5

Hershey Foods Corporation-2005

Fred R. David Francis Marion University

HSY
www.hersheys.com
Have you ever been to Hershey, Pennsylvania, the home of Hershey Foods Corporation? Known as Chocolate Town, USA, the air in this city actually smells like chocolate. There you can walk down Chocolate Avenue, see sidewalks lit with lights in the shape of Hershey's Kisses, visit Hershey's ZooAmerica, and see the chocolate kiss tower in HersheyPark. Hershey's Chocolate World is America's most popular corporate visitor's center. Hershey has grown from a one-product, one-plant operation in 1894 to a $4.4 billion company producing an array of quality chocolate, nonchocolate, and grocery products. The company markets confectionery and grocery products in over 60 countries worldwide, down from 90 countries a few years ago. Hershey's prominent products are chocolate and nonchocolate confectionery products consisting of bar goods, bagged items, and boxed items. Hershey grocery products include baking ingredients, peanut butter, chocolate drink mixes, dessert toppings, and beverages. Hershey markets these products under more than 50 different brands, such as Hershey's Milk Chocolate, Mr. Good bar, Reese's, KitKat, Kisses, and Mounds. Less than 1 percent of Hershey's sales are generated outside the United States. Hershey remains inexperienced, ineffective, and uncommitted in markets outside the United States, Mexico, and Canada, even though the candy industry has globalized. Mars, Borden, Nestle, and other competitors all have a growing and effective presence in international markets. Analysts question whether Hershey Foods can continue to survive as a domestic producer of candy while its competitors gain economies of scale and learning inworld markets. Shareholders are becoming concerned, too.

History
Milton Hershey's love for candy making began with a childhood apprenticeship under candy maker Joe Royer of Lancaster, PennsylvaniaMr, Hershey was eager to own a candy-making business. After numerous attempts and even bankruptcy, he finally gained success in the caramel business. Upon seeing the first chocolate-making equipment at the Chicago Exhibition in 1893, Mr. Hershey envisioned endless opportunities for the chocolate industry, .,~ By 1901, the chocolate industry in America was growing rapidly. Hershey's sales reached $662,000 that year, creating the need for a new factory. Mr. Hershey moved his company to Derry Church, P;nnsylvania, a town that was renamed Hershey in 1906. The new Hershey factory provided a means of mass-producing a single chocolate product. In 1909, the Milton HersheySchool for Orphans was founded.' Mr. and Mrs. Hershey could not have children, so for years the Hershey

Chocolate Company operated mainly to provide funds for the orphanage. Hershey's sales reached $5 million in 1911. In 1927, the Hershey Chocolate Company was incorporated under the laws of the state of Delaware and listed on the New York Stock Exchange. That same year, 20 percent of Hershey's stock was sold to the public. Between 1930 and 1960, Hershey went through rapid growth; the name "Hershey" became a household word. The legendary Milton Hershey died in 1945. In the 1960s, Hershey acquired the H. B. Reese Candy Company, which makes Reese's Peanut Butter Cups, Reese's Pieces, and Re!se's Peanut Butter Chips. Hershey also acquired San Giorgio Macaroni and Delmonico Foods, both pasta manufacturers. In 1968, Hershey Chocolate Corporation changed its name to Hershey Foods Corporation. Between 1976 and 1984, William Dearden served as Hershey's chief executive officer. An orphan who grew up in the Milton Hershey School for Orphans, Mr. Dearden diversified the company to reduce its dependence on fluctuating cocoa and sugar prices. In the 1970s, Hershey acquired Y&S Candy Corporation, a manufacturer of licorice-type products, such as Y&S Twizzlers, Nibs, and Bassett's Allsorts. Hershey purchased Procino-Rossi, a pasta company, and Skinner Macaroni Company. During the 1980s, Hershey acquired A. B. Marabou of Sweden, aswell as the Dietrich Corporation; maker of Luden's Throat Drops, Luden's Mellomints, Queen Anne chocolate-covered cherries, and 5th Avenue candy bars. It also acquired the Canadian confectionery (chocolate and nonchocolate candy) and snack nut operations of Nabisco Brands Ltd. Hershey also acquired Peter Paul/Cadbury's U.S. candy operations, which gave them new products, such as Mounds, Almond Joy, York Peppermint Pattie, Cadbury Dairy Milk, Cadbury Fruit & Nut, Cadbury Caramello, and Cadbury Creme Eggs. Hershey has rights to market the Peter Paul products worldwide. Hershey purchased Nacional de Dukes (NDD) and renamed this company Hershey Mexico, which today produces, imports, and markets chocolate products for the Mexican market under the Hershey brand name. In 1996, Hershey acquired Leaf North America to gain market-share leadership in North America in nonchocolate confectionery candies. In 2000, Hershey purchased the breath freshener mints and gum businesses of Nabisco to obtain such products as Ice Breakers, BreathSavers, Bubble YUill,and Fruit Stripe gum .. In 2004, Hershey acquired two firms: Grupo Lorena in Mexico and Mauna Loa Macadamia Nut Corporation. Mauna Loa, which is the leading processor and marketer of macadamia snacks, has annual sales of about $80 billion. The Mauna Loa brand name includes cookie and snack items. Grupo Lorena is the leader in Mexico. in the spicy candy market and haS annual sales of over $30 million. Its Pelon Pelo RIco brand is especially popular. Hershey also manufactures and/or markets grocery products in the baking, beverage, peanut butter, and toppings categories. Its grocery products include such items as HERSHEY~S Syrup, HERSHEY'S Cocoa, and Reese's Peanut Butter.

