Hershey Stock: An SPY Outperformance Case Study (NYSE:HSY)

Introduction

Let’s start from one chart that shows how, since the beginning of this century, The Hershey Company (NYSE:HSY) has outperformed, not to say crushed, the S&P 500 (SPY), no matter how we look at it, if through price % change or from a total return point of view (I like this latter perspective more). We are, in fact, before a 37.43% CAGR when looking at total return. Enticing, isn’t it?

The question that arises is: what has enabled a company like Hershey to achieve such outstanding results? This time, instead of just reviewing the most recent quarterly report, I would like to address in this article because I think we can understand better where returns come from.

Summary of previous coverage

Hershey has been on my watchlist for a while and I discussed in a previous article how the current valuation made me a little uncertain whether to rate it as a buy or as a hold. Just to be transparent, I still have not bought into Hershey. Even though it is on my watchlist, I decided that I had some buys that were a bit more compelling, as I explained in two of my recent articles why I bought Apple (AAPL) and Texas Roadhouse (TXRH) at the close of 2022. This second purchase of mine leans somewhat in the direction of Hershey, as it deals, though from a different bull case, with the food industry in general.

But let’s get to Hershey. It is a company I see as a high-quality one. In fact, Hershey has a strategy targeting an annual 2-4% net sales growth leading an annual 6-8% adjusted EPS growth. However, Hershey has also overdelivered in the past decade, as its adj. EPS CAGR is close to 10%.

What I like about Hershey is that it high profitability thanks to its pricing power and its scalability, two things that help margins stay high and enable the company to invest at a lucrative rate of return.

In addition, I like the fact that, though it owns premium brands in its confectionary products, it is also expanding its salty snack division, since this is a market that is growing more rapidly compared to the other. In fact, just from 2021 to 2022, Hershey saw its North American snacks sales jump 26.7%.

Now, it is true that the consumer staples has been one of the winning sectors of 2022, however, some analysts are also turning bearish on it due to the high valuations most of the stocks in the sector have reached.

Let me be honest. I do look at what analysts say but I just take their analysis as chance to see if my investment thesis is good or flawed. It is always interesting to listen to other people’s opinions to test ours. However, I have come to the conclusion that many analysts do not have my same time frame and are more swing traders rather than long-time investors, so I rarely happen to follow their ratings.

Q3 in short

Hershey’s Q3 results came in for the most part ahead of expectations, with all business segments seeing strong growth. Since the second half of the year is traditionally the strongest one for Hershey, the company felt confident in raising its full year outlook.

In fact, net sales increased 15.6% YoY (11.8% CC) with the new acquisitions of Dot’s and Pretzels being already net sales accretive by 4.1 percentage points.

However, net income decreased by 9.3% to $399.5 million, which gives EPS at $1.94. But if we look at adj. EPS, the increase YoY was 3.3%.

This made the company raise its full year outlook as follows:

• Net sales growth between 14%-15% (prior guidance 12%-14%)
• EPS growth 11%-13% (prior guidance 9%-12%)
• Adj. EPS growth 14%-15% (prior guidance 12%-14%)

There is one more aspect I would like to highlight. In the report, Hershey shows net sales growth rates by segment, reporting also how much of this growth is due to organic price and how much is linked to organic volume/mix. Here we can find something interesting:

• N.A. Confectionery grew 10.7% on a cc basis: 7.7% linked to pricing; 3% due by organic volume/mix growth
• North America Salty Snacks saw 21.5% growth on a cc basis: 12.5% linked to pricing and 9% to volume and mix

Thanks to this data, I understand two things that I like: Hershey is not growing only because of pricing power. This is important, but it may not be always enough. For a company like Hershey, volume and mix is quite important because it shows whether or not it is able to take market share. Keep in mind that we are not talking about the auto industry where once a customer purchases a car it may not buy a new one for another ten years. Here, since we are talking about consumer staples, we are talking about goods that are sold and consumed quite quickly thus needing to be bought once again by customers. As a consequence, gaining market share for Hershey means that it will have more recurrent revenue in the future as every new customer is expected to buy Hershey once again on its next purchase. Hershey’s chocolate products, for example, grew 12.6% YoY, with share gains of over 100 bps. On the other hand, Hershey’s salty snacks gained only 10 basis points of market share during the quarter. This business is becoming a new focus for the company and I expect that in the upcoming quarters we should see some aggressive marketing expense to take more market share from competitors.

