Hershey’s 2016 results and 2017 outlook, issued on Friday (3 February), suggested both a stronger finish to the year than the preceding nine months had suggested and confidence on this year’s earnings above that seen on Wall Street. Nevertheless, analysts still had questions on Hershey’s earnings expectations, on its performance in China and on its plans for its cost structure. Dean Best reports.

Sales growth accelerates in Q4 of 2016 but what of profitability?

The first nine months of 2016 were challenging for Hershey when viewing the US confectioner’s sales performance – so the Reese’s maker would have taken some heart from its top-line performance in the last quarter of the year

Between the start of 2016 and July, Hershey cut its forecast for annual sales three times, with problems in China a common theme in each warning and pressure in North America rearing its head during the third quarter. In October, when Hershey announced its third-quarter results, the company cut its 2016 sales forecast.

Fast-forward to Friday (3 February) and the publication of Hershey’s fourth-quarter results and the numbers showed the company’s top line gathered pace in the last three months of 2016.

The Kisses maker’s net sales grew 3.2% in the fourth quarter to $1.97bn. Exchange rates trimmed 0.5 percentage points off the result, although Hershey’s top line received a 0.9 point boost from acquisitions.

Hershey’s underlying fourth-quarter earnings came in ahead of Wall Street consensus estimates, although not all analysts were quick to hail that result. “Below the line, lower tax rate and other expense drove the majority of the EPS beat,” Barclays analyst Andrew Lazar reflected. Meanwhile, at Morningstar, equity analyst Erin Lash, noted some pressure on Hershey’s margins. “Adjusted gross margins slipped 50 basis points to 44.5% and adjusted operating margins contracted 70 basis points to 19.2%,” she said.

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What does Hershey’s 2017 outlook suggest?

Hershey’s forecast for its 2017 adjusted earnings per share, like its underlying Q4 2016 EPS, was above analyst estimates.

However, some on Wall Street pointed to below-the-line factors benefiting that forecast. “We would note that nearly half of Hershey’s expected 7-9% year-on-year EPS growth in 2017 could well be driven by a lower year-on-year tax rate, which although a tangible earnings contributor – and likely sustainable – ultimately suggests 2017 EPS growth is less indicative of the underlying business turning a fundamental corner,” Lazar wrote.

That view was echoed by Alexia Howard, an equity research analyst at Sanford Bernstein, who also noted the forecast jump in earnings per share this year should not be taken to be a sign Hershey’s cost-saving efforts will be bearing fruit on the bottom line just yet. “Investors might have been disappointed by management’s indication that the cost-cutting
programme should only produce substantial impacts from 2018 onwards,” Howard said. “2017 adjusted EPS of $4.72-$4.81 at first glance seems above consensus expectations of $4.64, but once adjustments are made for lower tax rates (-21c) and accounting changes (-5c), the midpoint is actually 14c below prior consensus, probably driven by the delayed impact of the cost-cutting programme.”

The company expects to see growth in its EBIT margins in 2017, though it cautioned the rate of growth would not be as high as in 2016, as it plans to reinvest some of the savings back into the business.

Hershey also gave a forecast for its top line, predicting its net sales would grow by 2-3%, a step up from the 0.7% growth in 2016 and the 0.5% fall in 2015. Barclays’ Lazar, however, noted how it seemed Hershey’s forecast meant its expectations for its organic growth would be its long-term plans. “We note that Hershey’s 2017 implied organic sales forecast (+1.75-2.75% year-on-year) sits below its long-term algorithm (+3-5%). Then again, perhaps we should not fully surprised with this more muted underlying outlook, as an expectation reset often comes alongside a new CEO.” Michele Buck, Hershey’s COO, is set to move to the CEO’s chair on 1 March when J.P. Bilbrey steps down from the role. Bilbrey will remain as chairman.

Hershey’s cautious optimism on North America

With China proving the major problem for Hershey in 2016, it was something of a surprise in October, when Hershey reported its third-quarter results, to hear the company say the revenue from its business in North American business had come in below expectations during that period. Hershey watchers, then, were keen to hear how the Reese’s maker had performed in its home – and largest – market during the final three months of 2016 and for the company’s outlook for its business there this year.

After a challenging couple of quarters in North America, Hershey upped its investment in advertising and trade support in the fourth quarter. Prices fell but volumes jumped 3.4% and the company said it gained share during Hallowe’en and Holiday – two key selling periods in North America.

