Weekly Reading - 11/30/15

by Scuttlebutt Investor

Some reading (and listening) that piqued my interest this holiday weekend:

(a small tip: if you can't access WSJ or Barron's articles due to a paywall - copy and paste the article title into Google and click on the link; it should work)

The Travails of being a Businessman

by Scuttlebutt Investor

Download a print friendly pdf version of the article here

It's been some time since I last wrote. I've been busy working on a few ideas and reading some great writing like Howard Marks' brilliant investor letter comparing investing to sports.  

I am also winding down my current day job of 3ish years to move on to a new opportunity. On the eve of this change, I thought I would spend some time reflecting on my role over the last three years because I think that there are wonderful investment learnings to be had. Learnings that have benefitted my investing abilities tremendously. Warren Buffett has said a lot of great things over the last few decades, but this one personally resonates with me and is particularly applicable in this circumstance:


"I am a better investor because I am a businessman and a better businessman because I am an investor.” 


I took the Oracle of Omaha's advice to heart and left the investing world as my day job several years ago to get some operational experience. What's it like to actually run a business? What are the inherent challenges of running a business?  And how can I learn from this experience to make me a better investor? 

And if we're all being honest here, most of us that are in the investing world have never really run a business. We know how to read 10-Ks and spread the numbers like the best of them and we know how to call out bone-headed decisions by management teams, but we have never actually been in the driver's seat making the decisions that impact those 10-Ks and numbers. Analyzing a business as an outsider and running it are two very different things.  I realized some time ago that being on the operational side of the business would help me understand a business and business models better, help me empathize with the challenges of the businessman and ultimately impact my investing in a beneficial way. And in the circular way that things work sometimes, my investment experience would in return be invaluable in providing me with that big picture lens with which to evaluate my actions as a businessman. In other words, what would a long term investor in this company think of this project or initiative?  Is it a decision that is right for the long term or just for the now? I do have to say that my investor lens made my day job challenging at times as I was forced to question the rationale of certain projects and tasks rather than go with the flow.

To provide more context, I have spent the last few years working in the consumer packaged goods (CPG) industry, which is a great perch from which to evaluate the travails of a businessman. It is a very traditional industry that manufactures goods and sells them to retailers that ultimately sell those goods (whether they be cleaning products like Clorox cleaning spray or food products like Lays potato chips) to consumers. As with many traditional industries, the threats are many and come from many different places. However, the experience has provided me with amazing exposure to general management and running a very traditional business- even if there are many other cooks in the kitchen involved in decision making at times (one of the learnings but let me not get ahead of myself). The experience of operating a business (albeit at a quasi junior level) over the last few years has been humbling to say the least.  It's not always easy and the pressure to make decisions that may not always be in the best interest of the long term business comes from many different directions.   

Being on the operational side has provided me with a several lessons on sound management and running a business. There are a few (5 to be exact) lessons that I thought all of us investors could embrace or learn from as we evaluate management teams, provide advice to management, serve on boards or just analyze businesses. Some of the thoughts are more specific to brand building (CPG speak) but brands are merely the reputation of a business so I believe that the lessons are also applicable for almost any business. 


Make big bold bets and put all (or most) your chips in on them. 

Within every company, every division and person is competing for their share of limited resources. Frankly, there aren't enough to go around. But every division and person wants to work on exciting projects like new product launches. However, companies usually do not have the resources to support several new product launches in a given year. Alternatively, they spread their resources too thin by supporting multiple projects with resources and investment that are insignificant to have any impact on such launches. Spreading resources thin across a multitude of projects is not a recipe for success. Rather, it is up to management to make the tough choices and decide on which products or services can meaningfully drive the business for the long term and invest in making those launches as big and successful as possible. Yes, these are not easy decisions and there is the risk of angering team members but good leaders know that execution is compromised when a company tries to do too much. Thus, management teams must choose impactful projects from a set of competing priorities and allot those projects with the resources necessary for success. I often listen to management earnings calls with an eye towards evaluating management strategy with regard to this principle. I have seen management teams that try to do too much impulsively and reactively and other teams that behave pro-actively with focused strategies. I'll take the latter any day and direct my capital in that direction.    


Autonomy is a recipe for success while micro management is a recipe for failure.  

Managers need to hire really smart people, give them some structure and let them loose (give them autonomy).  The reasons for autonomy are many. First, autonomy motivates employees in a way that is relatively inexpensive. Yes, there are other ways to motivate employees like money, free meals, gym memberships, etc. but these are expensive forms of motivation and also usually do not provide enduring motivation for the long term. They make employees temporarily content but autonomy has the power to provide enduring motivation.  In reality, smart people do not like to be micro managed. They are typically intelligent enough to make smart decisions and by micro-managing, managers are often self-selecting for people that are less intelligent, lack conviction or incapable of leading without direction. These aren't the people that we want running the organization one day.  Second, autonomy leads to better decisions. The people closest to a decision often have the best information and data and are in the optimal position to make the best decision if they are empowered to do so. However, what often happens is that senior managers don't feel comfortable relenting such autonomy or have not established a structure that enables subordinates to fail within reason or to feel confident about such decisions. This is poor management and one that is not likely to endure.  The scrutiny of subordinates should not happen when they are making decisions on behalf of the company. Rather, all of the scrutiny needs to happen in the hiring decision. Managers need to selectively hire people that are very smart and capable of making the decisions for which they are being hired. As an investor, the management style of the senior ranks is more challenging to evaluate. However a deep management team with several capable leaders with tenure is a good sign - good people don't stick around if they aren't given autonomy. Furthermore, CEOs that provide the limelight to other senior leaders in the company during external facing meetings is also a good sign that they are pushing down authority and decision making.        


Controlling the primary channel of distribution is a significant competitive advantage that is often under-appreciated. 

