Hershey Co

NYSE:HSY

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, everyone, and welcome to The Hershey Company's First Quarter – my apologies, Second Quarter 2018 Results Conference Call. My name is Erica and I will be your conference operator today.

At this time, all participants have been placed in listen-only mode. After the speakers' remarks, there will be a question-and-answer session. This is call is scheduled to end at about 9:30 AM. Please note this call may be recorded. Thank you.

It is my pleasure to turn the conference over to Ms. Melissa Poole. You may begin your conference.

[Melissa A. Poole, The Hershey Co.]

Thank you, Erica. Good morning everyone. We appreciate you joining us for The Hershey Company's second quarter 2018 earnings conference call and webcast. Michele Buck, President and CEO; and Patricia Little, Senior Vice President and CFO, will provide you with an overview of our results followed by a Q&A session.

Before we begin, please remember that during the course of this call, we may make forward-looking statements within the meaning of the federal securities laws. These statements are based on our current expectations and involve risks and uncertainties that could differ materially from actual events and those described in these forward-looking statements contained in our 2017 10-K filed with the SEC and today's press release.

Finally, please note that on today's call, we will refer to certain non-GAAP financial measures that we believe will provide useful information for investors. The presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Please refer to today's press release for a reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP.

With that, I would like to turn the call over to Michele.

[Michele G. Buck, The Hershey Co.]

Thank you, Melissa. Good morning, everyone, and thank you for joining us. Our second quarter sales and EPS were in line with our expectations and we remain on track to achieve the annual financial guidance we shared in April.

In March 2017, I shared with you a vision for transforming our business and our focus, as a company, remains on delivering that multi-year strategic plan and driving long-term value creation. We participate in on-trend growing categories with a portfolio of great brands that resonate with our consumers.

As consumers, their shopping and the retail environment evolve, we will continue to build capabilities and evolve our business as we have done previously when the marketplace transforms. In the second quarter, we continued to invest in our brands and capabilities for growth, while taking measured steps to enhance long-term profitability.

We developed new advertising campaigns on our two largest brands, rolled out enhanced selling tools for our retail sales force and made solid progress on our capacity expansion initiatives. Amplify's marketplace performance remains strong with high single-digit growth, resulting in share gains and the integration is proceeding well.

The ongoing transformation of our international business is ahead of schedule. We delivered solid organic growth for the quarter, completed the successful divestitures of Tyrrells and Golden Monkey and drove year-to-date profit to $34 million, just shy of our largest ever full-year profit in this segment.

Constant currency net sales increased 5.3% in the second quarter, including a 590-basis-point benefit from the Amplify acquisition. Adjusted earnings per share diluted of $1.14 increased 5.6% compared to the second quarter last year. This morning, we also announced the 10% dividend increase and a new stock repurchase authorization, a testament to our solid balance sheet and strong cash flow generation.

Last week, we announced to our retail partners a selective price increase to enable us to maintain strong investment in our business and help offset rising operational costs. This was a targeted approach and it included a combination of list price increases, price-pack optimization and changes to customer terms. As part of this communication, we also shared packaging enhancements that improved the consumer shopping experience to drive growth while delivering net price realization.

In the past, you've seen us take infrequent large actions across the entire portfolio that were largely commodity-driven. Our new pricing approach is much more precise both in terms of magnitude and breadth, it utilizes more levers and will be more dynamic. This go-forward approach is critical in a fast changing environment and enables us to balance market opportunity with operational complexity.

On our last call, we discussed our gross margin outlook. While our margin performance is not yet where we wanted to be, we delivered second quarter results in line with our April outlook and our plans and full year estimate remain unchanged.

This operating environment requires an agile approach to portfolio, strategy and pricing. We continue to take a proactive approach to optimize our portfolio and deliver increased profitability. Our SKU rationalization efforts are a great example and we are encouraged by early results. We have also added resources against optimizing our price-pack architecture, improving mix and enhancing planning.

Our investments in capacity expansion, supply chain flexibility and ERP technology all remain on track. We believe these enhancements, in addition to our price increase, will be important levers to address our recent gross margin headwinds. We are confident in the strength of the categories in which we compete and our compelling brands. Our team is committed to making strategic investments in the business to fuel our future growth and success.

Now, let me provide an update on U.S. marketplace performance. Overall, the retail environment continues to change rapidly as consumers blur the physical and digital shopping experience. Both traditional brick-and-mortar channels and e-commerce are growing, emphasizing the importance of the holistic commerce ecosystem. E-commerce grocery sales remain robust as retailers invest in and consumers adapt to new platforms.

In measured channels, snacking categories are still performing well. Hershey's snacking sales grew 0.3% for the 12 weeks ending July 15, driven by strong Amplify growth. SkinnyPop ready-to-eat popcorn grew 8.3% during this same timeframe, gaining 1.2 points of marketplace share. This growth was balanced across class of trade and driven by gains in both household penetration and purchase frequency. The category remains healthy with growth of approximately 4% year-to-date.

