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HSY > SEC Filings for HSY > Form 10-Q on 4-Nov-2011All Recent SEC Filings

Show all filings for HERSHEY CO

Form 10-Q for HERSHEY CO


4-Nov-2011

Quarterly Report


Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition

SUMMARY OF OPERATING RESULTS

Analysis of Selected Items from Our Income Statement


                                For the Three Months Ended                      For the Nine Months Ended
                                                           Percent                                        Percent
                                                           Change                                          Change
                        October 2,       October 3,        Increase     October 2,       October 3,       Increase
                           2011             2010          (Decrease)       2011             2010         (Decrease)
In thousands except per share amounts
Net Sales              $    1,624.3     $    1,547.1           5.0%    $    4,513.6     $    4,188.2          7.8%
Cost of Sales                 944.1            891.9          5.8           2,612.9          2,392.5         9.2
Gross Profit                  680.2            655.2          3.8           1,900.7          1,795.7         5.8
Gross Margin                  41.9%            42.4%                          42.1%            42.9%
SM&A Expense                  356.9            357.6         (0.2)          1,080.6          1,035.2         4.4
SM&A Expense as a
percent of sales              22.0%            23.1%                          23.9%            24.7%
Business Realignment
and Impairment Charges
(Credits), net                  2.2             (2.1 )      206.6              (5.9 )           83.1      (107.1)
EBIT                          321.1            299.7          7.2             826.0            677.4        21.9
EBIT Margin                   19.8%            19.4%                          18.3%            16.2%
Interest Expense, net          23.0             22.3          3.5              70.9             68.8         3.0
Provision for Income
Taxes                         101.4             97.2          4.3             268.3            234.3        14.5
Effective Income Tax
Rate                          34.0%            35.0%                          35.5%            38.5%
Net Income             $      196.7     $      180.2          9.2      $      486.8     $      374.3        30.1
Net Income Per
Share-Diluted          $       0.86     $       0.78         10.3      $       2.12     $       1.63        30.1

Results of Operations - Third Quarter 2011 vs. Third Quarter 2010

U.S. Price Increases

In March 2011, we announced a weighted-average increase in wholesale prices of approximately 9.7% across the majority of our U.S., Puerto Rico and export portfolio, effective immediately. The price increase applied to our instant consumable, multi-pack, packaged candy and grocery lines. Direct buying customers were able to purchase transitional amounts of product into May, and we do not expect seasonal net price realization until Easter 2012. Given this timing and some higher than anticipated costs, we do not expect this action to materially impact our financial results this year. We expect the majority of the financial benefit from this pricing action to impact our earnings in 2012.

Usually there is a time lag between the effective date of list price increases and the impact of the price increases on net sales. The impact of price increases is often delayed because we honor previous commitments to planned consumer and customer promotions and merchandising events that occur subsequent to the effective date of the price increases. In addition, promotional allowances may be increased subsequent to the effective date, delaying or partially offsetting the impact of price increases on net sales.

Net Sales

Net sales increased 5.0% for the third quarter of 2011 over the comparable period of 2010 due primarily to net price realization, partially offset by sales volume decreases in the United States. Net price realization contributed about 5.4% to the net sales increase, primarily due to the impact of list price increases, offset somewhat by higher promotional rates. Sales volume declines of approximately 1% were primarily associated with lower core brand sales due to pricing elasticity. These core brand sales volume decreases were substantially offset by incremental sales of new products, primarily the introduction of Reese's Minis and Hershey's Drops in the United States. Favorable foreign currency exchange rates contributed approximately 0.6% to the sales increase.

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Key Marketplace Metrics

Consumer takeaway increased 8.7% during the third quarter of 2011 compared with the same period of 2010. Consumer takeaway is provided for channels of distribution accounting for approximately 80% of our U.S. confectionery retail business. These channels of distribution include food, drug, mass merchandisers, including Wal-Mart Stores, Inc., and convenience stores.

Market share in measured channels increased by 1.0 share point during the third quarter of 2011 compared with the same period of 2010. The change in market share is provided for measured channels by syndicated data which include sales in the U.S. food, drug, convenience store and mass merchandiser classes of trade, excluding Wal-Mart Stores, Inc.

Cost of Sales and Gross Margin

Cost of sales increased by 5.8% in the third quarter of 2011 primarily due to higher input costs which increased cost of sales by about 4%. Higher supply chain costs were only partially offset by productivity improvements, resulting in a net increase to cost of sales of approximately 1%. Business realignment charges of $9.5 million were included in cost of sales in the third quarter of 2011 compared with $6.1 million recorded during the comparable period of 2010, contributing approximately 0.4% to the cost of sales increase.