Internal Affairs
Mr. R. H. Lenny was elected president and chief executive officer of Hershey Foods in 2001 after previously serving as a division president with Nabisco. He is still CEO of Hershey. Hershey does not make public an organizational chart, but titles of . executives suggest that Hershey operates from a centralized, functional structure with no divisional presidents. This type of structure would be somewhat unusual for 'an organization of Hershey's size, since the more common design would be

decentralized in some manner. Another indication of the functional structure is that Hershey does not provide for its shareholders financial data by segment such as geographic region or product, again implying centralized control and accountability. Hershey, in the late 1990s, had operated with two divisions: Hershey North America and Hershey International. Hershey has approximately 13,700 full-time arid 2,300 part-time employees, of whom about 5,100 are members of a union. Hershey's stated objectives include increasing sales 3 t04 percent annuajly, increasing gross margin 70 to 80 basis points annually, increasing earnings before interest and taxes 7 to 9 percent annually, and increasing earnings per share 9 to 11 percent annually. Hershey's North American manufacturing operations are located in the following cities: Hershey, Pennsylvania Oakdale, California Stuarts Draft, Virginia Lancaster, Pennsylvania Robinson, Illinois Smith Falls, Ontario, Canada Guadalajara, Mexico Denver, Colorado (sold in February 2005) Hershey's North American operations produce an extensive line of chocolate and nonchocolate products sold in the form of single bars, bagged goods, and boxed items. These products are marketed under more than 50 brarid names and sold in over 2 million retail outlets in North America, including grocery wholesalers, chain stores; mass merchandisers, drug stores, vending companies, wholesale clubs, convenience stores, and food distributors.

Social Responsibility
Hershey Foods Corporation is committed to the values of its founder Milton S.. Hershey: the highest standard of quality, honesty, fairness, integrity, and respect. The firm makes annual contributions of cash, products, and services to a variety of national and local charitable organizations. Hershey is the sole sponsor of the Hershey National Track and Field Youth Program. Hershey also makes contributions to the Children's Miracle Network, a national program benefiting children's hospitals across the United States. . The corporation operates the Milton Hershey School, whose mission is to provide full-time care and education, including all costs, to disadvantaged children, mainly orphans. The school currently cares for over 1,000 boys and girls in grades kindergarten through 12. The Hershey School Trust owns over 75 percent of aU Hershey Food Corporation common stock.