We have good visibility into second-half plans and expect both SkinnyPop and ready-to-eat popcorn category strength to sustain as we move throughout the year. Our expansion to participate in broader snacking will continue to be an important lever in our growth.

Confection category growth of 0.6% in measured channels during the 12 weeks ending July 15 was a bit pressured. This was driven primarily by competitor lapping significant innovation during the same time last year. Trends for most other competitors were in line with year-to-date performance.

Hershey's CMG takeaway of minus 0.4% resulted in a share decline of 30 basis points during the 12 weeks ending July 15. Consistent with what we shared with you earlier this year, we expected softer first-half performance due to a shorter Easter and promotional and innovation timing. While measured channels are a little soft, we are seeing growth in untracked channels as consumers' purchase patterns become increasingly fluid.

Our core franchises grew 1.3% during this period, driven by Reese's and Ice Breakers gum. Reese's growth accelerated, driven by the limited rollout of Reese's Outrageous! innovation and additional media supporting a new campaign.

Hershey's Gold innovation is selling in line with expectations and continuing to help drive the core, which was a key goal for us. Velocities on core Hershey's branded instant consumables were up 5% during our launch window, benefiting from additional co-merchandising with Gold. And we continue to expand Gold to the Take Home Pack-types where customer on-shelf timing is a bit slower than we had anticipated.

Now, for an update on barkTHINS, we have applied learnings from recent acquisitions and are building new capabilities to successfully manage and grow our emerging brands. To that end, we established Amplify as a separate division to nurture and strengthen our emerging and better-for-you brand portfolio.

We have a talented team in Austin with expertise and demonstrated success in acquiring, integrating and growing emerging brands. The barkTHINS portfolio, now managed within Amplify, continues to perform well, with measured expansion and activation helping drive solid growth in year two of the acquisition.

barkTHINS is delivering incremental consumers and occasions to our portfolio and growing approximately 35% over the latest 12 weeks. Importantly, we are increasing velocity while expanding distribution, a key metric of sustainability. This is evidence of the results possible when applying these lessons.

We continue to build our digital commerce capabilities. Grocery shopping, today, occurs in one holistic retail ecosystem, where brick-and-mortar and online are inextricably linked. We are focused on continuously learning more about shopper needs based on the fulfillment models through which they choose to receive their goods.

Each of these models are for different levels of convenience and have different economics, which inform different strategies. One thing that remains consistent is the consumers' desire for Hershey brands. We have been consistently gaining e-commerce share this year through upgrades in content, search optimization and clear merchandising and marketing strategies that are linked to our physical retail environment activation.

We are also engaged in a full enterprise data and digital transformation program, which includes upgrades to our core digital ecosystem platforms and will allow us to leapfrog in broader digital capabilities across all functions. These efforts resulted in another quarter of e-commerce growth greater than 30% and we have confidence this trend will continue in the second half of 2018 and beyond. I'm excited by the progress we've made here.

While we delivered our commitment in the second quarter, we are not satisfied. Consistent with what we shared earlier this year, we expect our overall business results to improve in the second half of the year. An important and unique part of our business is seasons. We have good visibility into strong seasonal orders. Our Halloween and Holiday outlooks are a testament to the hard work of our teams, who were able to not only successfully reduce complexity and increase margins, but also improve our consumer proposition and drive growth. Retailer response has been excellent and we are excited by the opportunity to expand this work to the rest of the portfolio.

We are leveraging our capabilities to secure additional space at key retailers with a focus on our fastest-moving, most profitable SKUs. We have good visibility into customer reset changes this fall and believe this will be a growth driver for us. Reese's Outrageous! is off to a strong start and is important innovation to drive our profitable instant consumable business. It is just now starting to achieve full distribution. And we expect additional growth in the second half as it expands to all classes of trade. And we continue to invest in our core brands. This translates into new campaigns, sharper positioning, better packaging and robust marketing support to drive velocities.

Now, for an update on International and Other segment, last year, we shared aggressive initiatives to reset our international business model. I am proud of the teams that have delivered on these plans. Across our international markets, they have exceeded our expectations to set the right foundation to capture growth profitably. Year-to-date, our International segment has delivered operating income of $34 million. This represents an increase of $24 million versus the same period last year.

In addition to the significant margin improvement, we have built the right foundation in our key markets to capture growth. With a focus on our Hershey's brand, we delivered consistent mid-single-digit sales growth during the first half of the year. This has contributed approximately a 0.5 point of overall company growth in the first half.

In Mexico, our business is performing well. Constant currency sales grew high single digits, resulting in continued marketplace share gains. And through a combination of mix, pricing and continuous improvement, we have also improved profitability.