Gross margin decreased by 0.5 percentage points for the third quarter of 2011 compared with the third quarter of 2010. Business realignment and impairment charges reduced gross margin by 0.3 percentage points as compared with 2010. Excluding the impact of business realignment and impairment charges, adjusted gross margin decreased by 0.2 percentage points in the third quarter of 2011 compared with the same period of 2010, reflecting higher input and supply chain costs. These cost increases were only partially offset by productivity improvements and favorable price realization.

Selling, Marketing and Administrative

Selling, marketing and administrative expenses decreased primarily due to the $17.0 million gain on the sale of certain non-core trademark licensing rights, substantially offset by increases in other selling, marketing and administrative costs primarily reflecting higher employee-related expenses. Advertising expense in the third quarter of 2011 increased approximately 7% from the same period in 2010.

Business realignment charges of $1.9 million were included in selling, marketing and administrative expenses in the third quarter of 2011 compared with $0.4 million in the third quarter of 2010.

Business Realignment and Impairment Charges (Credits)

Pre-tax business realignment and impairment charges of $2.2 million were recorded in the third quarter of 2011 associated with Project Next Century. The charges related primarily to costs associated with the relocation of production lines and employee separations.

In the third quarter of 2010, we recorded credits of $2.1 million associated with Project Next Century which were related to previously recorded amounts for employee separation costs and reflected lower expected termination costs based on severance elections during the third quarter of 2010.

Income Before Interest and Income Taxes and EBIT Margin

EBIT increased in the third quarter of 2011 compared with the third quarter of 2010 as a result of higher gross profit. The pre-tax gain of $17.0 million on the sale of trademark licensing rights more than offset increases in selling, marketing and administrative expenses. Pre-tax business realignment and impairment charges of $13.5 million were recorded in the third quarter of 2011 compared with $4.5 million recorded in the third quarter of 2010.

EBIT margin increased from 19.4% for the third quarter of 2010 to 19.8% for the third quarter of 2011. The gain on the sale of trademark licensing rights recorded in the third quarter of 2011 increased EBIT margin by 1.1 percentage points and the impact of business realignment and impairment charges reduced EBIT margin by 0.8 percentage points. Net business realignment and impairment charges recorded in the third quarter of 2010 reduced EBIT margin by 0.3 percentage points. Excluding the impact of the gain on sale of trademark licensing rights and business realignment and impairment charges, adjusted EBIT margin was 19.6% in the third quarter of 2011 compared with 19.7% in the third quarter of 2010.

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Interest Expense, Net

Net interest expense was slightly higher in the third quarter of 2011 than the comparable period of 2010, primarily reflecting increased interest expense resulting from higher average debt outstanding, substantially offset by increased capitalized interest.

Income Taxes and Effective Tax Rate

Our effective income tax rate was 34.0% for the third quarter of 2011 compared with 35.0% for the third quarter of 2010. The effective income tax rate was reduced by 0.2% in the third quarter of 2011 as a result of the net impact of tax rates associated with the gain on the sale of trademark licensing rights and business realignment and impairment charges. In the third quarter of 2010 the effective income tax rate was reduced by 0.1% as a result of the tax rates associated with business realignment charges recorded during the period. Excluding the impact of tax rates associated with the gain and business realignment and impairment charges, our effective tax rate decreased in 2011 as a result of the mix of income among various tax jurisdictions.

Net Income and Net Income Per Share

Earnings per share-diluted for the third quarter of 2011 increased $0.08 as compared with the third quarter of 2010. Net income in the third quarter of 2011 was increased by $11.1 million, or $0.05 per share-diluted, as a result of the gain on the sale of trademark licensing rights and was reduced by $8.2 million, or $0.03 per share-diluted, reflecting business realignment and impairment charges. In the third quarter of 2010, net income was reduced by $2.7 million, or $0.01 per share-diluted, as a result of net business realignment and impairment charges. Excluding the gain on the sale of trademark rights and the impact of business realignment and impairment charges, adjusted earnings per share-diluted increased $0.05 per share, or 6.3%, in 2011 compared with 2010.