In CPG brand building or marketing, we often reference the 4 "P's" of marketing - Product, Price, Promotion and Place.  It is a simple mnemonic for thinking through the levers that are within the control of brand managers. Imagine a fictional company - Acme Widget Corporation. Widget products are created by the company with certain attributes and features that consumers want or need. Prices for the widgets are set based on consumer willingness to pay, retailer margins and input costs. Promotions for the widgets are created to build awareness, communicate product benefits and ultimately generate demand for the product. Finally, the widgets are sold in to retailers or distributors to sell on to consumers. This last leg of the widget product journey is critical because if it does not happen, consumers can never actually purchase the intended widgets. However, the Place or distribution piece is also the "P" over which Acme managers have the least control. Ultimately, the retailers or distributors (not Acme) get to decide how the widgets are merchandized on shelf and communicated to consumers within the store (whether it is a brick and mortar store, a catalog or an online store). Sure, there is some input that the sales team of Acme Corporation can provide to retailers to ensure that Acme widgets get prominent placement and attention, but it is a guarantee that the sales team of competitor Ajax Corporation is providing similar guidance for Ajax widgets. Ultimately, consumers will see and experience Acme widgets how the retailer wants, not how Acme Corporation wants.  This leads me to my key learning - Businesses that control their channel of distribution have a significant competitive advantage. They have a lot of control over how consumers see and experience their product or service. Granted that this is not always possible in every business and industry. For example, in the world of consumer packaged goods - consumers don't really want to shop at one store to buy Tide detergent (made by P&G) and then go to another store to buy Colgate toothpaste (made by Colgate Palmolive). Consumers would rather just go to Target or Walmart and buy all the brands that they need (with little regard to which company actually made the product). However, there are several other businesses where such a strategy can make sense.

Think Starbucks Coffee. Starbucks produces all of its own products (or works closely with vendors to manufacture on its behalf) and then sells those products through it own stores. Whether or not you like the taste of Starbucks coffee, you would probably agree that the store experience and environment is pretty darn good. They do a great job bringing new products to stores and displaying those products prominently with signage and pictures. The experience is tightly controlled because the company is more or less, vertically integrated. When Howard Schultz retook the reins at Starbucks in 2008 to stage a turnaround, he implemented changes to improve the store experience. He was able to implement these changes quickly because they own the stores. Furthermore, Schultz did not believe in franchising and ensured that Starbucks retained ownership of every domestic outlet - he understood the power of tight control over your channel of distribution.

A second example of success with controlling the channel of distribution is the Apple store. There was a time when all Apple products were sold through third party channels like big box retailers (Best Buy, Sears, Circuit City, etc.). However, Apple had been through some tough times and Apple products had been given short shrift by many major retailers - poor placement within stores and poorly trained salespeople that could not communicate the product benefits versus PCs. Jobs realized these shortcomings of third party retailing and worked on developing the Apple store concept. Initial predictions for the Apple Store were doom and gloom when the store first launched in 2001, but with nearly 500 stores and significantly higher sales per square foot than any other retailer in the world, Apple has been extremely successful in its endeavor to control a significant aspect of its distribution. Selling product through its own stores has the benefits of tightly controlling the presentation of the Apple brand and its products to consumers, providing a wonderful brand and retail experience for consumers, a knowledgable salesforce that can educate consumers on product benefits, an interactive environment where consumers can try before they buy and a place where consumers can go to receive high touch, high quality after-sales support. The Apple stores also have an added benefit - they shift some of the balance of power back into the hands of Apple versus retailers. Apple still sells a majority (76% of sales) of its products through third party retailers (Best Buy, Target, etc.), but by exercising control over a channel like its own stores (26% of sales), it can influence retailers to carry certain products or merchandise products in a way that benefits the company and brand (the Apple store within a store that you see at other retailers are a good example of this).  

It does not directly follow that every business that controls it channel of distribution will be successful, but it does provide a significant competitive advantage. There are businesses that have not had as much success despite controlling their distribution channel- think fashion apparel retailers like GAP. I attribute this lack of success partly to the challenges of the business model itself  - predicting fashion trends and staying trendy is difficult even when the distribution model is successful. While somewhat different, the success of franchised restaurants has also been predicted partly on the amount of control that the franchisor exerts on the franchisees. Franchised restaurants that are tightly controlled have generally had much more success (think Subway) versus franchised restaurants that have been able to operate fast and loose (think Blimpie - I don't blame you if you have never heard of it).

I realized early on in my foray into the CPG industry that many companies in the space did benefit from a durable competitive advantage in the form of a strong existing brand name but they lacked control of their primary channel of distribution. And this is a characteristic of the industry that was not likely to change meaningfully. The lack of control over this "P" in no way signals doom for the industry but is merely one aspect of its business model that will be more challenged than the other aspects. There have been some CPG players, like P&G for example, that have tried to remedy this situation by launching e-commerce storefronts, but these are unlikely to comprise a significant portion of revenue in the near term given that companies have been careful not to dis-intermediate their existing channel partners by providing uncompetitive pricing in owned channels. This latter fact has proved a boon for start-ups trying to disrupt these traditional players. With nearly all of these start-up players (whether it is Dollar Shave Club or Casper mattresses), they have chosen to control their channel of distribution by selling directly to consumers.  

The application to investing is more obvious here. Businesses that control their primary channel of distribution aren't necessarily going to be successful as there may be deficiencies in other aspects of the business. However, these businesses do possess a significant competitive advantage that makes for a powerful combination when coupled with a great product or service.  


Don't dilute the brand in the name of short term growth. Don't forsake the long term for the short term.

Managers don't typically stay in the same position at companies for longer than a couple years. Thus they are typically not necessarily incentivized to build businesses for the long term, but rather drive share growth or some similar target in the current year. Given the mis-aligned incentives, managers often take outsized risks, sacrifice profitability or dilute brand equity in the name of short term growth. The issues that result from this short-term thinking typically become "the next manager's problem". In fact, sticking to a sound strategy and enduring some interim pain as a result is typically not the way to get promoted in middle management. Unfortunately, managers typically don't have the patience to see a strategy through even if it is the right decision for the business in the long term. However, as the owners or stockholders of a business, we don't want managers that operate this way. We want managers that are acting in the best interests of the brand and the company in the long term.  If higher input costs necessitate a price increase, then we (as investors) want them to stick to a price increase despite some volume losses in the short term.     

