Thursday, December 07, 2006

Color on news: Hershey (NYSE:HSY)

Several firms are commenting on Hershey (NYSE:HSY) after the co warned the Street that Q4 and 2007 would be below expectations:

- UBS notes that they anticipated, HSY revised its '06 and '07 sales and EPS outlook to reflect slower current momentum and greater investment to reinvigorate growth. A slower and more expensive turnaround is what the firm had feared when they downgraded their estimates and rating on 12/5.

Mgmt's new growth targets were largely in-line with firm's recent est. UBS discussed HSY's flawed promotion strategy in '06, and they believe '07 promotions would cost more (and be higher up-front). Furthermore, HSY will not get an instant innovation lift, and it has to pay greater attention to the core (a slower build). Other headwinds include likely delisting of some limited editions and of Kissables.

Firm's new EPS '06 is $2.44 (+7% y/y vs. mid SD guidance, down from $2.47). New EPS est for '07 and '08 are $2.62 (down from $2.66) and $2.89 (from $2.94), respectively (+7% and +10.5% y/y). Tgt is cut by $1 to $55 with Neutral rating maintained.

- Bear Stearns notes the news not a major surprise, as they expected Canadian product recalls to hurt sales in the fourth (December) quarter. What was surprising, however, was that the company also said that 2007 would be disappointing, with EPS ranging from 7-9% rather than the previously stated 9-11%.

When the firm upgraded the HSY shares in October, they noted certain near-term risks to the story, including a potential earnings miss in 4Q and the possibly inauspicious signal sent when higher marketing is announced. Alas, these fears have come to pass in recent weeks, with more speed and impact than they anticipated.

On the positive side, the upgrade was based on a belief that dark chocolate, Hershey's latest initiative, would drive mix and margin growth. Nothing the firm has seen dissuades them from maintaining this belief. In fact, in the middle of yesterday's otherwise discouraging press release, management cited "success in dark chocolate " as a bright spot.

Bear is lowering their estimates but notes that after the dip, they see a positive trend for the HSY shares -- mostly because of dark chocolate -- and therefore maintain Outperform rating for 2007. As evidenced by Wrigley and McCormick in 2006, fallen stars in the food group can bounce back on even the slightest of positive news.

- JP Morgan has by far the best comments on HSY so far noting that while they admit to having been fans in the past of CEO Rick Lenny, in hindsight tey would criticize him on three fronts: a) cost cuts have led to a bare bones advertisings budget (2% of sales vs. 11% for WWY), b) excessive reliance on line extensions (leveraging the so-called "core brands", Hershey, Kisses, and Reese's), without creating new single-serve chocolate platforms (Mars is still stronger in this regard); the exceptions being Take5 and Kissables where support has been lacking; c) a trial and error approach to snacks that has yielded few "singles" (let alone, "home runs"); nuts, granola bars, and nutritional bars have not worked.

The competitive landscape changed. According to AC Nielsen, HSY's chocolate share in the FDM+WMT channel increased from 43.1% in 12/01 (Mars 30.1%) to 45.3% by 11/05; but it was down to 44.5% in 11/06 (Mars 32.1%). HSY continues to lose share and under perform Mars; sales for the latter at FDM+WMT have grown at a 6-7% pace for the past 4 reported periods taking 12-week moving averages, compared with -1% to +1% for HSY.

Firm sees few catalysts to lift the PE from the current trough levels. The only catalysts they see that can help push up the PE multiple would be of the top line/earnings kind. But in this regard they see downside both to the 3-4% top line growth target for FY07, and the 7-9% EPS growth target. Why? Based on market momentum, the firm does not see dark chocolate boosting category growth and would expect HSY to continue to show yoy market share losses thru mid 2007.

They believe confidence will take a hit and the stock may reach its trough PE level (18x). Firm notes they would only step in if HSY reached the trough PE on the new low end of guidance EPS of $2.56.

Notablecalls: While some of the miss was anticipated I tend to believe this is just the beginning of a major battle for HSY. The co has been underspending on marketing and will need to increase that in 07 and beyond. That will eat into margins. Must agree with JPM here - dark chocolate will not save the day. JPM notes they would only step in if HSY reached the trough PE on the new low end of guidance EPS of $2.56. That implies levels around $46. Suspect HSY can go even lower in the coming weeks.

PS: I'm hearing Goldman Sachs has taken their rating to Neutral on HSY this AM.

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