The painful note of the report was that gross margin fell to 40.6% from 45% due to well-known factors: raw material cost, packaging inflation, increased labor costs. Overall, we are still before a best-in-class gross margin that has proven to be quite resilient even when under a lot of pressure. As inflation eases, I think it is rather easy to say that we will see the gross margin going upwards once again.

Overall, the report proved to me that Hershey is well-managed and that it keeps on growing at a steady pace with long-term investments in focus, such as the expansion of the salty snacks division.

What drives stock performance

Now, let’s tackle the question: how can a stock of a so-called “boring” company achieve a CAGR of 37.43% since the beginning of the century when its EPS usually grow around 9% a year?

Just to get an idea of what we are talking about let’s consider these two numbers:

• $1 of EPS in 2000 that grows at a CAGR of 9% becomes $6.65 at the end of 2022.
• $1 invested in the stock in 2000 is now worth $1,500.

So the question is: where do returns come from?

Many would answer: from EPS growth. But this is not enough to explain the whole picture, as the graph below shows.

We can say that more or less 22% of the total return came from EPS. But where does the remaining 78% come from?

I think we need to start from the top line of every income statement. Revenue growth is in fact the very first number that is reported as it gives a sense of how the company is growing. In addition, there are companies, such as Costco, whose business model is really top-line centered. Now, Hershey grew its revenue by 125.9% since 2000. Still this is not enough to explain the whole picture.

Let’s take another step and let’s look at net income growth. Since 2000, Hershey grew its bottom line by 244.1%. This is a very good sign meaning that every dollar of revenue has, over time, led to higher earnings. As a consequence, every dollar of revenue has become more valuable. The key is margins: Hershey has been able to improve its margins greatly to the extent that its net income has grown almost twice as fast as its revenue.

Now, 125.9%+244.1% gives us 370%.

Now net income growth can be different from EPS growth because the latter is affected by the number of shares outstanding, that can be increased through dilution or reduced through stock buybacks. Since the beginning of 2000, Hershey has been able to reduce its shares outstanding by 26.43% and this, too, contributes to the total return.

There is one last number we have to look at before we do some calculations: dividend growth. Here Hershey has a big surprise: since 2000, its dividend has grown by 696.9%. This is equal to 46.7% of the total return and it is quite impressive if we think about it.

Let’s look at the final chart:

And let’s do some math:

Revenue growth 125.9% + net income growth 244.1% + EPS growth 346.2% + dividends 696.9%=1,413.1%

Let’s add buybacks with a 26.43% and we reach 1,430.5%.

So where does the remaining 70% come from? The answer is multiple expansion.

As we can see, at the very beginning of 2000 the stock was trading at a P/E ratio below 15, a multiple the stock has never seen since then, as it usually it has traded between 20 and 30.

Right now, the stock trades at the high end of its usual range and its P/E is about twice the initial one. This gives us another 100% that we can add to our calculation. This would lead us to 1,530.5% which is just slightly more of the total return Hershey stock has achieved. It can be explained easily: multiples bake in future expectations and the current multiple somewhat expects the company to keep delivering good results in the future.

Conclusion

In my past article, I shared a discounted cash flow model that made me understand that, although Hershey is trading near its all-time highs, it is indeed reasonable to expect it to keep on growing its free cash flow. I stick to that model which has become even more conservative now that Hershey has raised its guidance.

However, I hope this article shows that only looking at multiples may be somewhat misleading because they are just a part of a much greater picture.

And when we look at Hershey’s total returns and its full performance, we see many things that seem to justify a P/E in the high 20s. This is why I keep saying that Hershey is one of the most promising stocks to hold for a decade or more.