Hershey Has Gotten So Hot, It Might Melt – The Hershey Company (NYSE:HSY)

Stocks of high-quality companies typically command premiums in the market. They are usually a bedrock of stability when the economy/market turns lower. On the other hand, they can become bloated when things get too hot. This appears to be the case with The Hershey Company (HSY). The leading (public) confectionary company in the United States, Hershey is a business that prospers through all economic environments because chocolate is essentially recession proof. Hershey’s stock has traded range bound between $90 and $110 for much of the past five years before busting out at the beginning of 2019. Now near highs at $146, the stock has gotten a little ahead of itself. Even high-quality companies can make for poor investments if the valuation is too high. We will identify where we feel shares need to fall to, and some growth drivers that could benefit the company over the long term.

Source: YCharts

The appreciation of Hershey’s stock has been extraordinary over the past six months. We were bullish on the company a few months ago despite the stock trading at 52-week highs at the time. Since then, Hershey’s strong 2019 first-quarter report and upward market momentum has carried the stock to new highs. With management affirming its FY2019 guidance last quarter, the approximate midpoint of $5.70 per share puts the stock at 25.61X full year earnings. While this seems steep, it’s actually in line with the stock’s 10-year median PE ratio (which goes to show the premium that Hershey commands considering just mid-single-digit revenue growth).

Hershey Has Gotten So Hot, It Might Melt - The Hershey Company (NYSE:HSY)Source: YCharts

At the same time, the stock’s 36% run in just the past six months likely means that we are closer to a near term “top” than not. After years of range-bound trading, Hershey has now become a little too rich for us. With modest growth projected over the long term (management is projecting 2-4% revenues growth and 6-8% EPS growth as “long-term” targets), it’s important to avoid wandering into upper 20 something PE ratios. If everything stays the same, we like shares up to 22X earnings, or $125 per share.

There are some potential tailwinds on the horizon however. There are rumors that privately owned arch rival Mars (maker of Snickers and M&Ms) is increasing its wholesale prices 9%. Considering that Mars and Hershey combine for a majority of the confectionary market share in the US, such a price increase would leave room for Hershey to follow suite in some manner.

Hershey Has Gotten So Hot, It Might Melt - The Hershey Company (NYSE:HSY)Source: YCharts

Hershey has done a great job expanding its operating margin over the years, and a sizable price increase would not only boost revenues, but also result in an uptick in operating cash flow. The company’s fantastic cash flow streams ($0.16 of every dollar ends up as FCF) would further allow for the company to distribute cash to shareholders.

Hershey Has Gotten So Hot, It Might Melt - The Hershey Company (NYSE:HSY)Source: YCharts

Just under half of Hershey’s cash flow goes to pay the dividend and the increased cash flow would unlock further room for growth. The other half of Hershey’s cash streams have been used to buy back stock and manage its balance sheet (less than 2.0X EBITDA on a net basis in 2019).

In addition to this, the company is utilizing growth trends in grocery consumption to further weave itself into customers’ buying habits. Grocery shopping is becoming increasingly digital with dedicated services such as Instacart, and retail players such as Walmart (WMT) offering pick-up services. These services are allowing consumers to establish “pantry” type shopping lists, and Hershey is working to lock itself into consumers as a recurring “need” item rather than an impulse purchase at the checkout counter.

We have previously touched on Hershey’s dependence on the US market, where it generates the overwhelming majority of its revenues. Perhaps due to culture or foreign competition, the international landscape has been elusive to Hershey for years.

Hershey Has Gotten So Hot, It Might Melt - The Hershey Company (NYSE:HSY)Source: The Hershey Company

Success outside of the US has been inconsistent at best with annual growth rates ranging from negative figures to high single digits. Hershey has access to plenty of capital, so it could look to buy itself into the international scene should it choose to. But based on its hefty acquisitions of Amplify Snack Brands ($1.6B) and Pirate’s Booty ($420M) over the past couple of years, it appears that management has chosen to focus on the snack business within the US as a growth driver.

People always have and will continue to love snacks and chocolate, which makes Hershey about as stable a business as they come. Through a combination of pricing, innovation, and expansion, we like Hershey’s chances at sustaining modest growth moving forward. Despite a high-quality and profitable business, the stock at 25X earnings is brushing up against what we would feel comfortable paying for the honor of ownership. Hershey’s recent ascension was explosive and quick, but investors should probably pump the brakes now that the stock hovers near $150. We like this blue chip on a pullback if shares fall back down to the $125 neighborhood.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.