Buck expects to see Hershey’s sales growth in North America “accelerate” this year, boosted by the roll-out of its recently-launched Cookie Layer Crunch bars and other new products, including Reese’s Crunchers candy and Krave meat bars and sticks. Reflecting on the challenges Hershey saw in North America last year, Buck pointed to the range re-sets undertaken by a number of its retail customers in the market. “There were some big retailers that implemented cleaner floor policies, and it really took us through mid-last year into Q3 to kind of lap that. And I think once we did we started to see similar momentum there. And I’d also say the other thing I’m encouraged by is, where there has been strong activity in certain categories or with certain brands, there have been strong results. And I look at the high-single digit results we saw on Reese, on Kit Kat, on Ice Breakers this past year, so I feel confident that where we have those we can really drive impact. And I think the results we’re seeing on Cookie Layer Crunch speak to that as well.”

Hershey’s struggles in challenging China

Hershey is a business that, even as it has sought to expand its operations internationally over the last decade or so, generates the majority of its sales and profits in North America.

The company has a strong position in the North American confectionery market and in the US in particular but analysts have been watching the group’s international businesses closely. Growth from North America is set to remain low and the overseas countries on which Hershey has chosen to focus – Brazil, Mexico, India and China – all have confectionery markets that on paper at least give cause for optimism about growth.

That said, China’s confectionery market has been a challenge. In 2015, Hershey booked an impairment charge on Chinese unit Shanghai Golden Monkey, while having to downgrade its sales forecasts for the business part-way through the year. Hershey’s four downgrades to its sales forecasts during 2016 had China as a central factor. Not all of Hershey’s problems in China have been down to the business. The chocolate category, in particular, has been at times under pressure; Hershey said chocolate category sales fell 4% in China during the fourth quarter. However, over the same period, Hershey’s own chocolate sales dropped 11%, another indication of the tough task on the company’s hands there.

Speaking to analysts on Friday, Buck said: “Overall CPG performance in the modern trade [in China] is not where we thought it would be. Many categories were sluggish, including chocolate where the category declined about 7% for the full year. While our Chinese New Year sell-in was good, we’ll have to wait until sell-through data is available to determine our net seasonal results.” In Hershey’s other focus markets, fourth-quarter sales were “increased nicely” on a constant-currency basis, Buck noted.

At Morningstar, Lash reflected: “We’ve long thought Hershey may be challenged as it extends abroad, and our forecast calls for international sales to remain muted in fiscal 2017, before resuming a high-single-digit rate of top-line growth in fiscal 2018 as investments to reignite operations – by extending its product and distribution reach – take hold.”

All eyes on 1 March investor day

As well as Buck formally taking on the reins, the start of March will see Hershey host an investor day. There were a number of times on the fourth-quarter results call on Friday when Hershey’s management said they would give more details on certain issues on 1 March.

One topic set to be high on the agenda is Hershey’s cost structure. In April, Hershey upped its target for annual cost savings in a bid to be able to invest in its brands while achieving its targets on earnings. The company has “continuous improvement and productivity” programmes it follows each year to control costs. From next year and through to 2019, Hershey will have a target of saving “about US$100m” through those initiatives. The major listed US food companies have come under some pressure to work on their costs, not just due to sluggish sales trends across the sector but due to the emergence of the cost-focused, margin-driving 3G Capital in the sector through its acquisition of HJ Heinz and subsequent merger of that business with Kraft Foods Group.

Morningstar’s Lash believes Hershey could outline plans for more savings beyond those programmes on 1 March. “In light of the erosion in profitability, management seems laser-focused on driving improvement, alluding to plans to ramp up its cost savings beyond current efforts,” she said, reflecting on the fourth-quarter results announcement.

On the other side of the coin, the investor day will likely see Hershey set out where it believes it can invest to drive its margins. Buck said on Friday: “We started to take a fresh look at our business operations and our investment choices in 2016, and we’ll share more about this in March. The goal of these margins for growth efforts is to improve overall margins, particularly in our international and other segment. We expect that this will be a multi-year programme, enabling us to achieve strong margin and EPS growth in 2018 and 2019, and provide us with the fuel to deliver consistent annual net sales and EPS growth post-implementation.”

At Barclays, Lazer posited whether similar recent programmes at Hershey’s US food peers to drive margins will play out in the same manner at the York chocolate owner. “While we would expect further detail around Hershey’s ‘margin for growth’ programme to include both an absolute savings and margin target, frankly, we would expect this initiative to embed a more balanced approach towards re-investment than some of the programmes laid forth by many of Hershey’s peers. That is, given Hershey’s already above-average EBIT margin (circa 20%, versus a circa 15% average, excluding Kraft Heinz) and exposure to higher-growth categories, we believe the same playbook employed by its peers may not necessarily apply.”