Research and Development

. Hershey engages in research and development activities to develop new products, improve the quality of existing products, and improve and modernize production processes.Recently, Hershey's research and development expenditures have declined steadily from 1998's level of $28.6 million to $23.2, $24.2, and $23.4 million respectively in 2004, 2003, and 2002. Hershey engages in a variety of research activities to develop new products, improve the quality of existing products, improve and modernize production processes, and develop and implement new technologies to enhance the quality and value of both current and proposed product lines. In 2004; Hershey introduced the

following new products: Hershey's Kisses filled with caramel milk chocolates; Ice Breakers Liquid Ice mints; Hershey's Snack Barz rice and marshmallow bars; Hershey's SmartZone nutrition bars; TakeS candy bars; Hershey's Almond Joy, York, and Reese's cookies; Reese's Pieces candy with peanuts; and Reese's Big Cup.

Finance
Hershey's 2004 financial statements are provided at the end of this case. Note that Hershey's sales increased about 6 percent in 2004, and gross margin increased to 39.5 percent from 39.0 percent in 2003. Net income was $590.9 million in 2004 compared to $457.6 million in 2003. Hershey purchased 11;)8 million shares of its common stock from the Milton Hershey School Trust in July 2004 at a price of .$44.32 per share. Hershey has a $900 million revolving line of credit with a consortium of banks and has the option to borrow an additional $600 million if needed. Hershey has more than $463 million in goodwill on its balance sheet, which is not good.

Marketing
In 2004, Hershey's sales to McLane Company comprised about 25 percent of all cornpany sales. McLane is one of the largest wholesale distributors in the United States to convenience stores, drugstores, wholesale dubs, and mass merchandisers. Hershey has developed a. distribution network from its manufacturing plants, distribution centers, and field warehouses strategically located throughout the United States, Canada, and Mexico. Hershey has steadily reduced its advertising expenses from $187.5 million in 1998 to $137.9, $145.4, and $162.9 million in 2004, 2003, and 2002 respectively. Hershey changes the prices and weights of its products to accommodate changes in manufacturing costs, the competitive environment, and profit objectives. In December 2004, Hershey announced an increase in the wholesale prices of about half of its domestic confectionery line. A weighted average increase of about 6 percent of Hershey's standard bar, king-size bar, six-pack, and vending lines was effective in January 2005. A weighted average price increase of about 4 percent on packaged candy was effective in February 2005. Hershey's selling, marketing and administrative expenses in 2004 increased by $31.1 million, or 4 percent. However, as a percentage of sales, these expenses decreased to 19.1 percent from 19.6 percent in 2003. Per capita candy sales in the United States have increased by7.1 percent over the . last 5 years. Americans spend over $21 billion a year on sweets. Upscale candy items; such as Mars's Dove Promises, are selling well. People are eating more ethnic foods today than 10 years ago, which means more garlic and flavor. Breath-freshener candies .are selling really well in response to this eating trend. Conventional wisdom in the candy industry is that a person rarely selects the same candy bar twice in a row; consequently, product variety is crucial to success. Marketing issues relative to health, nutrition, and weight consciousness are important. The media Hershey uses most for advertising are network television, followed by syndicated television, spot television, magazines, and network and spot radio. Confectionery sales are generally lowest during the second quarter of the year and highest during the third and fourth quarters, due largely to the holiday seasons ... . Hershey generates about 20 percent of annual sales during the second quarter and 30 percent of annual salesduring the fourth quarter of each year.

