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Chocolate maker The Hershey Company (HSY - Free Report) posted third quarter 2012 adjusted earnings of 87 cents a share, above the Zacks Consensus Estimate of 86 cents by a penny. Also, earnings rose 3.6% from the prior-year quarter driven by revenue growth and improved gross margins.

The adjusted earnings mainly excludes acquisition/integration costs related to the Brookside acquisition, pension costs and expenses related to Hershey’s supply chain and cost savings program, Project Next Century.

The company raised its earnings forecast for 2012 and provided an encouraging financial outlook for 2013, which is expected to be in line with its long-term targets.

Quarter in Detail

Hershey’s net sales of $1.75 billion rose 7.5% from the prior-year quarter, driven both by price and volume growth. Pricing added 3.9 percentage points, whereas volume grew 2.1 percentage points.

A benefit of 2.3 percentage points from the January 2012 acquisition of Canadian confectionary company Brookside Foods was partially offset by currency headwinds of 0.8 percentage point. Quarterly sales were in line with the Zacks Consensus Revenue Estimate.

For the 12 weeks ended October 6, 2012, Hershey’s U.S. CMG (Candy, Mint, Gum) retail takeaway in channels accounted for over 90% of the U.S retail business and it grew 5.9% year over year. These channels include food, drug, mass merchandisers including Wal-Mart Stores, Inc. (WMT - Free Report) , and convenience stores. Meanwhile, market share improved 0.4 point over the same timeframe driven by Hershey’s core brands and product innovation.

Hershey is one of the largest U.S. confectioners and is well known for chocolate products 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’s adjusted gross margin for the quarter expanded 70 basis points (bps) to 43.2%, as pricing and productivity benefits and improved efficiencies from supply chain initiatives offset headwinds from rising input costs.

Excluding advertising, selling, marketing and administrative expenses (SM&A) increased 12% in the third quarter of 2012. The SM&A increase was lower than management expectations of an increase of 15% to 20%.

Advertising spend increased 12% over the prior-year quarter as the company continued with its aggressive marketing efforts both in the U.S. and internationally. Operating margin declined 30 bps in the quarter to 17.5%. In the quarter, the company raised its dividend by 10.5%.

2012 Earnings Outlook Upped

For 2012, the company expects to record adjusted earnings in the range of $3.22–$3.25 per share, up from prior forecast of $3.17–$3.23 per share on improved gross margins and slightly higher contribution from the Brookside acquisition. The adjusted earnings guidance represents a growth range of 14%–15% year over year, higher than prior expectation of growth in the range of 12%–14%.

The 2012 net sales growth guidance (including the impact of foreign currency headwinds) was narrowed to 8%-9% from prior expectations of 7%-9%. The guidance includes 1.75 to 2.0 percentage points benefit from the Brookside acquisition. Organic volume is expected to accelerate in the fourth quarter as the company reaps benefits from the Halloween and holiday season, which is already off to a good start.

For 2012, gross margins are expected to expand between 120–140 basis points year over year, up from prior expectations of an increase of 100–120 basis points. The gross margin guidance was raised due to lower-than-expected increase in input costs. Input costs in 2012 are however still expected to be higher than 2011 levels.

Advertising expenses (as a percentage of revenue) are expected to increase 13% to 15% year over year in 2012. The guidance is higher than prior expectations of an increase in low double digits as the company plans an additional advertising investment in the fourth quarter.

SM&A expenses, excluding advertising, are expected to rise in a low double digit percentage rate for 2012 due to increased investments in marketing capabilities in both the U.S. and internationally. Full year tax rate is expected to be about 35%.

2013 Outlook Encouraging

For 2013, the company expects its adjusted earnings and net sales growth rates to be within its long-term targets of 5%-7% and 8%-10%, respectively. Adjusted earnings are expected to range between $3.48 and $3.58.

Investments in core brand marketing, regular product innovation, productivity improvement and moderate commodity cost inflation are expected to help it achieve these targets despite a challenging macroeconomic environment.  Gross margins are also expected to expand in 2013 as input cost inflation subsides.

Our Recommendation

We currently have a Neutral recommendation on The Hershey Company. The stock carries a Zacks #3 Rank in the near term (Hold rating).

We are impressed by the company’s out-performance in all the three quarters of 2012. The company upped its earnings guidance for the third time this year, highlighting its attractive earnings potential. The 2013 outlook is also encouraging.

Moreover, the company’s strong brand positioning, strategic marketing investments in core brands, disciplined innovation, and consumer capabilities make it attractive. However, lack of significant presence outside U.S. keep us on the sidelines.

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