Results of Operations - First Nine Months 2011 vs. First Nine Months 2010

Net Sales

An increase in net sales of 7.8% in the first nine months of 2011 compared with the same period in 2010 was attributable to sales volume increases of 4.5% primarily related to sales of new products, particularly in the U.S. Price realization in the U.S. and for our international businesses contributed approximately 3% to the net sales increase. The favorable impact of foreign currency exchange rates increased net sales by approximately 0.6%.

Key Marketplace Metrics

Consumer takeaway increased 8.3% during the first nine months of 2011 compared with the same period of 2010. Consumer takeaway is provided for channels of distribution accounting for approximately 80% of our U.S. confectionery retail business. These channels of distribution include food, drug, mass merchandisers, including Wal-Mart Stores, Inc., and convenience stores.

Market share in measured channels improved by 1.0 share point during the first nine months of 2011 compared with the same period of 2010. The change in market share is provided for measured channels by syndicated data which include sales in the U.S. food, drug, convenience store and mass merchandiser classes of trade, excluding Wal-Mart Stores, Inc.

Cost of Sales and Gross Margin

The cost of sales increase of 9.2% in the first nine months of 2011 compared with 2010 was primarily associated with higher sales volume which increased cost of sales by about 5%. Higher input and supply chain costs increased cost of sales by a total of approximately 5%. These cost increases were offset somewhat by supply chain productivity improvements which reduced cost of sales by approximately 2%. Business realignment and impairment charges of $23.3 million were included in cost of sales in the first nine months of 2011, compared with $7.1 million in the prior year, contributing approximately 1% of the cost of sales increase.

Gross margin decreased by 0.8 percentage point in the first nine months of 2011 compared with the same period of 2010. Higher input and supply chain costs reduced gross margin by about 2.6 percentage points, substantially offset by productivity improvements and price realization of approximately 2.3 percentage points. The impact of higher business realignment and impairment charges recorded in 2011 compared with 2010 reduced gross margin by 0.4 percentage points.

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Selling, Marketing and Administrative

Selling, marketing and administrative expenses increased in the first nine months of 2011 as a result of higher marketing and employee-related expenses, offset somewhat by the $17.0 million gain on the sale of non-core trademark licensing rights. Advertising expense in the first nine months of 2011 increased approximately 14.5% from the same period in 2010.

Business realignment charges of $4.0 million were included in selling, marketing and administrative expenses in the first nine months of 2011 compared with $0.5 million in 2010.

Business Realignment and Impairment (Credits) Charges

Total net pre-tax business realignment and impairment credits of $5.9 million were recorded in the first nine months of 2011 compared with charges of $83.1 million recorded in the comparable period of 2010. The net credits recorded in the first nine months of 2011 were associated with a reduction of employee separation expense of $9.7 million, partially offset by asset retirement costs related to Project Next Century.

Total pre-tax business realignment and impairment charges of $83.1 million were recorded in the first nine months of 2010, including a non-cash goodwill impairment charge of $44.7 million related to our Godrej Hershey Ltd. joint venture and $38.4 million associated with Project Next Century related to estimated employee severance and asset retirement costs.

Income Before Interest and Income Taxes and EBIT Margin

EBIT increased in the first nine months of 2011 compared with the first nine months of 2010 as a result of higher gross profit and lower business realignment and impairment charges. Higher selling, marketing and administrative expenses were offset somewhat by the pre-tax gain of $17.0 million on the sale of trademark licensing rights. Pre-tax net business realignment and impairment charges of $21.4 million were recorded in the first nine months of 2011 compared with $90.7 million recorded in the first nine months of 2010.

EBIT margin increased from 16.2% for the first nine months of 2010 to 18.3% for the first nine months of 2011 as the gain on the sale of trademark licensing rights increased EBIT margin by 0.4 percentage points and the net impact of business realignment and impairment charges reduced EBIT margin by 0.5 percentage points. Net business realignment and impairment charges recorded in the first nine months of 2010 reduced EBIT margin by 2.1 percentage points. Excluding the impact of the gain on sale of trademark licensing rights and business realignment and impairment charges, adjusted EBIT margin was 18.4% in the first nine months of 2011 compared with 18.3% for the comparable period of 2010.

Interest Expense, Net

Net interest expense in the first nine months of 2011 was higher than the comparable period of 2010 due to higher average debt outstanding, partially offset by an increase in capitalized interest.

