Business Context and Reporting Period
Company: The Hershey Company
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: April 1, 2007
Business Overview: The Company manufactures and distributes confectionery products, snacks, and beverages. The first quarter is typically a seasonal period, and results may not be indicative of full-year performance.
Key Financial Metrics
| Metric (in thousands) | Q1 2007 | Q1 2006 |
|---|---|---|
| Net Sales | $1,153,109 | $1,139,507 |
| Cost of Sales | $739,078 | $707,365 |
| Gross Profit | $414,031 | $432,142 |
| Gross Margin | 35.9% | 37.9% |
| Income Before Interest & Taxes (EBIT) | $170,053 | $212,017 |
| Net Income | $93,473 | $122,471 |
| Diluted EPS (Common Stock) | $0.40 | $0.50 |
| Operating Cash Flow | $303,520 | $165,990 |
| Cash and Equivalents (End of Period) | $60,483 | $43,940 |
| Total Debt (Short-term + Long-term) | $1,970,807 | $1,903,361 |
Material Changes vs. Prior Period
- Revenue: Net sales increased 1.2% to $1.15 billion, driven by volume increases from new products and growth in Canada and Mexico. This was partially offset by lower price realization due to higher promotional spending and returns.
- Profitability: Net income decreased 23.7% to $93.5 million. EBIT declined 19.8% primarily due to a significant increase in business realignment charges.
- Business Realignment Charges: A net charge of $27.5 million was recorded in Q1 2007 (vs. $3.3 million in Q1 2006). This relates to a new three-year supply chain transformation program involving fixed asset impairments, plant closures, and employee separation costs.
- Gross Margin: Declined 200 basis points to 35.9%. Approximately half of the decline is attributable to the realignment charges; the remainder reflects higher raw material, fuel, and packaging costs.
- Interest Expense: Net interest expense increased 12.1% to $28.3 million due to higher interest rates and the issuance of $500 million in long-term debt in August 2006.
- Cash Flow: Operating cash flow improved significantly to $303.5 million (vs. $166.0 million), aided by a reduction in accounts receivable. However, financing activities used $298.4 million, primarily for debt repayment ($188.7 million) and share repurchases ($150.0 million).
Guidance, Outlook, and Risks
Management Commentary and Outlook
- Input Costs: Management revised full-year 2007 expectations due to significant, unexpected increases in dairy input costs announced by the USDA in April 2007. Dairy markets are not easily hedged for long periods.
- Realignment Program: The Company expects total pre-tax charges for the supply chain transformation to be between $525 million and $575 million over three years. Approximately $270 million to $300 million is expected in 2007.
- 2007 Guidance (Excluding Realignment Charges):
- Sales Growth: Expected to be within the long-term goal of 3% to 4%.
- Gross Margin: Expected to be essentially flat.
- EBIT Margin: Expected to decline somewhat due to maintained brand investment levels despite higher costs.
- Diluted EPS: Expected to increase 4% to 6% compared to 2006.
- Q2 2007 EPS: Expected to be $0.34 to $0.35 (excluding realignment charges), impacted disproportionately by the interim accounting of the new dairy costs.
Risks and Contingencies
- Commodity Prices: Significant exposure to dairy, cocoa, and sugar prices. Recent dairy price hikes are expected to reduce earnings.
- Supply Chain Transformation: Risks related to executing the realignment plan within the anticipated timeframe and cost estimates.
- Canada Recall: A receivable of $14.0 million is recorded for damages related to a Q4 2006 product recall and plant closure in Canada caused by a contaminated ingredient. Recovery depends on third-party liability.
- Tax Audits: The Canada Revenue Agency is auditing returns for 1999-2002 regarding transfer pricing. Management does not anticipate a significant impact.
Subsequent Events
- India Joint Venture: Agreed to form a 51% owned joint venture with Godrej Beverages and Foods, Ltd. to manufacture and distribute products in India.
- Price Increase: Implemented a 4% to 5% wholesale price increase on domestic confectionery lines to offset input costs.
- Strategic Partnership: Announced a strategic supply and innovation partnership with Barry Callebaut AG, including a minimum supply agreement of 80,000 tonnes of chocolate annually.
Investor Verification Checklist
- Dairy Cost Impact: Verify the magnitude of the USDA dairy price increase and its specific impact on Q2 and full-year 2007 margins.
- Realignment Execution: Monitor the progress of the supply chain transformation and the timing of the expected $270-$300 million in charges for 2007.
- Canada Recall Recovery: Track the status of the $14.0 million receivable related to the Canadian product recall.
- Market Share: Review subsequent quarters for market share trends, as Q1 2007 saw a 1.2 share point decline in measured channels.
- Share Repurchases: Confirm the remaining $150 million authorization under the December 2006 repurchase program and future buyback activity.