The applications to investing are clear.  We want to invest in businesses that are creating strategies and executing on these strategies to build long term businesses. We need to keep an eye out for red flags that the business is forsaking the long term for the short term like diluting profit margins substantially in the name of cannibalistic growth, taking big risks to grow market share that cannot be retained or expensive product launches that will juice revenue growth in the current year only to be discontinued in Year 2.   


Continuity and consistency in strategy and messaging is critical for resonating with consumers and ultimate business success.  

Even when you have a great product, high quality communications and you spend a lot of media on it, strategies can often be ineffective. This is because strategy and supporting messaging can take a long time to resonate with consumers - often several years. Think about how cluttered mass media has become and how many messages you get a day as a consumer. Consumers have become desensitized to advertising, especially traditional advertising. However, marketers and managers are often ready to evaluate the success of a product launch or a media campaign in only a few months. They are ready to kill a new product launch or completely revamp their strategy fairly quickly, well before it has had a fighting chance to succeed. Sometimes, new products require a fair degree of consumer education or just time to traverse the adoption curve. The impulsiveness for immediate gratification comes from the top down (and could be driven by Wall Street's lack of patience) and is dangerous to sound decision making and strategy. But time and time again, companies make discontinuation or kill decisions too quickly, only to see a competitor launch the same or similar product the following year. The media reaction is often that Company X was too early while Company Y timed it just right. "Bullhockey!" to quote a guy I once worked with. Rather, it was that Company X's execution was poor or they were too impatient and wanted immediate results. Often, Company X did some of heavy lifting (consumer education and introduction) to make Company Y's launch a success.  

As an investor, I often evaluate companies based on their continuity and consistency in strategy and messaging. The latter often provides insight into the former. Continuity and consistency is critical for building businesses for the long term. This is often easier to evaluate for consumer businesses because they break out advertising expenses as a separate line item in their financial statements. I want to first judge the continuity of strategy and messaging - is the company spending similar or greater amounts on marketing and advertising (as a % of revenue) over the last ~5 or so years. Does senior management understand the importance of continuity in messaging and cut waste and fat to ensure that the organization can invest back into marketing? Has the management team wavered back and forth with new plans and strategies every year?This can often be evaluated by reading earnings call transcripts and paying close attention to the tone of management.  Furthermore, the consistency of messaging and the patience to stick with a strategy or product launch and see it through is critical. This requires a bit more of the "scuttlebutt" method to evaluate, but involves reading through filings, transcripts, engaging with TV, social media communications and talking to people with familiarity to the industry to understand how consistent the company has been with its strategies and communications supporting those strategies.  

These are merely five of the learnings I have had from the operational side. There have been many more but thought that these were the most important and relevant. I know that this post was a bit of a departure from my usual writing focused on fundamental analysis of businesses but these learnings do provide tremendous insight into the latter and I thought it was a important to convey them while they were fresh and lucid. Working on the operational side of a business has provided me with tremendous insight into both the workings and failings of companies today - insights that have improved my investing for the better. I know that most of you readers out there are in the investing world so I hope that there are some takeaways for you, but I also hope that some of you folks on the operational side (of any type of business) might find a few things that you agree with.  

Send me your thoughts: scuttlebuttinvestor@gmail.com.  I would love to hear from you.  

A Moat of Kisses and Peanut Butter Cups– Hershey (HSY)

by Scuttlebutt Investor

Yes, I actually spent time making a "moat" out of Hershey products.

Yes, I actually spent time making a "moat" out of Hershey products.


Hershey (HSY) operates a simple but wonderful business with a moat in the form of strong, iconic chocolate and candy brands that are likely to have consistent demand for the foreseeable future. Strong operating margins and market share gains over the last several years provide proof positive that Hershey benefits from a durable competitive advantage.

Hershey’s management team is making the right strategic decisions for the long term health of the company, which include stepping up investments in brand marketing, making smart acquisitions and improving the ingredient profile of its products, while also increasing its return of cash flow to shareholders in the form of dividends and share repurchases.

There are some considerations that prospective buyers should be aware of. They include a cost structure highly levered to commodity prices and slow strategic moves towards international expansion, premium products and a “cleaner label”.

Due to recent underperformance and resulting cuts in guidance, Hershey is trading at a rare discount of nearly ~20% to our estimate of intrinsic value.  While this is below our typical 25% margin of safety requirement, Hershey is a wonderful low-risk business that is worth picking up on sale and accumulating during future dips.

We want to be clear that our Hershey thesis is as simple as they come – it’s a wonderful business trading at a reasonable price due to recent underperformance- so unfortunately, it may not be the sexiest thesis for all investors. There is nothing misunderstood about the company or no hidden drivers of value to be unlocked. At Scuttlebutt, we love when we can buy things on sale due to missed earnings or guidance cuts that don’t impact the long-term story.      



I started both a top down and bottoms up approach to land on Hershey for this article. I have a particular fondness for consumer packaged goods (CPG) companies and set my sights on analyzing and finding a business that met many parameters in the CPG space.  My fondness for the CPG space can be summed up pretty succinctly by Warren Buffett’s quote on what interested him in Wrigley’s chewing gum some years back. “The internet isn’t going to change the way people chew gum.” 

In other words, CPG companies don’t change much because they satisfy demands that are likely to stay in popular demand for many years to come  - eating, cleaning and personal care are three big demand areas where CPG companies play. Said another way, we can predict what these businesses will look like 10 or 15 years from now with much more accuracy than we can predict what a company like Tesla or Google will look like in that same timeframe because CPG companies aren’t as susceptible to the risk of technological obsolescence. Similar to Buffett, it is the lack of change in the CPG sector that appeals to me very much. It’s no surprise that Buffett has several investments in CPG companies that include Mars Inc. and P&G and more recent investments in Kraft and Heinz (co-investments with 3G Capital).