Income Taxes and Effective Tax Rate

Our effective income tax rate was 35.5% for the first nine months of 2011 compared with 38.5% for the first nine months of 2010. The effective income tax rate was reduced by 0.1% in the first nine months of 2011 as a result of the effective tax rates associated with the gain on the sale of trademark licensing rights and business realignment and impairment charges. In the first nine months of 2010 the effective income tax rate was increased by 2.5% as a result of the tax rates associated with business realignment charges recorded during the period. Excluding the impact of tax rates associated with the gain on sale of the trademark rights and business realignment and impairment charges, our effective tax rate decreased in 2011 as a result of the mix of income among various tax jurisdictions.

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Net Income and Net Income Per Share

Earnings per share-diluted for the first nine months of 2011 increased $0.49, or 30.1%, compared with the same period of the prior year. Net income in the first nine months of 2011 was increased by $11.1 million, or $0.05 per share-diluted, as a result of the gain on sale of trademark licensing rights and was reduced by $13.3 million, or $0.06 per share-diluted, as a result of net business realignment and impairment charges. In the first nine months of 2010, net income was reduced by $73.1 million or $0.31 per share-diluted as a result of business realignment and impairment charges. Excluding the gain on the sale of trademark rights and the impact of business realignment and impairment charges, adjusted earnings per share-diluted increased $0.19 per share, or 9.8%, in 2011 compared with 2010.

Liquidity and Capital Resources

Historically, our major source of financing has been cash generated from operations. Domestic seasonal working capital needs, which typically peak during the summer months, generally have been met by utilizing cash on hand or by issuing commercial paper. Commercial paper may also be issued, from time to time, to finance ongoing business transactions such as the repayment of long-term debt, business acquisitions and for other general corporate purposes. During the first nine months of 2011, cash and cash equivalents decreased by $592.3 million to $292.3 million.

Cash on hand at the beginning of the period, cash provided from operations and other cash inflows, particularly from stock option exercises, during the first nine months of 2011 were sufficient to fund the repurchase of Common Stock of $357.7 million, capital additions and capitalized software expenditures of $265.6 million, repayment of long-term debt of $254.8 million and dividend payments of $228.4 million.

Net cash provided from operating activities was $257.2 million for the first nine months of 2011 and $388.2 million for the comparable period of 2010. The decrease was primarily attributable to the change in cash used by working capital as well as an increase in cash used by other assets and liabilities and the impact of business realignment and impairment charges, partially offset by higher net income in 2011. Cash used by working capital was $304.3 million in 2011 and $193.3 million in 2010. The increase was principally related to higher inventories resulting from seasonal sales patterns and increases in inventory levels in anticipation of the transition of production under the Next Century program, along with an increase in accounts receivable resulting from higher sales in 2011 compared with 2010. Cash used by changes in other assets and liabilities was $95.6 million for the first nine months of 2011 compared with $33.4 million for the same period of 2010. The increase in the amount of cash used by other assets and liabilities from 2010 to 2011 primarily reflected the timing of payments associated with selling and marketing programs and incentive compensation of $32.1 million as well as the impact of business realignment and impairment charges of $20.0 million.

During the third quarter 2011, the Company recorded an $11.1 million gain, net of tax, on the sale of trademark licensing rights. We received net proceeds of $20.0 million from this sale. Additionally, we entered into a sale and leasing agreement for the 19 East Chocolate Avenue manufacturing facility. Based on the leasing agreement, we are deemed to be the "owner" of the property for accounting purposes. We received net proceeds of $47.6 million and recorded a lease financing obligation of $50.0 million under the leasing agreement.

Interest paid was $84.1 million during the first nine months of 2011 versus $90.7 million for the comparable period of 2010. The decrease in interest paid in 2011 was due to timing of long-term interest payments. Income taxes paid were $224.0 million during the first nine months of 2011 versus $236.6 million for the comparable period of 2010. The decrease in taxes paid in 2011 was primarily related to reduced extension payments in the first nine months of 2011 compared with the first nine months of 2010, partially offset by the impact of higher annualized taxable income in 2011.

The ratio of current assets to current liabilities was 1.5:1.0 as of October 2, 2011 and December 31, 2010. The capitalization ratio (total short-term and long-term debt as a percent of stockholders' equity, short-term and long-term debt) decreased to 63% as of October 2, 2011 from 66% as of December 31, 2010.

Generally, our short-term borrowings are in the form of commercial paper or bank loans with an original maturity of three months or less. However, at the end of the third quarter of 2011, no commercial paper borrowings were outstanding. In October 2011, we entered into a new five-year unsecured revolving credit agreement and terminated our existing credit agreement entered into in December 2006. The credit limit of the new agreement is $1.1 billion with an option to borrow an additional $400 million with the concurrence of the lenders.

