Sugar, almond and peanut prices also increased in 2014 due to drought, import duties and supply constraints.

In summary, commodity prices, which are well outside of its control, impact Hershey’s cost structure in a meaningful way. However, there are a few points that bring us solace. First, Hershey is not alone in being impact by commodity prices. Nearly every other CPG company and every other company is in some way impacted by increases in commodity prices.

Second, the recent price decline of some of HSY’s key inputs is likely to benefit the bottom line. Third, Hershey initiated an ~8% price increase in July 2014 to account for higher input costs, packaging, fuel and transportation. If we couple the relief on commodity prices with the price increase, there may be a double benefit to the bottom line. It’s worth pointing out that the price increase won’t benefit revenue until later in 2015 because of higher trade promotions in the near term.

Most importantly, I believe that Hershey’s brands and products are strong enough to weather most commodity price volatility and demonstrate strong pricing power – an ability to pass these costs on to consumers over some period of time without a significant impact to demand.

While it is now making the right strategic moves, Hershey is late to the game in responding to the evolving consumer trend for “wholesome” food and “cleaner” label

We have previously noted that Hershey is moving in the right strategic direction with regards to “cleaner” ingredients and ingredient sourcing. It’s worth noting here that Hershey has been spared or lucky in that it hasn’t been singled out as “evil” like many of the large CPG companies. As previously discussed, this is likely due to the fact that Hershey deals in indulgences where consumers tend to care less about the source and quality of ingredients than certain other food products (vegetables and meat for example). Additionally, Hershey is a smaller company than many of it peers, which makes it less likely to be targeted by NGOs and the like. Hershey has made the right strategic decisions in moving towards a “cleaner” label with no artificial ingredients, colors, etc. but it needs to execute swiftly as it is already late to the game and consumers won’t be forgiving for much longer.

What’s up with the International segment?

The International segment has experienced strong double-digit revenue growth but declining profits over the last 3 years and international expansion has been slow, too slow.

International segment operating margins hovering near 5% are significantly depressed versus North America operating margins near 30%. It seems like the International segment will continue to have depressed margins for some time as new launches in new markets or immature markets require more investment in trade, consumer promotions, advertising and headcount. The alternative is that Hershey not invest internationally. This is a challenging situation for management because they have experienced domestic success and are constantly being pushed to move internationally by outside forces and competitors. But international expansion may not make sense if it leads to significant deterioration of profits and cash flow.

In international markets, Hershey lacks the competitive advantages like scale and strong brand recognition that it benefits from in its home market. Companies can be very successful for a very long time by dominating a certain niche like a certain product or geographic area, as Hershey has been able to do in North America for a very long time. And I see no signs of Hershey's position in North America abating.

I am hopeful that international operating margins improve in ~5 years as the company achieves greater scale and brand awareness in some international markets that would enable it to reduce upfront costs and heavy investments in marketing.

I often praise management for being disciplined about growth especially into verticals or geographies they don’t completely understand, but I am a bit critical in the case of Hershey. Competitors like Nestle and Mondelez have established their brand footprints across international geographies, while Hershey has been very slow in growing its strong brands outside of the US. This is despite investments and a desire to do so. I would be less critical if Hershey had made a conscious decision to focus its energy on maintaining its strong position in North America and returned the excess cash flow to shareholders. But this isn’t the case. They have spent a considerable amount of shareholder money and invested significant resources with very little to show for it in the international arena. Brands like Reese’s Peanut Butter Cups and Kisses have the potential for strong sales in international markets, but Hershey has thus far been ineffective in this regard. They need to either go big or go home when it comes to International.

Hershey’s move up market has historically been too slow.

Hershey management has historically been complacent when it comes to moving upmarket – more premium products with higher price points. Consumers have demonstrated a willingness to trade up and pay for more premium products made with better ingredients, especially in the chocolate and indulgence space and I believe that Hershey has not done a great job capitalizing on this demand thus far.

Hershey acquired Dagoba- a specialty maker of organic chocolate in 2006, but since then, there hasn’t been much done to develop this brand. The brand’s distribution is still fairly limited and the brand’s key digital properties (website, facebook) look like they are stuck in the 90’s. This is all the while smaller organic and specialty artisan brands are experiencing double digit growth rates. Hershey needs to invest the marketing dollars and prioritize distribution for Dagoba so it can claim its share of the organic/specialty growth and not concede all of the growth in this space to the hundreds of new smaller competitors like Tcho, Theo and Green & Black to name just a few.

Hershey also acquired Scharffen Berger Chocolate, a high-end chocolate maker, in 2005. While they subsequently experienced some challenges with ethical sourcing, Hershey has since invested more resources in growing and developing the Scharffen Berger brand.