I started my process reviewing a long list of CPG companies that operate in the food and drink categories. This includes the likes of Coca Cola (KO), Dr. Pepper Snapple (DPS), Pepsi (PEP), Kellogg (K), General Mills (GIS), CAG (ConAgra), Campbell’s Soup (CPB), Pinnacle Foods (PF), Diamond Foods (DF), Mondelez (MDLZ), Mead Johnson Nutrition (MJN) and Hershey (HSY). An aside, I love this chart that I saw online some time ago that shows the handful of CPG companies that control many of the world’s major CPG brands.  

Source: Convergence Alimentaire 2012; Note that this chart was created in 2012 so it is not fully updated for M&A activity since then. Also note that Hershey is not present because it much smaller than the behemoths shown here

Note that there are also many great CPG companies that operate in the home and personal care verticals like Clorox (CLX) and Proctor & Gamble (PG) but we’ll explore them further at another time.

Using metrics for operating margins, valuation and productivity of capital as well as some more qualitative metrics, I narrowed the list of CPG food and beverage companies further. From this high quality group, I landed on Hershey partly because it ranks favorably on metrics like Return on Capital Employed (ROCE) and operating margins while maintaining low leverage. That is not to say that there aren’t other companies among this group of CPG companies that would make for wonderful investments, but Hershey appealed to me both due to quantitative reasons and a wonderful brand portfolio that has managed to buck some of the downward trends of other packaged food companies.  A chart comparing operating margins of several food and beverage CPG companies is below.

Note: Certain adjustments have been made for non-recurring items

Also a note that I have purposely written this as a brief (more brief than usual) investment thesis primarily for two reasons: 1) to aid in the digestion of it by you, my readers; 2) As mentioned above, Hershey is a simple business that doesn’t require a whole lot of explanation of the business model (although I will offer you some!).


Business Overview

Hershey (HSY) is a relatively simple and well-known business.  I am probably correct saying that every reader here has consumed a Hershey product at some point in their life, but let’s devote just a bit of time talking about the business for those less familiar.

Hershey is a chocolate and candy company. Hershey manufactures and markets chocolate, confections and snacks products under several well-known brands that are ultimately sold to consumers at retail.  The portfolio of iconic American brands includes the namesake Hershey’s, Reese’s, Kisses, Jolly Rancher, Almond Joy, Brookside, Kit Kat (US only), Twizzlers and many others that generated $7.4bn of revenue in 2014.    

Hershey's iconic brands from a 2012 Investor Update presentation. Note that this does not include more recent acquisitions and new brands like Krave, Brookside and Lancaster.

Hershey operates its business in a matrix structure that reports both geographically and through 3 strategic business units: 1) Chocolate 2) Sweets and Refreshments and 3) Snacks and Adjacencies.  However, in terms of financial reporting, the granularity of individual brands or strategic business units does not exist.  Hershey only reports geographic segments: North America and International. 

Compared to many of its competitors (includes the likes of Mars Inc., Nestle and Mondelez), Hershey’s geographic footprint is far more domestic – 85% of revenue is generated from the North American market and 15% is derived from International markets. 

In addition to its owned brands, Hershey also has long term licenses to manufacture and sell several wonderful brands and products that are owned by other companies as shown in the chart below.  I have no idea which brilliant person at Hershey struck these deals many years ago, but they clearly were prescient in their ability to identify brands with enduring value.  Among these deals, Hershey has valuable licenses to produce products under the Kit Kat and Cadbury brands, which are owned by Nestle and Mondelez respectively.  My understanding is that these are very long term agreements that aren’t going away any time soon.    

Source: Hershey 2014 10-K


Industry Landscape

We at Scuttlebutt have a predisposition for slow moving industries where there are a couple of strong players with dominant and stable share.  The confections category definitely fits these parameters. Over recent history, the confections category has experienced a CAGR of ~5% globally and ~3% in the US. Over more than a century of existence, Hershey has built powerful brands and carved out a nice niche for itself in this category and it isn’t going away anytime soon.

Source: Hershey Fact Book 2015; Refreshment = Mint + Gum

Hershey is the largest confections company in the US with a leading ~31.4% market share of a ~$24bn category that consists of chocolate products, non-chocolate candy products and refreshment products like mint and gum.  The Company’s primary US competitors in confections (chocolate, candy, mint and gum) include:

  • Mars Inc. makes Snickers, M&Ms and Wrigley’s chewing gum among others. Mars is privately owned by the Mars family. It became the large confections player it is today when Mars acquired Wrigley back in 2008. Warren Buffet’s Berkshire Hathaway provided some of the financing for this acquisition and still holds a minority ownership stake of the Wrigley subsidiary. Mars is a close second in market share with approximately 29.2% share of the US confections category. There is a big drop off in share after the top two players that dominate the category.

  • Mondelez, which makes Cadbury (in International markets) and Dentyne gum, among others. Mondelez has a 5.4% share of the US market.

  • Nestle, which makes Butterfinger and Nestle Crunch, and has much smaller share domestically compared to its massive presence in the confections category internationally. Nestle comprises about 5.2% share in the US.

Source: Hershey Fact Book 2015; Based on Nielsen data for 52w ending 12/27/14

In additional to these large multinational competitors, Hershey competes directly against a host of regional and national confection companies and indirectly with other snacks and indulgent product companies.  Even though they are small individually, these smaller players represent about ~20% share of the US market in aggregate.

It is worth noting that while Hershey has carved out a dominant position in the US market, the global market share picture is very different with Mondelez, Mars/Wrigley and Nestle occupying the top three market share positions and Hershey occupying a distant fourth share position.

While it is the relative lack of change or more accurately, the snail pace of change in the CPG industry that attracts me to it, it doesn’t mean that the industry isn’t continuing to evolve. There are a few key industry dynamics and trends that will help us get a better long-term picture of Hershey.  