Global Issues
Hershey exports confectionery and grocery products worldwide but not with vigor. Europeans have the highest per-capita chocolate consumption rates in the world, but Hershey has no plans to overtake or even threaten Nestle or Mars in Europe. In the Far East, Hershey has signed licensing agreements with Selecta Dairy Products to manufacture Hershey's ice cream products in the Philippines and with Kuang Chuan Dairy in Taiwan to manufacture Hershey's beverages. Hershey introduced its products into Russia, the Philippines, and Taiwan. Overall in the Far East, however, Hershey is not planning sustained efforts due to perceived high political and economic risks coupled with the company's lack of experience. The most significant raw material used in the production of Hershey chocolate products is cocoa beans. This ~ommodity is imported principally from West African, South American, and Far Eastern equatorial regions. West Africa accounts for approximately 70 percent of the world's crop. Cocoa beans are not uniform, and the various grades and varieties reflect the diverse agricultural practices and natural-conditions found in the many growing areas. Hershey buys a mix of cocoa beans to meet its manufacturing requirements. Cocoa prices hit an I8-year high in February 2003 and since then have remained high, averaging 67.7 cents per pound in 2004, down from 77.8 cents in 2003. Hershey's second most important commodity for its domestic chocolate and confectionery products is sugar. Due to import quotas and duties imposed to support the price of-sugar, sugar prices paid by United States users are currently substantially higher than prices on the world sugar market. The average wholesale list price of refined sugar has remained in a range of 25 to 32 cents per pound for the past 10 years. Hershey also uses a large arnount of peanuts, almonds, and dairy products. Prices for almonds were $2.00 per pound during the first half of 2004 and rose to $3.00 per pound during the second half of the year. Milk prices were especially high in 2004 and moderated down some in 2005. . The chocolate/cocoa products industry is SIC 2066, while candy/confectionery is SIC 2064. The main distribution channels for chocolate are grocery, drug, and department stores as well as vending machine operators. Almost ill of these distributors are local, regional, or national; only a few are multinational. While chocolate producers have not yet developed globally uniform marketing programs, the situation is changing. European unification extended grocery and department store channels of distribution. For example, Safeway, a U.S. grocery chain, now operates stores in Canada, Britain, Germany, and Saudi Arabia.: As global channels of distribution become more available for chocolate manufacturers, global marketing uniformity will become more prevalent in the industry. Global cultural convergence is accelerating the need for more global marketing uniformity in the confectionery industry. Hershey's competitors are taking advantage of this globalization trend. The confectionery industry is characterized by high. manufacturing economies of scale. Hershey's main chocolate factory, for example, occupies more than 2 million square feet, highly automated, and contains much heavy equipment, vats, and containers. It is the largest chocolate plant in the world. High manufacturing costs in any industry encourage global market expansion, globally standardized products, and globally centralized production. The confectionery industry is also characterized by high transportation costs for moving milk and sugar, the primary rawmaterials. This fact motivates companies, such as Hershey, to locate near their sources of supply. Since milk can be obtained in large volumes in many countries, chocolate producers have many options

is

in locating plants. Also, producing chocolate is not labor intensive, nor does it require highly skilled labor. Industry analysts expect the candy industry to continue to grow. Consumption of chocolate, according to industry analysts, is closely related to national income, although the Far East is an exception to this rule. Candy consumption varies in the major markets of the developed nations. Americans annually consume about 22 pounds of candy per person and Europeans consume about 27 pounds of candy per person . .Chocolate accounts for about 54 percent of all candy consumed. Northern Europeans consume almost twice as much chocolate per capita as Americans. Among European countries, Switzerland, Norway, and the United Kingdom consume the m st chocolate, while Finland, Yugoslavia, and Italy consume the.least. The Japanese also consume very little chocolate-about 1.4 kilos per capita. Throughout Asia and Southern Europe, there is a preference for types of sweets other than chocolate, partly because of the high incidence of lactose intolerance (difficulty in digesting dairy products) .

Competitors
The $10-billion U.S. confectionery industry is composed of six major competitors who control nearly 70 percent of the market: Hershey, M&M Mars, Brach & Brock, Nestle of Switzerland, RJR Nabisco, and LeafInc. The remaining 30 percent is divided among many local and regional candy manufacturers. 'Based in Switzerland, Nestle clearly has an edge internationally, being the world leader in many food categories, including candy. Almost 98 percent of Nestle's revenues come from international sales. Hershey's other competitors also do much of their business outside North America. For example, Cadbury Schweppes obtains 50 percent from international sales, and Mars 50 percent, while Hershey has the least with 1o percent. Hershey's two major candy competitors are Mars and Nestle.

