The Hershey Company — Q3 2014 Form 10-Q
Business context and reporting period. The filing covers the quarter and nine months ended September 28, 2014; comparative periods ended September 29, 2013. Hershey reported seasonally influenced results for its confectionery business. The company completed its acquisition of 80% of Shanghai Golden Monkey (SGM) on September 26, 2014, and consolidated Lotte Shanghai Food Company (LSFC) after obtaining operational control in March 2014.
Financial performance
| Metric | Q3 2014 | Q3 2013 | First nine months 2014 | First nine months 2013 |
|---|---|---|---|---|
| Net sales | $1,961.6 million | $1,853.9 million | $5,411.7 million | $5,189.8 million |
| Gross margin | 43.8% | 46.1% | 45.3% | 46.7% |
| EBIT | $366.2 million | $370.6 million | $1,047.3 million | $1,031.4 million |
| EBIT margin | 18.7% | 20.0% | 19.4% | 19.9% |
| Net income | $223.7 million | $233.0 million | $644.4 million | $634.4 million |
| Diluted EPS, common stock | $1.00 | $1.03 | $2.86 | $2.79 |
| Effective tax rate | 35.2% | 33.2% | 34.5% | 34.3% |
Q3 sales increased 5.8% (6.0% excluding foreign exchange); nine-month sales grew 4.3% (4.9% excluding foreign exchange). U.S. candy, mint and gum takeaway rose 3.3% for the 12 weeks ended October 4, with market share up 0.5 points; year-to-date takeaway increased 2.3% and share rose 0.2 points.
- Margins and earnings: Q3 gross margin fell 230 basis points and EBIT declined 1.2%. Higher dairy and other input costs, unfavorable mix, elevated trade activity, packaging obsolescence, and freight and warehousing costs outweighed productivity savings. Nine-month gross margin decreased 140 basis points, while EBIT increased 1.5%.
- Cash flow: Nine-month operating cash flow was $387.4 million, down from $623.7 million. Investing used $692.4 million, including $362.4 million for acquisitions and $98.3 million for short-term investments; financing used $336.5 million. Cash and equivalents declined $641.4 million to $477.1 million. Capital additions and capitalized software totaled $232.3 million.
- Liquidity and debt: Cash and short-term investments were $575.4 million at quarter-end. Current assets were $2.53 billion and current liabilities $2.19 billion. Short-term debt was $649.2 million, current long-term debt $250.9 million, and long-term debt $1.56 billion. Short-term debt included $330.0 million of commercial paper; the company said it expected to repay the commercial paper by mid-November. A $1.0 billion revolving credit facility was available through November 2018, and Hershey was in compliance with its covenants.
- Capital returns: Nine-month dividends paid were $325.2 million and share repurchases were $542.6 million. The February 2014 $250 million repurchase authorization had $175 million remaining at quarter-end. Q3 dividends per share were $0.535 for common stock and $0.486 for Class B stock.
Material changes and unusual items
- SGM was acquired for cash consideration of $393.2 million for an 80% interest; a $100.1 million liability was recorded for the contractually agreed purchase of the remaining 20%, subject to approvals and closing conditions. SGM had approximately $200 million in annual sales. Its purchase-price allocation was preliminary.
- Hershey’s LSFC ownership increased from 44.1% to 50%, and amended governance gave it operational control. Hershey began consolidating LSFC and recorded a $4.6 million gain related principally to remeasurement of its previously held interest.
- Q3 included a $13.3 million noncash impairment of an indefinite-lived trademark associated with a non-chocolate brand. Business realignment and impairment charges totaled $16.4 million for the quarter and $20.5 million year to date.
- Inventories increased to $900.7 million from $659.5 million at December 31, 2013; the filing attributes part of the increase to acquisitions, China growth needs, and bulk purchases of certain ingredients at favorable prices.
- The company agreed in October to acquire all of Allan Candy Company for approximately $28 million, subject to regulatory approval and a working-capital adjustment; closing was expected by year-end 2014.
Outlook, commentary and risks
- 2014 outlook: Management estimated full-year net sales growth of about 4.75%, including foreign exchange and less than 1% contribution from 2014 acquisitions. It expected gross margin to decline about 60 basis points versus 2013. Reported diluted EPS guidance was $3.88–$3.92, or 8%–9% growth; adjusted diluted EPS guidance was $4.01–$4.03, or about 8% growth. The adjusted measure is non-GAAP.
- 2015 outlook: Management projected net sales growth of 7%–9%, including foreign exchange and about 2.5% contribution from acquisitions; gross-margin expansion; reported diluted EPS of $4.27–$4.40, or 10%–12% growth; and adjusted diluted EPS of $4.37–$4.47, in line with its 9%–11% long-term target. India product-line changes were expected to reduce 2015 sales growth by about 40 basis points.
- Management cited strong U.S. marketplace performance, new-product contributions, and solid holiday orders, but noted irregular food-channel traffic and weaker nonseasonal candy sell-through. International performance was mixed; full-year sales growth outside the U.S. and Canada, excluding acquisitions, was revised to the low double digits from about 15%.
- Risks include commodity and energy-cost inflation, pricing elasticity, product demand and competition, product quality and safety, supply-chain disruption, execution and integration of acquisitions, international-market conditions, and information-technology disruption. The company said its listed risk factors had not materially changed from its 2013 Form 10-K.
- U.S. direct-purchaser antitrust plaintiffs appealed a summary judgment in Hershey’s favor; other U.S. plaintiff groups dismissed their cases with prejudice, subject to possible reinstatement if the appeal succeeds. Canadian civil cases were settled; Hershey Canada had pleaded guilty to one count of price fixing in 2013 and paid an approximately $4.0 million fine. Management did not expect the proceedings to materially affect financial position or liquidity, but said a future fine, settlement, or judgment could materially affect results or cash flows in the period recorded or paid.
- Hershey identified increased commodity market sensitivity: the estimated impact of a hypothetical 10% adverse move in net commodity positions was $44.6 million, versus $10.6 million at December 31, 2013. Disclosure controls were reported effective, with no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether pricing actions and productivity gains offset dairy and other input-cost inflation without materially weakening volumes or mix.
- Whether working-capital needs normalize and operating cash flow recovers seasonally, and whether commercial paper was repaid as expected.
- SGM and LSFC integration, SGM’s final purchase-price allocation, and the closing and contribution of the remaining SGM interest and Allan Candy acquisition.
- Progress and outcome of the U.S. antitrust appeal, and any material developments in tax audits or other contingencies.
- Actual results against 2014 and 2015 guidance, including the assumptions and exclusions underlying adjusted, non-GAAP EPS.