Business Context and Reporting Period
Company: The Hershey Company
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: October 2, 2005
Business Overview: The Company manufactures and sells chocolate and non-chocolate confectionery products. The reporting period covers the third quarter and the first nine months of fiscal year 2005. The Company is an accelerated filer and is not a shell company.
Key Financial Metrics
| Metric (in thousands) | Three Months Ended Oct 2, 2005 | Nine Months Ended Oct 2, 2005 |
|---|---|---|
| Net Sales | $1,368,240 | $3,483,101 |
| Cost of Sales | $849,486 | $2,139,316 |
| Gross Margin % | 37.9% | 38.6% |
| Net Income | $119,475 | $335,057 |
| Diluted EPS | $0.48 | $1.34 |
| Operating Cash Flow (9mo) | $13,009 | |
| Cash and Equivalents | $37,898 (as of Oct 2, 2005) | |
| Short-term Debt | $834,954 (as of Oct 2, 2005) | |
| Long-term Debt | $943,104 (as of Oct 2, 2005) |
Material Changes vs. Prior Period
- Revenue Growth: Net sales increased 9.1% in the third quarter and 10.2% for the nine-month period compared to 2004. Growth was driven by unit volume (new products, international performance) and price realization, with acquisitions contributing approximately 2.6% to 2.9% of the increase.
- Profitability Decline: Net income decreased 28.1% in the quarter and 20.3% for the nine months. This decline was primarily due to a $101.4 million pre-tax business realignment charge ($84.8 million in operating expenses and $16.6 million in cost of sales).
- Margin Compression: Gross margin decreased from 39.7% to 37.9% in the quarter. Factors included the realignment charges, higher raw material/labor costs, and a less favorable product mix (lower-margin seasonal items and international businesses).
- Cash Flow Volatility: Operating cash flow for the nine months dropped significantly to $13.0 million from $363.4 million in the prior year. This was largely due to a $275.5 million contribution to pension plans (vs. $2.5 million in 2004) and increased working capital needs.
- Debt Levels: Short-term debt increased to $834.9 million from $343.3 million at year-end 2004 to fund seasonal needs, stock repurchases, and pension contributions. The capitalization ratio rose to 67.6%.
Guidance, Outlook, and Risks
- Business Realignment Program: The Company estimates total pre-tax charges of $140 million to $150 million for the program, with approximately 90% recorded in 2005. The program is expected to generate annual savings of $45 million to $50 million upon full implementation by December 31, 2006.
- Cost Outlook: Management expects broadly higher input costs for raw materials, packaging, and energy in the future due to economic uncertainty.
- Acquisitions: Completed acquisitions of Joseph Schmidt Confections and Scharffen Berger Chocolate Maker for a combined $47.1 million (subject to adjustment up to $61.1 million).
- Stock Repurchases: Completed the $500 million 2002 repurchase program. Under the 2005 program, $163.0 million remains available for repurchases.
- Accounting Changes: The Company is required to adopt SFAS No. 123R (Share-Based Payment) effective January 1, 2006, which is expected to reduce diluted EPS by approximately $0.08 to $0.10 on an annualized basis.
- Risks: Key risks include the ability to realize savings from the realignment program, changes in consumer preferences, raw material cost volatility, and pension cost factors.
Investor Verification Checklist
- Realignment Charges: Verify the composition of the $101.4 million charge and the projected timeline for the remaining $40-$50 million in charges expected in 2006.
- Pension Contributions: Confirm the impact of the $275.5 million pension contribution on future liquidity and whether similar large contributions are anticipated.
- Debt Maturity: Review the maturity schedule for the increased short-term debt ($834.9 million) and the $200 million of 10-year notes retiring in October 2005.
- Acquisition Integration: Monitor the performance of the Joseph Schmidt and Scharffen Berger acquisitions against the $25 million combined annual sales baseline.
- EPS Impact of SFAS 123R: Assess the specific valuation method the Company will use for stock options under the new standard, as this will directly impact future earnings.