The more recent acquisition of Krave also demonstrates a recent willingness to move up market (in this case within the snacking category), but only time will tell if Hershey will invest the resources to grow this brand in a meaningful way.

The ownership structure will prevent activist or acquisition related forces from exploiting any price-value gap.

Hershey has two classes of stock– Common Stock and Class B Common Stock. The Class B shares have 10 votes per share while Common shares have only 1 vote per share.

The Hershey Trust Company (a trust formed to manage the founder’s donation of his fortune to charity) currently owns 7.7% of the Common Stock and 99.9% of the Class B stock and thus effectively exercises voting control over the Company. Given that the Class B shares do not trade publicly and the Hershey Trust Company intends to maintain its ownership of these shares, it would be nearly impossible for a third party to acquire majority ownership of the voting stock in the company to drive management or operational changes. Thus, an investment in HSY is not for investors that want performance driven by a catalyst like an activist or think that the company should be acquired. Due to the special ownership structure, it is highly unlikely that Hershey would be acquired by a larger company or that Hershey would quickly adopt some type of transformation agenda pushed by an activist. In fact, the Hershey Trust did almost sell its ownership stake to Wrigley or a joint venture between Nestle and Cadbury back in 2002. The community and state of Pennsylvania put up a lot of legal hurdles to block the sale and the Board eventually halted it.

This ownership structure isn't much matter to us at Scuttlebutt though. We don’t typically rely on catalysts or events of this nature to close the gap between price and value. However, we did think it was important to point out this unusual ownership structure to the newbie Hershey investor. Rather we are students of Benjamin Graham who said at a Senate Committee hearing in 1955, “We know from experience that eventually the market catches up with value.” Thus, this unique ownership structure doesn’t change our fundamental thesis.

Management

John Bilbrey has been the man at the helm for the last 4 years, since 2011 when he was promoted from Chief Operating Officer. Prior to 2010, Bilbrey served roles as head of North America and as head of International. He has a wealth of consumer packaged goods experience including 22 years of experience at Proctor & Gamble, the company that created the discipline of brand management.

I would evaluate Bilbrey’s record during his tenure as pretty good. During that time, the stock has modestly outpaced the return of the S&P: +71% gain for HSY versus 67% gain for the S&P 500 (not including dividends) but trounced the return of its competitors in the food industry.

Additionally, Bilbrey has been a prudent capital allocator of capital during his tenure. He has made smart acquisitions (Krave, Brookside) as of late and also dedicated more investment to brand marketing. He has also been friendly towards shareholders by diverting an increasing portion of cash flow towards dividends and share repurchases. Bilbrey ramped up the dividend since he joined in 2011. Dividend increases were only ~7% in 2010 and 2011 prior to Bilbrey’s arrival but dividends have grown at a CAGR of ~13% from 2011 to 2014 during Bilbrey’s tenure. Bilbrey has also generously allocated capital towards share repurchases, which have amounted to nearly $1.8bn since his arrival. While I would like to see capital diverted more towards dividends than share repurchases in the long term, I am generally content with the level of dividend increases in the last few years.

Finally, Bilbrey has a decent bit of international experience so I am optimistic that he can right the international ship.

Valuation

Hershey operates a simple but wonderful business with a moat in the form of strong, iconic chocolate and candy brands that are highly likely to have consistent demand for the foreseeable future.

So let’s get to the elephant in the room – what’s the thing worth? I always like to preface any valuation discussion with the caveat that valuation is an art and science and we never know with any precision what something is worth, but we try to provide ourselves a margin of safety to account for this risk of imprecision.

Due to recent cuts in guidance driven by weakness in China, Hershey’s stock is trading at a rare discount. At a current price in the ~$88 territory, we believe that Hershey offers approximately 20% upside. Based on a DCF analysis, using reasonable assumptions for discount rate and growth, I arrived at an intrinsic value of ~$106 per share for HSY, which provides about ~20% upside from today’s price of ~$88. This is lower than the 25% that we typically require but it is rare for Hershey to trade at this type of discount. Thus our preference is to buy modestly at the current price and cost average down on dips.

As it is with Wrigley’s chewing gum and many other consumer packaged goods brands, the internet isn’t going to change the way people eat chocolate and this is a great thing for Hershey's iconic brands and its shareholders.

DISCLOSURE: I am currently long HSY stock. I am not an investment advisor and this article presents my personal views. While I have conducted a fair bit of research to write this, I encourage all readers to do their own homework and due diligence before making any investment decisions.