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The Hershey Company’s (HSY - Analyst Report) second-quarter 2014 results were in line with the preliminary numbers announced last week. Moreover, management continues to expect its fiscal 2014 results to be at the lower end of its long-term targets due to higher-than-expected dairy costs, as announced last week.

Hershey’s second-quarter adjusted earnings of 76 cents per share were in line with the Zacks Consensus Estimate and were within the preliminary range of 75 to 77 cents released last week.

Earnings grew 5.6% from the prior-year quarter as lower brand building and advertising costs made up for weak gross margins and lower-than-expected sales in the U.S.

The adjusted earnings mainly exclude acquisition/transaction costs, pension income, and expenses related to Hershey’s supply chain and cost savings program — Project Next Century.

 

Revenues Improve Sequentially; U.S. Sales Soft

Net sales of $1.58 were also in line with the Zacks Consensus Estimate. Net sales increased 4.6% year over year in line with the preliminary numbers. Positive volume growth and market share gains pulled up the top line.

However, though sales improved sequentially from a weaker first quarter, performance in the U.S. fell short of management’s expectations due to soft retail trends.  In the U.S., sales increased 4.4%.

Currency hurt revenues by 0.7 percentage points, lower than the last quarter. Organically, sales increased 5.3% in the quarter.

High Dairy Costs Severely Dent Gross Margins

Hershey’s adjusted gross margin for the quarter declined 230 basis points (bps) to 45.4%, due to higher input costs, mainly dairy and an unfavorable sales mix, which offset productivity gains and improved efficiencies from supply chain initiatives.

The costs of Hershey’s key ingredients like dairy, nuts, cocoa and sugar have increased dramatically so far this year and are expected to rise further in the coming quarters.

The higher costs are expected to dent the company’s margins which prompted the guidance cut last week (discussed below). The costs of other inputs — packaging, fuel, utilities and transportation — are also rising.

In fact, in 2014/2015, the overall cost environment for food commodities is expected to be under pressure due to domestic and worldwide agricultural supply and demand imbalance and other macroeconomic factors.

Excluding advertising, selling, marketing and administrative expenses (SM&A) were almost flat in the second quarter of 2014 as gains from a foreign exchange currency contract offset higher selling and employee related costs. SM&A includes investments in non-advertising brand-building and go-to-market capabilities in both the U.S. and international markets.

Advertising spend declined around 5% from the prior-year quarter. Despite lower advertising costs, operating margin declined 60 bps in the quarter to 17.7% due to weak gross margins.

2014 Outlook

Last week, the company announced price increases for its chocolates and candies in response to rising input costs of its key ingredients. As a result, the company announced that it expects its fiscal 2014 results to be at the lower end of its previous targets.

Effective from Jul 15, the company raised wholesale prices by approximately 8% across its instant consumable, multi-pack, packaged candy and grocery lines. Direct buying customers will be exempted from the raised prices until Aug 12.

Management does not expect the price increases to have any material positive impact on 2014 results.

However, in anticipation of volume elasticity due to price rises, management lowered its top-line expectations last week. 2014 net sales growth guidance was reduced to the lower end of the long-term target range of 5–7% (including currency headwinds). Previously, the company was expecting it to remain within the range.

Adjusted earnings for 2014 are also expected at the lower end of the previously provided range of $4.05–$4.13. 2014 adjusted earnings per share growth will be around the lower end of its long-term target of 9–11% versus prior expectation of its remaining within the range.

Moreover, gross margins are expected to decline slightly from the year-ago levels due to greater-than-anticipated commodity cost headwinds. Previously, Hershey expected gross margins to increase around 20 bps. The gross margin guidance cut last week was the second time this year that Hershey slashed the figure. At the first-quarter conference call, the company lowered gross margin expectations from a 50 bps rise to 20 bps in anticipation of higher dairy costs and a less favorable sales mix. Commodity costs are expected to be higher in 2014 than the last year.

It seems management is trying to combat the sharp rise in input costs through reduced advertising spend.

Concurrent with the second-quarter press release, management lowered the advertising expense (as a percentage of revenues) guidance from a mid single-digit range to a low single-digit range. The company will continue to incur advertising costs to support core brands as well as product launches in both U.S. and international markets. SM&A (excluding advertising) expenses are expected to increase at a lower rate than the top line.

The financial outlook excludes benefits from the pending Shanghai Golden Monkey acquisition (expected to close in the second half).

Other Stocks to Consider

Hershey carries a Zacks Rank #4 (Sell).Better-ranked food stocks include Treehouse Foods, Inc. (THS - Snapshot Report), PepsiCo, Inc. (PEP - Analyst Report) and Pinnacle Foods Inc. (PF - Snapshot Report).While Treehouse Foods sports a Zacks Rank #1 (Strong Buy), Pepsi and Pinnacle Foods have a Zacks Rank #2 (Buy).

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