Business Context and Reporting Period
Company: The Hershey Company
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2006
Business Overview: The largest North American manufacturer of quality chocolate and confectionery products. The company operates as a single reportable segment, aggregating operations in the Americas (U.S., Canada, Mexico, Brazil) and other international locations. Principal product groups include confectionery, snack products, gum and mint refreshment, and food/beverage enhancers.
Key Financial Metrics (2006)
| Metric | 2006 Value | 2005 Value |
|---|---|---|
| Net Sales | $4,944.2 million | $4,819.8 million |
| Net Income | $559.1 million | $488.5 million |
| Diluted EPS | $2.34 | $1.97 |
| Gross Margin | 37.8% | 38.7% |
| EBIT Margin | 20.1% | 17.7% |
| Operating Cash Flow | $723.2 million | $461.8 million |
| Total Assets | $4,157.6 million | $4,262.7 million |
| Total Debt (Short + Long Term) | $2,092.1 million | $1,761.9 million |
| Stockholders' Equity | $683.4 million | $1,016.4 million |
Note: Stockholders' Equity decreased significantly in 2006 due to the adoption of SFAS No. 158 (pension accounting) and share repurchases.
Material Changes vs. Prior Period
- Revenue Growth: Net sales increased 2.6% to $4.94 billion, driven by U.S. confectionery volume increases, new product sales, and improved price realization. This was partially offset by lower sales in Canada due to a product recall.
- Profitability: Net income rose 14.4% to $559.1 million. EBIT increased 16.3% primarily due to significantly lower business realignment charges ($11.6 million in 2006 vs. $119.0 million in 2005).
- Margins: Gross margin declined 0.9 percentage points to 37.8% due to higher raw material and energy costs, product obsolescence, and unfavorable sales mix. However, EBIT margin improved to 20.1% due to reduced administrative costs and lower realignment charges.
- Balance Sheet: Total assets decreased slightly. Long-term debt increased by $305.4 million following the issuance of $500 million in notes in August 2006. Stockholders' equity dropped by $333 million, largely due to the reclassification of pension assets/liabilities under SFAS No. 158.
- Cash Flow: Operating cash flow improved significantly to $723.2 million, aided by lower pension contributions ($23.6 million in 2006 vs. $277.5 million in 2005).
Guidance, Outlook, and Risks
Management Commentary and Outlook
Management described 2006 as a "difficult year" with a slowdown in retail performance in the second half. For 2007, the company plans to accelerate growth by focusing on core confectionery products and revitalizing iconic brands (Hershey's, Reese's, Kisses).
- 2007 Sales Growth: Expected to be within the long-term goal of 3% to 4%.
- 2007 EBIT Growth: Expected to grow 3% to 4% (excluding items affecting comparability).
- 2007 EPS Growth: Expected to increase 7% to 9% (excluding items affecting comparability), driven by share repurchases.
- Supply Chain Transformation: In February 2007, the Board approved a three-year program to enhance manufacturing and sourcing. This is expected to incur pre-tax charges of $525 million to $575 million over three years, with approximately $300 million expected in 2007. The program aims to generate annual savings of $170 million to $190 million by 2010.
Risks and Contingencies
- Raw Material Costs: Significant exposure to cocoa, sugar, milk, and peanut prices. While hedging is used, cost increases may not be fully offset by price increases.
- Customer Concentration: McLane Company, Inc. accounted for more than 25% of total net sales in 2006.
- Product Recall: A contaminated ingredient in Canada caused a product recall and temporary plant closure in Q4 2006, negatively impacting results.
- Competition: Intense competition in the global confectionery and snack markets.
Investor Verification Checklist
- Supply Chain Charges: Verify the timing and magnitude of the $525-$575 million charges associated with the new supply chain transformation program announced in February 2007.
- Raw Material Hedging: Assess the effectiveness of hedging strategies given the volatility in cocoa and sugar prices and the company's reliance on forward purchasing.
- Customer Concentration: Monitor the relationship with McLane Company, Inc., which represents over 25% of sales, and the potential impact of any changes in that distributor's strategy.
- Pension Funding: Review future pension funding requirements, noting that while 2006 contributions were low ($23.6M), the company adopted SFAS No. 158 which impacts balance sheet presentation of pension obligations.
- Share Repurchases: Confirm the execution of the $250 million share repurchase program approved in December 2006 and its impact on EPS.