantaged children in Hershey, Pennsylvania, decided that its portfolio was too exposed to the chocolate maker's fortunes. So the trust put Hershey up for sale and created a bidding war among the likes of Wm Wrigley and Cadbury Schweppes. The company was expected to fetch $12.5bn. However, in the last days of the auction Hershey school alumni teamed up with the Pennsylvania district attorney to scupper the deal.

Having put this unwanted auction debacle behind him, Richard Lenny, the new CEO, was then able to get on with implementing his "value enhancement strategy". The first task facing Lenny was to cut costs and dump less profitable products and packaging sizes. Hershey then dived into a product innovation phase that has seen its offerings expand into lucrative new businesses.

One of these new businesses is sugar-free confectionery, which the company developed in 2003. Hershey spokeswoman Stephanie Moritz says: "Our sugar-free business continues to grow as sugar-concerned and diabetic consumers look to Hershey to provide them with great-tasting alternatives. In 2004, retail takeaway increased by 50% and we continue to see this as an area of growth."

Investing in the Hispanic market

Hershey has also been quick to realise the potential of the Hispanic market in the US, which has a population of more than 40 million with purchasing power estimated at $632bn a year. The company is using Latina pop star Thalia to help promote new products like Hershey Kisses filled with dulce de leche, and chilli-flavoured lollipops.

Moritz says: "We have generated a very high level of awareness with Latino consumers through Hershey's relationship with Thalia. We have seen a significant increase in our retail sales and market share in high-density Hispanic markets. A co-branded line with Thalia created a very powerful proposition - the great taste and credibility of the Hershey brand, with Thalia's recognised and trusted persona."

This initiative has led to a 21% increase in takeaway sales in Hispanic stores and a 1.8% gain in market share, says investment bank Piper Jaffray.

Hershey is also expanding south of the border. It bought Grupo Lorena in 2004 to expand its distribution and product operations across Mexico (and presumably other Latin American countries in the future).

New product development

Another new development has been Hershey's move into high-end cookies with Hershey chocolate and Reese's Peanut Butter branded products. And Hershey's most recent development is a confectionery bar called Take 5, which is a classic "only in America" product. It contains pretzel pieces, caramel, peanut butter and chocolate to create a "salty, sweet, crunchy and creamy" taste.

These new launches and innovations have impressed analysts because they require little extra investment, use well-established brand names and many of them can be sold at premium prices. Piper Jaffray said in a recent investment note: "The company's new product innovation programme is geared to enhance its existing large branded products, thereby leading to significant capital and capacity efficiency. Investors should be rewarded with higher returns on invested capital as well as above average food industry growth rates."

Morgan Stanley has also been impressed by Hershey's fundamentals: "The company's business outlook actually further improved throughout 2004 as Hershey accelerated its rate of new product development and revenue growth."

What's in a name?

But not all of Hershey's value enhancing strategies are food driven. The company is also restructuring itself, splitting into two: US confectionery and snacks - headhunters are currently looking for someone to run the snacks division. (Hershey is even considering a new name: "The Hershey Company" rather than Hershey Foods Corporation.)

But the really interesting question is why the company feels it needs all these new products and a separate snacks division? The answer lies in concerns raised by the Milton Hershey Trust back in 2002 when it flirted with selling the company: Hershey is poorly diversified.

The company gets more than 90% of its sales in the US, and 80% of its business is in chocolate - a stagnant market. Acquisitions would be an obvious way to diversify (both in product and geographically) but Hershey is struggling to do so because so many of its shares are held by the Trust, which limits capital raising opportunities. (Hershey was outbid last year for Kraft's Life Savers and Altoids business by Wrigleys.)

The company is in the process of asking investors to allow it to issue more shares if the right deal comes up but its pockets are unlikely to be deep enough to trump larger rivals if they are persistent.

Even trying to diversify geographically through organic growth is difficult outside the US because many consumers, Europeans in particular, don't like the taste of American chocolate.

Takeover target

As a result, Hershey is trying to innovate its way into the $56bn snack market and has created a separate division to facilitate that move. Moritz says: "We see an opportunity, as the snack category is large and growing because it's on trend with consumer behaviour and provides great growth for both manufacturers and customers across multiple channels and outlets."

But until Hershey can show its diversification strategy is working investors are going to consider its stock a more risky proposition than some of its rivals, which helps explain why many analysts rate the stock a "HOLD" or recommend being "Underweight" despite the recent share price run.

And while Hershey works on its diversification strategy it remains a target for larger rivals. Even with a $16bn market capitalisation Hershey is a middle-sized food company, which makes it consolidation fodder for the likes of Nestlé or Cadbury Schweppes, should the Hershey Trust ever decide it wants to sell again.