Brand Building

CPG companies engage in what is called brand building. They create branded products and invest in consumer marketing like TV ads or digital ads to drive consumer awareness, positive perception and willingness to pay for these brands. Branded products compare to lower priced private label products that are also often referred to as store brand products. In addition to investments in brand marketing, CPG companies also spend on trade, which is a temporary price decrease to drive trial. While trade spend is highly effective at driving sales, it is not as effective at driving long term positive perception and willingness to pay for a brand. In fact, when overused, trade spend trains consumers the opposite way – that these products can be frequently bought on discount and there is no reason to pay a premium over private label products. As compared to many of the other food categories (like ice cream or cereal for example), private label products comprise a much smaller portion of the confections category.  I attribute this to the theory that brands are much more important to consumers when it comes to chocolate and candy products. 

The food industry is evolving to “cleaner” ingredients

Big Food or the consumer packaged food industry has been vilified in recent years partly because of its reluctance and, in many cases, inability to provide foods that consumers are increasingly asking for – fresh, organic, all-natural, Non-GMO, hormone-free, gluten free, simple ingredients, and clean label are all likely terms you might have heard when browsing your local supermarket. Not surprisingly, there has been an increasing crop of smaller companies across all major food categories that have been able to both create and satisfy this new consumer demand for differentiated ingredients and charge a premium in the process. As a result, the larger CPG players have relented market share in many categories that were formerly viewed as highly defensible. Fortune recently put out a very good article discussing the important trends impacting these large CPG companies called: "The War on Big Food".  It’s worth a read - click through pic below. 

Investment Merits and Considerations

With some background on the company and the industry, let’s run through what we like about Hershey and some risks to our thesis.


Investment Merits

Hershey owns a portfolio of iconic American brands with high consumer awareness and strong brand equity

In addition to the namesake Hershey brand, the Company also owns Reese’s, Kisses and licenses Kit Kat, among many other brands. These are iconic brands that consumers know and love.  In many cases, the Company’s products define the sub-category in which they operate. For example, there really is no other type of Kiss chocolate, other than a Hershey Kiss and a Reese’s Peanut Butter Cup is the consumer definition of a peanut butter cup. Hershey's chocolate bar is also often the only bar of choice when it comes to making Smores. These branded products are not easily replicable by a competitor and would likely be rejected by consumers as “knock offs” if they were replicated.  

Hershey’s brands have high consumer awareness and strong brand equity as a result of dedicated and consistent brand marketing investments over many decades.  In fact, Hershey was recently rated the second the most powerful brand in the United States (second only to Coca-Cola) by the CoreBrand Index, a likely result of this consistent marketing spend over many years. 


Hershey operates a simple business that is likely to have consistent demand for the foreseeable future.

Peter Lynch said, “Go for a business that any idiot can run – because sooner or later, any idiot is probably going to run it". Buffett has followed this advice closely with many of his investments.   While it may be an exaggeration to say that an idiot could run Hershey, it is a relatively simple business. Hershey makes and markets candy products under familiar brands that are ultimately sold to consumers at retail.

More importantly, technology isn’t likely to impact the way people eat peanut butter cups or chocolate bars (as with Buffett’s investment in Wrigley). The slow pace of change in a mundane and slow moving industry like candy products is a great thing. Hershey’s products are discretionary so the demand for their products may fluctuate somewhat in the short term with economic cycles, but in the long term, people will undoubtedly continue to consume Hershey products. Consumers’ desire for chocolate and something sweet is not likely to change with faster internet speeds or higher mobile phone adoption. 


The metrics prove that Hershey is a wonderful operator with a durable competitive advantage.

As discussed previously, Hershey owns a wonderful portfolio of iconic brands that can command a price premium and can be counted on to generate earnings far into the future. Hershey’s operating and financial metrics are among some of the best of its peer set: operating margins of ~18% (3yr avg) and Return on Capital Employed of ~36% (3yr avg) handily beat many of its competitors. Also, Hershey has managed to gradually improve its margins over the last several years (from ~16% in 2010 to ~18.7% in 2014) through investment and cost cutting initiatives like Project Next Century.  

There are a lot of return metrics that can be used to measure productivity of capital usage but Return on Capital Employed (ROCE) is my preferred return calculation.  HSY generates strong returns both on a standalone basis and relative to its industry peers with a 3 year average ROCE of ~36%.  This compares very favorably to food industry peers like General Mills, Mondelez, Campbell Soup Company and Coca Cola.  In other words, Hershey is able to use its assets very efficiently to generate revenue and operating income. 

Market share is also a very important metric when measuring the durability of a company's competitive advantage in the CPG space and in this regard, Hershey has managed to churn out a stellar track record. As shown in the chart below, Hershey has managed to consistently grow its market share of the confections category (candy, mint and gum) for the last 6 years. While gains in share have been minor in certain years, this is incredibly impressive considering the increasing competition from existing players as well as the entrance of smaller, more nimble upstarts in recent years. It's even more impressive when you consider that Hershey's share gains have occurred amidst an environment where many traditional CPG brands have ceded share to a combination of less expensive private label brands and "cleaner label" upstarts. Hershey's strong performance benefits partly from competing in a category where private label has had a lesser impact - private label competition accounts for about only ~5% of the confectionary market while it is close to 20% for the rest of the food and beverage industry  

Also, Hershey operates with conservative leverage at 1.5x (Debt/Operating Income). Hershey's operating margins, ROCE and market share performance metrics are best in class and are clear proof that Hershey maintains a competitive advantage primarily in the form of its strong brands.

Source: Hershey financial statements; Market share of Candy, Mint Gum category based on Nielsen data


Opportunity for Significant International Growth

Hershey is making a big push to grow its international business, but it currently only represents 17.5% of revenue, while North America represents 82.5% of revenue. Relative to its multinational competitors like Mondelez and Mars, Hershey is a predominantly domestic business so it has not benefitted from the stronger growth of emerging markets. However, management has more recently refocused its efforts to transform Hershey into a global company by accelerating growth in international markets with a special focus on Mexico, Brazil, India and China. They have supported these efforts with targeted acquisitions and increased levels of marketing investment.  In 2014, the International segment grew 10% organically (ex currency impacts) so they may be starting to see some of the fruits of their efforts.  However, I do believe that the international push has been a bit too slow for the effort that the Company has put behind it. We’ll discuss this more later.

