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We maintained our Neutral recommendation on The Hershey Company (HSY - Analyst Report)following another impressive performance in the second quarter of 2012.

Hershey’s second quarter 2012 earnings of 66 cents per share beat the Zacks Consensus Estimate by 8%. Also, earnings increased 17.9% from the prior-year quarter, driven by revenue growth and improved gross margins.  Net sales rose 6.7% to $1.41 billion from the prior-year quarter, mainly buoyed by increased pricing. Gross margin expanded 170 basis points as pricing and productivity benefits and improved efficiencies from the company’s supply chain initiatives offset headwinds from rising input costs. We are impressed with the company’s solid first half performance. The company also upped its sales and earnings guidance, for the second time this year, highlighting its attractive earnings potential.

Moreover, the company’s strong brand positioning, strategic investments in core brands, disciplined innovation, and consumer capabilities make it attractive.

Hershey is the largest producer of quality chocolate in North America and markets some of the world’s leading brands which enjoy widespread consumer acceptance. The company is also a global leader in chocolate and sugar confectionery products, which is an attractive category as confectionery products are easily available, affordable and highly indulgent; thus making it almost recession resistant. The company is well known for chocolates like Hershey’s, Reese’s, and Kisses, as well as non-chocolate confectioneries, such as Jolly Rancher candy, Ice Breakers chewing gum, Breath Savers mints, and Bubble Yum bubble gum.

Hershey invests in core brand marketing, continuously launches new products and conducts advertising and promotional campaigns to stimulate sales. These resulted in consistent growth that continues to outstrip the company’s long-term targets. The company invests in advertising and marketing capabilities to build its brands globally and monitors the performance of its brands. The company’s strong brand investments give it a competitive advantage and are one of the principal reasons behind the company witnessing better volume elasticity and margin gains than its peers.

In an effort to boost long-term growth, management has embarked on several programs to divest low-margin brands, improve supply chain efficiencies and implement cost-reduction initiatives. These strategies have helped to restrict effects from rising input costs and expand margins.

However, more than 80% of the company’s business is generated in the U.S. In 2011, only around 15% of net sales were generated outside U.S. The company is gradually accelerating its investments in overseas markets, particularly in Mexico, Brazil, India and China. Management believes that the higher growth rates in the emerging and developing markets will help its international business to account for 25% of the company’s business over the next five years, up from the current share of 10%.

However, competitors like Kraft Foods, Inc. have a much more strong presence outside North America. Kraft Foods’ purchase of Cadbury in January 2010 has opened new sales channels for the company through the latter’s vast distribution networks in developing markets such as India, Brazil and Mexico. Kraft Foods’ solid presence outside U.S. has hurt Hershey’s international prospects significantly. Higher ingredient costs and a lack of significant presence outside U.S. keep us on the sidelines.

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