Mars
Mars has a stronger presence than Hershey in Europe, Asia, Mexico, and Japan. Mars gained 12 percent of the market in Mexico within one year of entering that market. Analysts estimate Mars worldwide sales and profits at over.$7 billion and $1 billion, respectively. Mars was successful introducing its Bounty chocolate candy, originally a European candy, into the United States without prior test marketing. Mars, unlike Hershey, globally uses uniform marketing. For example, the company's M&M candies slogan, "It melts in your mouth, not in your hands:' is used worldwide. In contrast, . . Hershey's successful BarNone candy is named "Temptation" in Canada. Mars is controlled by the Mars family through two brothers, John and Forrest, Jr. Mars is one of the world's largest private, closely held companies. It is a secretive company, unwilling to divulge financial information and corporate strategies. Unlike Hershey, Mars has historically relied upon extensive marketing and advertising expenditures to gain market share, rather than on product innovation. Mars has been repackaging, restyling, and reformulating its leading brands, including Snickers, .M&M's, Milky Way, and 3 Musketeers, but that strategy is now being supplemented with extensive product development. NewMars products include Bounty, Balisto, and PB Max. It also successfully developed and marketed frozen Snickers ice cream bars, a product that was so successful it dislodged Eskimo Pie and Original Klondike from the number-one ice cream snack slot without any assistance from promotional advertising. Mars has world-class production facilities in Hackettstown, New Iersey. from that plant it ships products worldwide. In addition, it has manufacturing plants

in Mexico and in several European locations. Mars entered Russia in 1992 and today virtually owns the chocolate market there.

Nestle
With annual sales exceeding $9 billion in the U.~., Nestle is the largest food company in the world. Nestle's U.S. operations are headquartered in Glendale, . California. With corporate headquarters in Vevey, Switzerland, Nestle is a major competitor in Europe, the Far East, and South America. Nestle sells products in over 360 countries on all seven continents, many in the Third World. It is the world's largest instant coffee manufacturer, with Nescafe the dominant product. Nestle alsd produces and markets chocolate and malt drinks and is the world's largest producer of milk powder and condensed milk. Nestle's chocolate and confectionery products carry some popular brand names, including Callier, Crunch, and Yes. With the acquisition of Rowntree, additional notable brands were added to the product line, including Smarties, After Eight, and Quality Street. The Perugina division produces Baci. Through the RJR Nabisco acquisition, Nestle acquired Curtiss Brand, a U.S. confectionery producer with such products as Baby Ruth and Butterfinger. Nestle manufactures chocolate in 23 countries, particularly in Switzerland and Latin America. Each factory is highly automated, employing an average of 250 people .. Another major product concentration for Nestle is frozen foods and other refrigerated products. Findus in Europe and Stouffer in the United States represent the bulk of the group's frozen food sales with well-known brands such as Lean Cuisine. Nestle also manufactures a fast-developing range of fresh pasta and sauces in Europe and the United States under the name Contadina.

Conclusion
Hershey's global market share in the chocolate confectionery industry is less than lO percent, lowest a~ong its competitors. A major strategic issue facing Hershey today is where, when, and how to best expand geographically. Perhaps Hershey should expand into the Far East, since economies of those countries are growing so rapidly, China and India are huge untapped markets. Malaysia, Indonesia, Vietnam, and Thailand also are untapped. Should Hershey wait for Mars and Nestle to gain a . foothold.in those countries? . . More and more firms are becoming environmentally proactive in their manufacturing and service delivery processes. Environmentally responsible firms market themselves and their products as being "green-sensitive," Concern for the natural environment is an issue Hershey should address before competitors seize the initiative. Developing environmentally safe products and packages, reducing industrial waste, recycling, and establishing an environmental audit process are strategies that could benefit Hershey. . . Some analysts contend that Hershey's functional structure is an ineffective structural design. Would a divisional structure by product be more effective? The product divisions could be Chocolate, Nonchocolate, and Grocery. Or would a divisional structure by geographic reason be moreeffectivei Can you recommend an improvedorganizational design that.could enhance Hershey's lackluster international operations? Should Hershey acquire firms in other foreign countries? Analysis is needed to identify and value specific acquisition candidates. In developing an overall strategic plan, what recommendations would you present to CEO Kenneth Wolfe? Should Hershey diversify. more into nonchocolate candies since that segment is growing most rapidly? Should a new manufacturing plant be built in Asia orin Europe?

CASE 5 '. HERSHEY FOODS CORPORATlON-2M5

53

Design a global marketing strategy that could enable Hershey to boost exports of chocolate. Should Hershey increase its debt further or dilute ownership of its stock further to raise the capital needed to implement your recommended strategies? Develop projected financial statements to fully assess and evaluate the impact of your proposed strategies.