To play devil’s advocate though, I could question the strategy of expansion into markets where the company lacks all of the competitive advantages (primarily scale and strong consumer brand recognition) it has in its home market. Hershey has been at this international push for a long time, with relatively little to show for it thus far.  The good news is that the Company seems to be aware of its failings in this department and recently created a new Global Leadership Team role focused on growth and expansion in emerging international markets in addition to some management changes to the Global Leadership Team. My watch out here is that I don't want to see management spending frivolously to grow its international revenue just for the sake of growth. Profits and cash flow are more important even if they are only generated domestically. 


Hershey has made smart acquisitions in high growth categories and markets

Reviewing Hershey’s acquisition record, it is clear that management has a smart and focused acquisition strategy.  They have generally acquired good brands that have strong long-term growth potential.   

Brookside Confectionary – Brookside makes chocolate covered clusters and the product line aligns well with Hershey’s existing product portfolio. More importantly, Brookside helps the company move upmarket to more adult indulgences that can garner a higher price point versus their existing confections product lines.  More recently, Hershey has extended this brand into the snack bar category with Brookside Fruit and Nut bars  (similar to Kind bars), which is a smart move to establish a presence in an adjacent category.

Chinese Shanghai Golden Monkey Acquisition (80% majority stake) – A confectionary company based in Shanghai, China.  This acquisition is strategically aligned with Hershey’s mission to grow its international business especially in high growth markets like China. 

Krave Jerky- Similarly, a smart acquisition to push into the adjacent category of savory snacks.  While meat snacks represent a small portion of the overall snacking category, it is growing at a double digit clip; especially among men and Krave is an emerging leader in providing healthy gourmet jerky within this high growth sub segment.  They create products that are on trend for consumers - all-natural, minimally processed with simple, easy to understand ingredients.  Furthermore, these up market jerky products are able to garner a much higher price point ($6-$8 for a 3.25oz serving) than other Hershey product offerings.

Hershey is moving in the right strategic direction with regards to “cleaner” ingredients and ingredient sourcing.

As discussed previously and in the article "The War on Big Food", there is a growing movement towards “cleaner label” going on in the packaged food industry and consumers are increasingly demanding more transparency and better products from Big Food (the large CPG food companies).  Food consumers have become much more sophisticated and discerning about what types of products they eat over the last several years. While Hershey definitely has not been a first mover with regards to the evolution of food consumers, they are making the right decisions to move the business forward with recent announcements:

  • Decision to transition to simple, easy to understand ingredients across all brands and product lines starting with the iconic chocolate bar and Kisses

  • Cocoa sourcing initiatives to ensure that 100% of cocoa is sourced in a certified sustainable way by 2020 and chocolate farming communities are supported. Hershey is making good progress against this goal.

  • Acquisitions like Krave (premium jerky) and Dagoba (premium organic chocolate) that are perfectly aligned with the evolution of food culture and consumers.

Another important point is worth noting here. While many large CPG companies (‘Big Food’) have lost share to smaller upstarts over the last several years with higher quality or more sustainable ingredients, Hershey has largely bucked this trend. As shown in a previous chart, Hershey has managed to consistently grow market share a cumulative total of 3.2pts over the last 5 years. I attribute this partly to the notion that consumers are more concerned with organic and other food quality certification when they are consuming more traditional food versus when they are consuming indulgences for which they have already conceded, “It is bad for me”. However, this will change and consumers will begin to demand higher quality even from their indulgences.  In this regard, management is not being complacent.  They are fully aware that consumers won’t continue to forgive the company for its use of artificial flavors or use of milk from cows injected with hormones. Thus, management is acting preemptively to evolve its ingredients and products before consumers begin to bucket Hershey with all of the other “evil” Big Food companies.    


Increasing investment in marketing for brands, which benefits consumer awareness and perception, brand equity and ultimately benefits sales.  

In the most recent quarter (Q1 2015), management stated its plan to increase marketing expenditures at a rate faster than sales growth in 2015.  Most investors get worried when they see that expenses are increasing.  But I see it as a positive when companies increase marketing expenditures in lieu of other expenditures like supply chain costs.  Why?  Because increased marketing helps drive brand equity and higher willingness to pay by consumers while spending in other areas doesn’t usually drive these things.  Also, I view higher marketing expenditures that drive brand equity as a positive versus trade driven investment largely focused on price that trains consumers in a “bad” way.

Hershey is at the tail end of its large cost cutting program called Project Next Century and thus, it has taken out a lot of excess costs out of the system that they can now redeploy into marketing.  I view this as a strong positive for the Hershey portfolio of brands.


Management has generally been friendly towards it shareholders.

The Hershey management team has for the most part been prudent with shareholders’ capital.  They have used capital to fund smart and strategic acquisitions (as previously discussed), consistently increase the dividend since 2010 and also repurchase nearly $2bn of shares since 2010 (this includes both repurchases under the purchase program and purchases to offset stock based compensation programs). The 5-year CAGR for dividend growth is north of ~11%, which is better than much of its peer group. Also, management has a long term Financial objective of a ~50% dividend payout ratio and they have for the most part stuck to this over the last few years. I do have some gripes with the capital allocation strategy over the recent past. 

Source: Hershey Fact Book 2015; Common stock dividends

The first is an unwillingness to increase the dividend in 2009.  I know that this was during the depth of the recession, but I view this as a major miss because HSY would have built a track record of consistently increasing its dividend for 20 years had this been the case. This isn’t just about plaques to hang on the wall. Being on the coveted short list of Dividend Aristocrat companies that have achieved this feat is a big deal because it signals confidence from management and also lends stability to the shareholder base – as true buy and hold dividend investors buy the stock due to the impressive track record. 

