The Hershey Company — Q2 2010 Form 10-Q
Business context and period. Hershey reported results for the three and six months ended July 4, 2010, compared with periods ended July 5, 2009. Results are seasonal and the company cautions that first-half performance may not indicate full-year results.
Financial performance
| Metric | Q2 2010 | Q2 2009 | Six months 2010 | Six months 2009 |
|---|---|---|---|---|
| Net sales | $1,233.2m | $1,171.2m | $2,641.1m | $2,407.2m |
| Gross margin | 44.3% | 38.7% | 43.2% | 37.1% |
| EBIT | $124.4m | $116.7m | $377.8m | $269.6m |
| EBIT margin | 10.1% | 10.0% | 14.3% | 11.2% |
| Net income | $46.7m | $71.3m | $194.1m | $147.2m |
| Diluted EPS, Common Stock | $0.20 | $0.31 | $0.84 | $0.64 |
- Revenue and operations: Q2 sales rose 5.3%, mainly on approximately 3% volume growth, new products, price realization and favorable currency. First-half sales increased 9.7%, with volume, pricing and currency contributing. U.S. consumer takeaway rose 4.0% in Q2 and 5.6% year to date; measured-channel share increased 0.3 points in both periods.
- Profit and margins: Gross margin gains reflected productivity, favorable mix, price realization and lower product-obsolescence costs. These benefits were partly offset by increased marketing and selling costs. Q2 net income fell 34.5%, despite higher EBIT, principally amid higher business charges and a 54.0% effective tax rate versus 24.1%. First-half net income rose 31.9%; the effective tax rate was 41.4% versus 34.0%.
- Cash flow: First-half operating cash flow was $264.8m, down from $446.2m. Management attributed the decline mainly to cash used by other assets and liabilities, including a $133.4m impact from hedging transactions, and lower cash inflows from receivables. Investing cash outflow was $74.1m, including $74.9m of capital and software additions. Financing cash outflow was $195.3m, including $141.7m of dividends and $133.4m of share repurchases.
- Liquidity and debt: Cash was $249.1m at July 4, 2010. Current assets were $1,415.0m and current liabilities $876.0m; the reported current ratio was 1.6:1. Total debt was approximately $1,542.3m, including $1,513.4m of long-term debt and its current portion. No commercial paper was outstanding at quarter-end. The $1.1bn revolving credit facility, with a potential additional $400m subject to lender agreement, expires December 2012; the company reported compliance with its covenants.
- Other financial items: Common Stock dividends were $0.32 per share in Q2. Long-term debt carrying value was $1,513.4m versus fair value of $1,731.3m. The capitalization ratio rose to 68% from 67% at year-end 2009.
Material changes and unusual items
- Q2 business realignment and impairment charges were $85.1m net ($86.2m including charges classified in cost of sales and selling, marketing and administrative expense), versus $37.9m net in Q2 2009. The 2010 charges included a $44.7m non-cash goodwill impairment for Godrej Hershey Ltd. and approximately $40.4m for Project Next Century.
- Project Next Century will move production from Hershey’s century-old East Chocolate Avenue facility to an expanded West Hershey facility; the company expects to reduce approximately 500–600 jobs. Estimated total pre-tax charges and implementation costs are $140m–$170m over three years.
- Management said Godrej Hershey’s growth had been below initial expectations due to slower development and distribution, input costs and macroeconomic conditions. The impairment had no tax benefit.
- Advertising and other marketing costs increased materially: advertising rose approximately 50% in Q2 and 58.5% in the first half. Management also cited legal costs, selling-capability investment, employee costs and expenses related to consideration of a Cadbury transaction.
- Management noted possible additional non-cash pension settlement losses of $12m–$18m in 2010. Sale proceeds for closed facilities could also differ from estimates, resulting in additional charges or credits.
Outlook, commentary and risks
- For 2010, management expected sales growth of about 7%, including approximately 1% from foreign exchange; diluted GAAP EPS of $2.04–$2.12; and adjusted diluted EPS of $2.47–$2.52, excluding business realignment and impairment charges. The company projected full-year charges of $0.40–$0.43 per diluted share, including Project Next Century and the Godrej impairment already recorded.
- Management expected advertising investment to increase 45%–50%, continued productivity and margin improvement, but at a slower pace than in the first half. It cited volatile commodity markets, less price realization after lapping the 2008 price increase, completed Global Supply Chain Transformation savings, less favorable LIFO inventory effects, and a possible shift of seasonal orders from Q4 2010 into Q1 2011.
- Expected 2010 capital additions were $190m–$210m, including $55m for Project Next Century. The company expected a full-year effective tax rate of approximately 35%, excluding the effect of business realignment and impairment charges.
- Key disclosed risks include commodity and energy costs and availability, product demand and competition, pricing elasticity, supply-chain disruption, joint-venture performance, execution and costs of Project Next Century, pension funding, international conditions, product safety, and potential effects of a government investigation into alleged confectionery-industry pricing practices.
- Management stated disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter. It did not anticipate potential tax adjustments having a significant financial impact and expected approximately $10m of reductions in unrecognized tax benefits within 12 months.
Important facts for investors to verify
- Whether the projected 2010 sales and EPS ranges, including the distinction between GAAP and adjusted EPS, were achieved; adjusted measures exclude specified charges.
- Actual costs, timing, workforce reductions and savings from Project Next Century, and whether the planned facility transition proceeds as expected.
- Whether Godrej Hershey’s operating performance supports the remaining carrying value and whether further impairment is necessary.
- Drivers of the substantial year-over-year decline in operating cash flow, particularly hedging-related working-capital movements and cash used by other assets and liabilities.
- Exposure to commodity, foreign-exchange and interest-rate movements; the filing reports hypothetical 10% adverse-movement risks of $47.8m for net commodity positions and $21.2m for foreign-exchange contracts.
- Potential pension settlement losses, facility-sale proceeds, tax-audit outcomes and any developments in the disclosed industry pricing investigation.