Hershey yesterday (26 April) reported a rise in reported first-quarter sales and earnings but took down its forecast for annual organic sales and cut its estimate for full-year adjusted gross margins. Simon Harvey looks into a challenging opening quarter for the US candy giant.

Hershey’s first-quarter results were received with some disappointment among market watchers after the US-based confectionery giant reported a bigger-than-expected decline in underlying gross margins and forecast further pressure on its near-term outlook.

On a statistical basis it was a mixed bag for the company, with reported sales, operating profits and net income all rising from the previous quarter. However, it was the cut in full-year guidance on profit margins and sales growth that drove a fall in its shares of more than 1% in intra-day trading on Thursday, before staging a recovery to close slightly down.

But there were also some bright spots, with a positive impact on sales from Hershey’s recent acquisition of Amplify Snack Brands, a lower than anticipated 2018 tax rate as a result of President Trump’s fiscal reforms – with the extra funds to be shifted from SG&A to capital expenditure – and an expansion of the company’s on-going SKU rationalisation programme.

Crunching the numbers, reported sales rose 4.9% to US$1.97bn in the three months to 1 April, while operating profit surged to $480m from $197m in the year-earlier quarter. Net income also did well, increasing to $350m from $125m.

In constant-currency terms, sales were up 4.4%, with a 340 basis-point contribution from Amplify, while volumes rose 2.4%.

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Nevertheless, Hershey cut its full-year guidance for sales to come in at the lower end of its previously forecast range of 5-7%, while organic sales growth (up 1% in the first quarter) is seen at the bottom end of what was expected to be a print of slightly up to an increase of 2%.

Still, earnings estimates were reaffirmed at $5.33 to $5.43 EPS on an adjusted, diluted basis.

For some perspective, Barclays’ analysts had estimated a 3.4% increase in reported sales, and a 0.2% decrease for both organic sales and volumes.

But it was Hershey’s adjusted gross margins that hit financial markets yesterday (26 April) and the subsequent cut in guidance for the year.

That metric fell 260 basis points in the quarter to 44.9%, prompting Hershey to predict margins would end the year down 125 points, compared to a previous forecast of flat. Barclays had expected a 100-point decline for the first three months. Hershey had also reported a fall in adjusted gross margins in the fourth quarter of 2017.

Chief executive Michele Buck explained on a conference call with analysts: ”We had anticipated gross margin contraction in the first quarter due to higher freight and logistics costs as well as incremental investments in trade and packaging. 

“However, this contraction was greater than we expected due to unfavourable mix, cost of complexity via incremental supply chain touch points and waste, as well as higher input costs.”

Hershey has made working on its margins a priority under Buck’s leadership. Last March, the company announced a programme dubbed ‘Margin For Growth’ under which it wants to invest in the business and generate about 22-23% adjusted operating profit margin by the end of 2019. In the first quarter of 2018, Hershey’s adjusted operating margin stood at 24.4%.

Buck said reversing the drop in gross margins remains a top priority towards driving future profits, and as a course of action is shifting the company’s planned tax reinvestment to capital expenditure from SG&A, as well as expanding its SKU rationalisation programme to the US.

“We feel confident in these efforts given the significant progress we’ve made in our international businesses on a similar initiative,” Buck added.

But she said margins will remain under pressure in the second quarter, before starting to improve in the second half and into 2019.

Asked by an analyst on the conference call whether the market should expect a similar performance in second-quarter gross margins to the first (a 260 basis-point drop), chief financial officer Patricia Little replied in the affirmative.

Andrew Lazar, a senior analyst for packaged foods in New York at Barclays, talked the market down when Hershey’s results were issued before the start of trading yesterday.

”While expectations were already muted heading into today’s print, we still believe investors will find the much-greater-than-forecast gross margin contraction and lower net price dynamic disappointing.”

Still, despite the initial plunge in Hershey’s share price on Thursday, the stock closed down 0.2% on the New York Stock Exchange.  

Looking forward, Hershey’s December acquisition of Amplify Snack Brands is already adding a positive contribution, although a sale of the latter’s international business is under “strategic review”.

”We have now reached a point where we believe it is likely that we will sell the business in the next 12 months,” CFO Little said on the conference call. ”The business is still included in our guidance as we’re not certain if and when a sale will occur. To assist with your modelling, 12-month sales are approximately $125m and operating income is immaterial.” 

In terms of the impact on EPS, the purchase of Amplify is expected to be $0.8-0.12 accretive in 2018.

And Trump’s tax reforms a proving a welcome bonus, too, enabling Hershey to put back more funds into the business, with the company expecting capital expenditure to rise $25m from initial estimates to around $355m to $375m.

The company now expects its tax rate to drop to 19% to 20% this year, from a previous estimate of 20-22%. For the first quarter, Hershey said its adjusted tax rate was 24.9%, compared to 31.5% in the year-earlier period.

However, CEO Buck said efforts still need to be made to drive profitable growth, with the expansion of the SKU rationalisation programme to the US a key component of that effort.

She explained Hershey’s business is “a high SKU-driven category with multiple locations in the store”, with some “good complexity” that adds growth, but also “bad complexity” that does not drive incremental growth.

“I think one of the most important things we always have to do is keep track of that. I think we got a little bit out of balance on that, and we think it’s really important to address that.” 

Buck added: “We think it’s the right thing to do, to really shift and work to drive mix. And we do know though, that there will be some short-term impact as we make those changes. So really that choice is the primary driver that led us to call the low-end of the guidance.”