The second gripe is that management has repurchased an average of $400mm of shares per year since 2010, but only repurchased $9mm of stock in 2009 when their stock price was the lowest it has been in recent history. In this case, I have to be more forgiving because Hershey was not alone in reigning in its share purchases in 2009.  Nearly every company tightened the purse strings in 2009 as they went into cash conservation mode because they thought the financial world was going to end. However, this does go back to my point that I have stated on occasion that I prefer companies to dedicate more to a consistent dividend policy than share repurchases, because management generally has poor judgment determining when their stock price is cheap and when it is expensive. Management teams tend to be fearful when they should be greedy and greedy when they should be more fearful. Furthermore, share repurchases are often used to mask overly generous equity awards to management at the expense of shareholders. Despite all of this, the management team has reduced the outstanding share count significantly over the last 20 odd years from 350mm shares in 1993 to 221mm shares in 2014.

The third gripe is that management has been too slow in pushing for international growth.  We discussed this previously and will delve a bit more into this in the ‘Investment Considerations’. 


Investment Considerations and Risks 

I generally like the strategic moves and capital allocation decisions that management has made, but here is the other side of the coin.

Hershey’s cost structure is subject to commodity price volatility, especially increases in recent years.

Hershey’s primary raw material inputs are cocoa, dairy, sugar and nuts, the cost of which has increased in recent years. Increasing consumption of chocolate by developing countries boosted cocoa prices to 3 ½ year highs in late 2014 to ~$3,400 a metric ton.  While prices do remain near historical highs, prices have subsided (down to ~$3,000/metric ton) in 2015 as higher retail prices have curbed demand and a strong yield from West African growers has increased supply.

Similar to cocoa, dairy prices reached a 10-year high in late 2014.  Since then, dairy prices have also declined considerably partly due to a global oversupply.  


Source: CME Group: Dairy Prices - Class III Milk Future prices

Sugar, almond and peanut prices also increased in 2014 due to drought, import duties and supply constraints.  

In summary, commodity prices, which are well outside of its control, impact Hershey’s cost structure in a meaningful way. However, there are a few points that bring us solace.  First, Hershey is not alone in being impact by commodity prices.  Nearly every other CPG company and every other company is in some way impacted by increases in commodity prices.  

Second, the recent price decline of some of HSY’s key inputs is likely to benefit the bottom line. Third, Hershey initiated an ~8% price increase in July 2014 to account for higher input costs, packaging, fuel and transportation. If we couple the relief on commodity prices with the price increase, there may be a double benefit to the bottom line. It’s worth pointing out that the price increase won’t benefit revenue until later in 2015 because of higher trade promotions in the near term.

Most importantly, I believe that Hershey’s brands and products are strong enough to weather most commodity price volatility and demonstrate strong pricing power – an ability to pass these costs on to consumers over some period of time without a significant impact to demand.      


While it is now making the right strategic moves, Hershey is late to the game in responding to the evolving consumer trend for “wholesome” food and “cleaner” label

We have previously noted that Hershey is moving in the right strategic direction with regards to “cleaner” ingredients and ingredient sourcing. It’s worth noting here that Hershey has been spared or lucky in that it hasn’t been singled out as “evil” like many of the large CPG companies. As previously discussed, this is likely due to the fact that Hershey deals in indulgences where consumers tend to care less about the source and quality of ingredients than certain other food products (vegetables and meat for example). Additionally, Hershey is a smaller company than many of it peers, which makes it less likely to be targeted by NGOs and the like. Hershey has made the right strategic decisions in moving towards a “cleaner” label with no artificial ingredients, colors, etc. but it needs to execute swiftly as it is already late to the game and consumers won’t be forgiving for much longer.


What’s up with the International segment?
The International segment has experienced strong double-digit revenue growth but declining profits over the last 3 years and international expansion has been slow, too slow.

International segment operating margins hovering near 5% are significantly depressed versus North America operating margins near 30%. It seems like the International segment will continue to have depressed margins for some time as new launches in new markets or immature markets require more investment in trade, consumer promotions, advertising and headcount. The alternative is that Hershey not invest internationally. This is a challenging situation for management because they have experienced domestic success and are constantly being pushed to move internationally by outside forces and competitors. But international expansion may not make sense if it leads to significant deterioration of profits and cash flow. 

In international markets, Hershey lacks the competitive advantages like scale and strong brand recognition that it benefits from in its home market. Companies can be very successful for a very long time by dominating a certain niche like a certain product or geographic area, as Hershey has been able to do in North America for a very long time. And I see no signs of Hershey's position in North America abating.

I am hopeful that international operating margins improve in ~5 years as the company achieves greater scale and brand awareness in some international markets that would enable it to reduce upfront costs and heavy investments in marketing.

I often praise management for being disciplined about growth especially into verticals or geographies they don’t completely understand, but I am a bit critical in the case of Hershey.  Competitors like Nestle and Mondelez have established their brand footprints across international geographies, while Hershey has been very slow in growing its strong brands outside of the US.  This is despite investments and a desire to do so. I would be less critical if Hershey had made a conscious decision to focus its energy on maintaining its strong position in North America and returned the excess cash flow to shareholders. But this isn’t the case. They have spent a considerable amount of shareholder money and invested significant resources with very little to show for it in the international arena. Brands like Reese’s Peanut Butter Cups and Kisses have the potential for strong sales in international markets, but Hershey has thus far been ineffective in this regard. They need to either go big or go home when it comes to International.


Hershey’s move up market has historically been too slow.

Hershey management has historically been complacent when it comes to moving upmarket – more premium products with higher price points.  Consumers have demonstrated a willingness to trade up and pay for more premium products made with better ingredients, especially in the chocolate and indulgence space and I believe that Hershey has not done a great job capitalizing on this demand thus far.  

Hershey acquired Dagoba- a specialty maker of organic chocolate in 2006, but since then, there hasn’t been much done to develop this brand.  The brand’s distribution is still fairly limited and the brand’s key digital properties (website, facebook) look like they are stuck in the 90’s.  This is all the while smaller organic and specialty artisan brands are experiencing double digit growth rates.  Hershey needs to invest the marketing dollars and prioritize distribution for Dagoba so it can claim its share of the organic/specialty growth and not concede all of the growth in this space to the hundreds of new smaller competitors like Tcho, Theo and Green & Black to name just a few. 