EX H I BIT

Hershey's Income Statements (in $ thousands, except per share amount)

FOR THE YEARS ENDED DECEMBER3l

2004

2003 4,172,55

2002 4,110,31

Net Sales Costs and Expenses: Cost of Sales Selling, Marketing, and Administrative Business Realignment and Asset Impairments, Net Gain on Sale of Business Total Costs and Expenses Income Before Interest and Income Taxes Interest Expense, Net Income Before Income Taxes Provision for Income Taxes Income Before Cumulative Effect . of Accounting Change Cumulative Effect of Accounting Change, Net of $4,933 Tax Benefit Net Income
Source: Hershey's Form 10K, 2004, p. 38.

4,429,24

2,679,53 847,540

3,527,07 902,177 66,533 835,644 244,765 590,879

2,544,72 816,442 23,357 (8,330) 3,376,19

796,356

2,561,05 833,426 27,552 3,422,03

698,287

63,529
732,8Z7

60;722
637,565

267,875
464,952

233,987
403,578

7,368
590,879 457,584 403,578

'"

EXHIBIT

Hershey's Balance Sheets (in $ thousands)

December 31, 2004 December 31, 2003

Assets Current Assets: Cash and Cash Equivalents Accounts Receivable-Trade Inventories Deferred Income Taxes Prepaid Expenses and Other Total Current Assets Property, Plant, and Equipment, Net Goodwill Other Intangibles Other Assets Total Assets Liabilities and Stockholders' Equity Current Liabilities: Accounts Payable Accrued Liabilities Accrued Income Taxes Short-term Debt Current Portion of Long-term Debt TotalCurrent Liabilities Long-term Debt Other Long-term Liabilities Deferred Income Taxes Total Liabilities Stockholders' Equity: . Preferred Stock, Shares Issued: None in 2004 ."and 2003 Common Stock, Shares Issued: 299,060,235 in 2004 and 149,528,776 on a Pre-Split Basisin 2003 Class B Common Stock, Shares Issued: 60,841,509 in 2004 and 30,422,096 on a Pre-Split Basis in 2003 Additional Paid-In Capital Unearned ESOP Compensation Retained Earnings Treasury-Common Stock Shares, at Cost: 113,313,827 in 2004 and 50,421,139 on a Pre-Split Basis in 2003 Accumulated Other Comprehensive Income (Loss) Total Stockholders' Equity Total Liabilities and Stockholders' Equity
Source: Hershey's Fot71iIOK, 2004, p. 39.

54,837 408,9,30 557,180 46,503 114,991 1,182,441 1,682,698 463,947 125,233 343,212 3,797,531

114,793 407,612 492,859 13,285 103,020. 1,131,569 1,661,939 388,960 38,511 361,561 3,582,540

..

148,686 472,096 42,280 343,277 279,043 1,285,382 690,602 403,356 328,889 2,708,229

132,222 416,181 24,898 12,032 477 585,810 968,499 370,776 . 377,589 2;302,674

299,060

149,528

60,841 28,614 (6,387) 3,469,169

30,422 4,034 (9,580) 3,263,988

(2,762,30) 309 1,089,302 3,797,531

(2,147,44) (11,085) 1,279,8663,582,540

EX HI BIT 3

Hershey's Income Statements

(in $ thousands)

FOR THE 6 MONTHS ENDING: JULY 3, 2005 JULY 4, 2004

Net Sales Costs and Expenses: Cost of Sales Selling, Marketing, and Administrative Total Income Before Interest and Taxes Interest Income Before Taxes Taxes Net Income EPS
Cj

2,114,861 1,289,830 446,036 1,735,866 378,995 40,029 338,966 123,384 215,582 0.90

1,906,777 1,158,836 413,694 1,572,530 334,247 30,342 303,905. 49,541 254,364 1.00

Source: Hershey's Form 10K, 2004, p. 4.

EX HI BIT 4 Hershey's Organizational Chart

Senior VPand President, Hershey International

Source: Adapted from Hershey's Form 10K, 2004, p. 76.