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Outlook

The outlook section contains a number of forward-looking statements, all of which are based on current expectations. Actual results may differ materially. Refer to the Safe Harbor Statement below as well as Risk Factors and other information contained in our 2010 Annual Report on Form 10-K for information concerning the key risks to achieving future performance goals.

We expect the economic environment to continue to be challenging during the remainder of 2011. In this environment, we will continue to build our business by focusing on a consumer-driven approach to core brand investment and new product innovation in the United States, along with investments in our strategic international businesses.

We will continue to focus on our core brands and leverage our scale at retail during 2011. Our third quarter results were strong and we expect to continue our marketplace momentum, including the roll-out and distribution of Hershey's Drops and Reese's Minis and the introduction of Hershey's Air Delight which began in June.

For the full year 2011, we now expect net sales growth, including the impact of foreign currency exchange rates, to be around 7%, greater than our long-term objective of 3% to 5%. Price increases effective in March 2011 are not expected to have a significant impact on financial results for the year. The impact of the price increase on our financial results for 2011 will be delayed because we will honor previous commitments to planned consumer and customer promotions and merchandising events subsequent to the effective date of the price increase. In addition, promotional allowances have increased subsequent to the effective date, partially offsetting the impact of price increases on net sales. We do not expect seasonal net price realization until Easter 2012.

Although the increase in advertising expense for the first nine months of 2011 was 14.5% compared with the same period of 2010, advertising expense is expected to decline in the fourth quarter versus 2010 considering the significant increase in our investment during the fourth quarter last year. For the full year, we now expect advertising to increase in the high-single digits on a percentage basis versus 2010. We will continue to invest in consumer insights, additional selling and go-to-market strategies in both the U.S. and international markets, new innovation on our Reese's and Hershey's franchises and quality merchandising and programming to drive profitable growth for both our Company and our customers. Excluding advertising expense, other selling, marketing and administrative expenses are expected to increase in the fourth quarter as we accelerate investments in go-to-market strategies and capabilities.

We expect our cost structure to remain at elevated levels during the remainder of 2011. Both primary and secondary commodity markets remain volatile and we expect that volatility to continue in the coming months. We have visibility into our cost structure for the remainder of the year and there is no change to our cost inflation outlook for the full year 2011. We also expect to continue to achieve productivity and efficiency improvements to help mitigate the impact of higher input costs. We expect growth in earnings per share-diluted to be around 25% on a GAAP basis in 2011. As indicated in the Note below, we continue to expect growth in adjusted earnings per share-diluted to be greater than our 6% to 8% long-term objective for the full year 2011 and increase around 10% for the full year.

During 2012 we expect the economic environment to remain challenging, however, we are well positioned to succeed in the marketplace. We will leverage our scale at retail in the U.S. and will work closely with our retail partners to enable achievement of our price elasticity model. We will also continue our disciplined investment in go-to-market capabilities within key international markets. While we anticipate significantly higher input costs in 2012, we will continue to focus on preserving our margin structure. Price increases implemented during 2011, along with productivity and cost savings initiatives will help mitigate the impact of increased commodity costs. Therefore, we expect 2012 net sales, including the impact of foreign currency exchange rates, and adjusted earnings per share-diluted growth to be within our long-term 3% to 5% and 6% to 8% objectives, respectively.

NOTE: In the Outlook above, the Company has provided income measures excluding certain items, in addition to net income determined in accordance with GAAP. These non-GAAP financial measures are used in evaluating results of operations for internal purposes. These non-GAAP measures are not intended to replace the presentation of financial results in accordance with GAAP. Rather, the Company believes exclusion of such items provides additional information to investors to facilitate the comparison of past and present operations.

In 2010, the Company recorded GAAP charges of $53.9 million, or $0.14 per share-diluted, attributable to Project Next Century. Additionally, in the second quarter of 2010, the Company recorded a non-cash goodwill impairment charge of $44.7 million, or $0.20 per share-diluted, related to the Godrej Hershey Ltd. joint venture. In the third quarter of 2011, the Company recorded a pre-tax gain of $17.0 million, or $0.05 per share-diluted, from the sale of trademark licensing rights. In 2011, the Company expects to record total GAAP charges of about $38 million to $43 million, or $0.11 to $0.12 per share-diluted, attributable to Project Next Century.

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