HSY

Business Context and Reporting Period

This Form 10-Q covers The Hershey Company for the quarterly period ended September 30, 2007, and the nine months ended September 30, 2007. The company is a large accelerated filer incorporated in Delaware. The reporting period includes the impact of a comprehensive three-year supply chain transformation program announced in February 2007, as well as the consolidation of the Godrej Hershey Foods and Beverages Company in India (acquired May 2007) and an equity investment in a joint venture in China.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue: Net sales for the three months ended September 30, 2007, decreased 1.2% to $1,399.5 million compared to $1,416.2 million in the prior year. For the nine months, sales were essentially flat, down 0.1% to $3,604.5 million. The decline was driven by lower U.S. sales volume and reduced price realization due to higher promotional spending, partially offset by international growth and the Godrej acquisition.
• Profitability: Net income dropped significantly, down 66.1% for the quarter and 60.6% for the nine months. This decline was primarily driven by a $112.0 million business realignment charge in the quarter (compared to $1.6 million in 2006) and a $219.3 million charge for the nine months (compared to $9.1 million in 2006).
• Costs: Cost of sales increased 6.7% for the quarter and 7.6% for the nine months, largely due to higher input costs (particularly dairy) and business realignment charges. Gross margin declined from 38.5% to 33.6% for the quarter.
• Liquidity: Cash and cash equivalents decreased by $55.6 million during the nine-month period. Short-term debt increased significantly to $1,086.1 million from $655.2 million at year-end 2006 to fund working capital needs and share repurchases.

Guidance, Outlook, and Risks

• Full Year 2007 Outlook: Management revised expectations, now forecasting full-year net sales to be essentially even with 2006 (excluding the Godrej acquisition, sales are expected to decline ~1%).
• Realignment Charges: Total pre-tax charges for the 2007 supply chain transformation are expected to be between $525 million and $575 million. For the full year 2007, charges are now expected to be $380 million to $400 million ($1.03 to $1.08 per share diluted).
• Earnings Guidance: Excluding business realignment charges, diluted EPS for 2007 is expected to be in the range of $2.08 to $2.12. Reported diluted EPS is expected to be $1.00 to $1.09.
• Management Changes: In October 2007, CEO Richard H. Lenny announced his intention to retire at the end of 2007. David J. West was named President and will assume the role of CEO on December 1, 2007.
• Risks: Key risks include the ability to execute the supply chain transformation, rising raw material costs (especially dairy), the outcome of litigation regarding a product recall in Canada, and pension cost factors.

Investor Verification Checklist

• Realignment Charge Timing: Verify the specific timing and composition of the $380-$400 million in expected 2007 realignment charges, as earlier-than-expected severance costs impacted Q3 results.
• Dairy Cost Hedging: Assess the company's exposure to rising dairy costs, as management noted the inability to hedge these costs effectively due to market structure.
• Canada Recall Litigation: Monitor the status of the claim for damages related to the Q4 2006 product recall in Canada, which resulted in a receivable of approximately $17.9 million.
• Share Repurchase Program: Confirm the remaining availability of the $250 million share repurchase program approved in December 2006 ($100 million remained as of Sep 30, 2007).
• Debt Covenants: Review compliance with financial covenants in the $1.1 billion revolving credit facility and the new $300 million short-term credit agreement, given the increased leverage ratio (81% capitalization ratio).