Hersheys China business has once again performed poorly

Hershey's China business has once again performed poorly

That China is central to Hershey's challenges at the moment was underlined on Friday after the US confectioner booked a second-quarter loss of almost US$100m following an impairment charge on local subsidiary Shanghai Golden Monkey.

The business, in which Hershey acquired an 80% stake in September after first announcing a deal in December 2013, is proving problematic, president, chairman and CEO, J.P Bilbrey, admitted on a conference call with investors to discuss the group's second-quarter results.

The initial sales forecast for the Shanghai Golden Monkey business in 2015 was $200m. Hershey's latest forecast is for sales to reach $90m.

"Results have been disappointing. We initially thought this was primarily due to macro-economic headwinds in China. As the integration has progressed and the situation on the ground evolved, we've come to understand that there are significant business issues that we need to address in order to achieve our goals. Accounts receivable collection has remained challenging, and sales continued to slow in the second quarter. Our assessment of the distributor network has made it clear that the network is not as stable as we believed, and therefore the related retail customer reach is not as broad as we believed it to be," Bilbrey said.

His comments shone more light on the issues facing Hershey in China, which the company had first started indicating earlier this year, when in April it cut its target for annual sales, in part on the back of lower-than-expected sales in the country. In June, Hershey again lowered its forecast for full-year sales. It again cited weakness in China, revealing its performance in the country in the two months between the two announcements had been "below expectations".

The company said that it had fallen foul of weak macro-economic conditions and changing consumption patterns as shoppers switch to smaller formats and e-commerce.

At the time, Hershey hinted it could make an impairment charge on Shanghai Golden Monkey. On Friday, it announced an initial impairment charge of $249.8m. Worryingly, Hershey added: "The company expects to finalise its valuation assessment in the third quarter of 2015 and additional charges, including charges related to other long-lived assets, may be required."

Hershey, however, seems to be standing firm behind its investment in Shanghai Golden Monkey. The company's reasoning behind the acquisition was the deal should boost its presence across China. Pre-acquisition, the Reese's owner's chocolate growth had been in hypermarkets in China's tier-one cities. The plan was for Shanghai Golden Monkey's sales force and distributors to help Hershey penetrate regional cities.

That vision is not about to change, Bilbrey told analysts, advocating the advantages the acquisition presented. Furthermore, Hershey still expects to complete its move to buy the rest of Shanghai Golden Monkey later this year (although the terms of the deal will, it said, depend on its ongoing revaluation of the business).

Ken Goldman, an analyst at JP Morgan, questioned whether the performance of Shanghai Golden Monkey would have an impact on Hershey's plans to "flow its legacy product into some new regions or channels".

"The strategy and intent we have with Golden Monkey is still intact," asserted Bilbrey. "What we're really looking at is understanding the right-sizing and some of the business model practices that we have on a global basis and how do we integrate the broadest spectrum of distributors into that. If you look at that business on a weighted basis and [ask] do we still have value within some of those distributors, the fact of the matter is, yes, and the strategy is right. We want to get moving ahead with building the business, so all the reasons that drew us to that business and being able to expand our footprint in China, still are there. We just have to get all the business practices aligned with what we believe is appropriate and what's required of us as a US corporation," he added.

So how does Hershey intend to fix the Shanghai Golden Monkey problem after making it clear it is still committed to the business? Bilbrey said Hershey would look at the unit's cost structure and the "different integration strategies intended to get the business back on track as quickly as possible". Hershey has also appointed a new chairman and general manager for Shanghai Golden Monkey with "solid China consumer packaged goods experience".

Away from the specific issues with Shanghai Golden Monkey, Hershey is facing a slowing Chinese economy that has impacted consumer confidence, and a crackdown on gifting - the fallout of which a number of the company's peers, including Nestle, have experienced in recent quarters.

While Hershey said it gained market share in China's chocolate category during the first quarter, growth was still lower than the historical performance and lower than its own expectations. The second quarter saw the category's growth return to a rate in the low double digits but there was also an increase in competitor activity as manufacturers responded to poor sales during the Chinese New Year period. Actions included more promotional activity and increased discounting which impacted Hershey's net sales and profitability.

Bilbrey was keen to point to Hershey's initiatives to try to improve the performance of its business in China.

"Some of the initial work we've done to help ensure that we execute against our plan in China and get back to our winnings ways includes the broader roll-out of Brookside Chocolates, distribution into smaller format stores, and continued focus and acceleration of our e-commerce business. Our e-commerce business, while small, is up 60% this year," he said.

Hershey, meanwhile, is partnering with key third-party online retailers like Tmall, Jingdong, and Yihaodian.

"We are learning a lot about digital consumers in China that will help us going forward. China is a priority market for us and we'll be focused on executing against our core brand building business model."

Some industry experts do believe the majority of Hershey's China problems have now surfaced. Alexia Howard at Sanford Bernstein says the second-quarter results are more indicative of "distribution/acquisition oversight" than problems with "consumer/brand strength".

"Year-on-year sales declines could start to look worse once we lap the anniversary of the Shanghai Golden Monkey deal in September, since this is clearly not going well. But with the ~50% write-down of the value of the Shanghai Golden Monkey deal this quarter, and with fairly clear signalling about how the lapping of the Shanghai Golden Monkey acquisition is likely to affect results, we believe that most of the bad news is likely on the table at this point. The category seems to be returning to a high-single digit growth rate, which could improve competitive dynamics going forward."

China is a market in which Hershey is committed to succeeding, Bilbrey said.

"As we look over the long term, I continue to have the same commitment and confidence of how we're going to grow our business there. This is about category building. It's not about fighting for market share. It's about participating in the growth of this category for the future in a very large and attractive market."

Nevertheless, the performance of Shanghai Golden Monkey meant questions were raised about Hershey's M&A strategy. Eric Katzman, an analyst at Deutsche Bank Securities, asked: "Given the M&A seems like it's still going to be part of your future as you move globally, is there something culturally missing or on the due diligence process that you've done in the past that's just for whatever reason seemingly made the company deal with M&A problems after the deal is signed?"

Bilbrey responded with examples of "good" acquisitions and joint ventures such as Pelon and Brookside.

"If you were to put it within the context of our due diligence process, I don't think we've gone about it in any errant way. We use the best advisors, the best names and family names that you can think of in terms of who you would partner with on looking at these things. I think the landscape in China is certainly a challenging one, and we're certainly finding that out.

"There's a lot of things that we do work on that we pass on, and we pass on it for exactly the kinds of things that you would expect - that either once we get under the hood they don't yield what we anticipated or there's things that we're concerned about. So in terms of rigour and so forth, I don't think there's any lack of that. Our goal is to get as many of these things right as we possibly can. You're correct, M&A is going to be important to our overall growth, and you can rest assured that we're reviewing every aspect of everything along the way with regard to this particular acquisition to make sure we learn as much as we can going forward."