Hershey also acquired Scharffen Berger Chocolate, a high-end chocolate maker, in 2005.  While they subsequently experienced some challenges with ethical sourcing, Hershey has since invested more resources in growing and developing the Scharffen Berger brand.

The more recent acquisition of Krave also demonstrates a recent willingness to move up market (in this case within the snacking category), but only time will tell if Hershey will invest the resources to grow this brand in a meaningful way. 


The ownership structure will prevent activist or acquisition related forces from exploiting any price-value gap.

Hershey has two classes of stock– Common Stock and Class B Common Stock. The Class B shares have 10 votes per share while Common shares have only 1 vote per share.  

The Hershey Trust Company (a trust formed to manage the founder’s donation of his fortune to charity) currently owns 7.7% of the Common Stock and 99.9% of the Class B stock and thus effectively exercises voting control over the Company. Given that the Class B shares do not trade publicly and the Hershey Trust Company intends to maintain its ownership of these shares, it would be nearly impossible for a third party to acquire majority ownership of the voting stock in the company to drive management or operational changes.  Thus, an investment in HSY is not for investors that want performance driven by a catalyst like an activist or think that the company should be acquired. Due to the special ownership structure, it is highly unlikely that Hershey would be acquired by a larger company or that Hershey would quickly adopt some type of transformation agenda pushed by an activist.  In fact, the Hershey Trust did almost sell its ownership stake to Wrigley or a joint venture between Nestle and Cadbury back in 2002. The community and state of Pennsylvania put up a lot of legal hurdles to block the sale and the Board eventually halted it.   

This ownership structure isn't much matter to us at Scuttlebutt though. We don’t typically rely on catalysts or events of this nature to close the gap between price and value. However, we did think it was important to point out this unusual ownership structure to the newbie Hershey investor. Rather we are students of Benjamin Graham who said at a Senate Committee hearing in 1955, “We know from experience that eventually the market catches up with value.”  Thus, this unique ownership structure doesn’t change our fundamental thesis.



John Bilbrey has been the man at the helm for the last 4 years, since 2011 when he was promoted from Chief Operating Officer. Prior to 2010, Bilbrey served roles as head of North America and as head of International. He has a wealth of consumer packaged goods experience including 22 years of experience at Proctor & Gamble, the company that created the discipline of brand management.  

I would evaluate Bilbrey’s record during his tenure as pretty good. During that time, the stock has modestly outpaced the return of the S&P: +71% gain for HSY versus 67% gain for the S&P 500 (not including dividends) but trounced the return of its competitors in the food industry.  

Additionally, Bilbrey has been a prudent capital allocator of capital during his tenure. He has made smart acquisitions (Krave, Brookside) as of late and also dedicated more investment to brand marketing. He has also been friendly towards shareholders by diverting an increasing portion of cash flow towards dividends and share repurchases. Bilbrey ramped up the dividend since he joined in 2011. Dividend increases were only ~7% in 2010 and 2011 prior to Bilbrey’s arrival but dividends have grown at a CAGR of ~13% from 2011 to 2014 during Bilbrey’s tenure.  Bilbrey has also generously allocated capital towards share repurchases, which have amounted to nearly $1.8bn since his arrival. While I would like to see capital diverted more towards dividends than share repurchases in the long term, I am generally content with the level of dividend increases in the last few years.  

Finally, Bilbrey has a decent bit of international experience so I am optimistic that he can right the international ship. 



Hershey operates a simple but wonderful business with a moat in the form of strong, iconic chocolate and candy brands that are highly likely to have consistent demand for the foreseeable future.

So let’s get to the elephant in the room – what’s the thing worth? I always like to preface any valuation discussion with the caveat that valuation is an art and science and we never know with any precision what something is worth, but we try to provide ourselves a margin of safety to account for this risk of imprecision.

Due to recent cuts in guidance driven by weakness in China, Hershey’s stock is trading at a rare discount. At a current price in the ~$88 territory, we believe that Hershey offers approximately 20% upside.  Based on a DCF analysis, using reasonable assumptions for discount rate and growth, I arrived at an intrinsic value of ~$106 per share for HSY, which provides about ~20% upside from today’s price of ~$88. This is lower than the 25% that we typically require but it is rare for Hershey to trade at this type of discount. Thus our preference is to buy modestly at the current price and cost average down on dips.   

As it is with Wrigley’s chewing gum and many other consumer packaged goods brands, the internet isn’t going to change the way people eat chocolate and this is a great thing for Hershey's iconic brands and its shareholders.   


DISCLOSURE: I am currently long HSY stock. I am not an investment advisor and this article presents my personal views. While I have conducted a fair bit of research to write this, I encourage all readers to do their own homework and due diligence before making any investment decisions. 



Weekly Reading - 6/21/15

by Scuttlebutt Investor

Currently piquing my interest:

The railroad with better profit margins than Google - Fortune

  • A deep dive into Union Pacific (UNP) and how it has managed to continuously improve efficiency and margins.

Tech Bubble?  What Tech Bubble? - Andreessen Horowitz

  • I'll just say that the four most dangerous words in the English language are "This time it's different"

Harley-Davidson’s Hurdle: Attracting Young Motorcycle Riders - WSJ

  • Harley-Davidson (HOG) trying to attract a younger demographic, while retaining its appeal to its core demographic.

Beware the Stock-Buyback Craze - WSJ

  • Yet another article cautioning investors about the recent surge in stock buybacks.

Marketers’ Fixation on the Millennial Generation - NYTimes

  • Marketers are trying to cater to millennials more and more but it turns out that we may all want what they want

PepsiCo's CEO was right. Now what? - Fortune

  • Pepsi (PEP) CEO Indra Nooyi tries to balance the introduction of healthier fare with the profit centers of junk food.

Profitable Summer Reads: 7 New Investment Classics - Forbes

  • Forbes' Summer Reading List of the Investment Genre