In China, our transformation is ahead of expectations. We remain committed to this important market and are optimizing our footprint to focus on core SKUs, provinces and channels. Sales are stabilizing. Our core Hershey's SKUs in targeted channels are growing share and our bottom line is improving meaningfully. I'd like to thank the local team for their tremendous work here.

This week, we also completed another key strategic priority by divesting Golden Monkey. We believe this will further enable our teams to focus on our strengths for future growth.

In Brazil, our business performed well, despite some macro volatility. While we did experience some impact from the truckers' strike, it was relatively immaterial to overall company sales. We are confident in our ability to recoup the volume in the second half of the year, given our strong marketplace performance and share gains. We have a strong team in Brazil with a great culture, so great work there.

Finally, in India, we remain committed to our strategy of evolving to a higher-margin portfolio. Our core brands, Hershey's, Sofit, Jolly Rancher and Brookside are growing over 50%. We anticipate these strong segment sales and profit trends to continue in the second half of the year.

In summary, we are pleased with the progress we are making against our strategic focus areas. We are investing in our brands, our supply chain and capabilities to position us to achieve growth. We have expanded our breadth in snacking via a high-growth, high-margin acquisition in Amplify with an experienced team leading our snacking expansion.

We have reset our international business model by divesting non-productive assets, rightsizing investments and focusing our efforts on key brands, key markets and key channels to drive profitable growth. We have made meaningful progress in reducing our foundational cost structure and redeploying assets to areas with the highest opportunity, focusing every function on driving maximum commercial value. And we are on track to deliver a strong year of earnings growth in a challenging environment.

I'll now turn it over into Patricia, who will provide you with details on our financial results.

[Patricia A. Little, The Hershey Co.]

Thank you, Michele, and good morning, everyone. Second quarter net sales of $1.75 billion increased 5.3% versus the same period last year, including a 5.9-point benefit from the Amplify acquisition. Volume increased 1 point, which was offset by negative net price realization of 1.6 points. Foreign currency translation impact was negligible.

Adjusted earnings per share diluted came in at $1.14, an increase of 5.6% versus the same period last year. Income from a more favorable tax rate, acquisitions and volume were partially offset by gross margin declines consistent with our April outlook.

As Michele stated, there is no change to our full-year organic sales or adjusted EPS guidance. We expect organic net sales to be towards the low-end of the slightly up to 2% range and adjusted earnings per share diluted in the $5.33 to $5.43 range. As we said in our press release, we updated our reported net sales outlook to reflect the strategic divestitures of Tyrrells and Golden Monkey.

By segment, North America net sales increased 5.6% versus the same period last year. The Amplify acquisition added 6.6 points and foreign exchange currency rates were 0.2-point benefit. Volume was a 1 point contribution to sales growth. Net price realization was a 220-basis-point headwind due to the impact of increased levels of trade promotional spending we planned in support of 2018 programming.

As a reminder, second quarter net sales were impacted by current year promotional shifts and the lapping of elevated inventory levels during the prior-year period. Organic net sales were relatively flat in the first half of 2018, in line with our expectations.

North America advertising and related consumer marketing spend increased on our scale confection brands in the second quarter. This was more than offset by optimization and shifts out of emerging brands as we emphasize more productive initiatives resulting in an overall decline of 6.1%.

Second quarter total International and Other segment net sales increased 3.1%, including a 1.7-point headwind from unfavorable foreign currency exchange. Net price realization was a 3.8-point benefit and volume was up 1 point, driven by solid sales growth in Mexico, Brazil and India, which grew a combined 15% on a constant currency basis, partially offset by lower exports. Our China team is delivering ahead of expectations on both the top and bottom line.

International and Other advertising and related consumer marketing declined 17%, in line with our expectations as we further rightsize our investments to drive more profitable growth.

Now, turning to gross margin, adjusted gross profit declined 0.4%, resulting in an adjusted gross margin of 44.5%, a decline of 260 basis points versus the second quarter of last year. This is in line with our expectations for the quarter and was driven by higher freight and logistics costs, unfavorable mix, incremental investments in trade and packaging to enhance the consumer experience at retail, plus additional plant costs related to new production lines.

Despite incremental pressure from recently enacted tariffs, we continue to expect a full-year gross margin decline of approximately 125 basis points. Given the pattern of last year's inflationary pressures, we expect year-over-year trends to sequentially improve in Q3 and Q4 versus the first half of 2018. We're making good progress against initiatives to address our gross margin pressures. We believe our price increase, additional capacity for our core brands, enhanced planning capabilities and SKU rationalization efforts will lead to sustainable gross margin improvement.

Second quarter adjusted operating profit of $339 million was impacted by $10 million of higher depreciation and amortization attributable to the Amplify acquisition and to our multi-year ERP initiative. This resulted in an adjusted operating profit margin of 19.4%, a decline of 140 basis points. Gross margin declines were partially offset by marketing spend shifts and optimization as well as continued SG&A discipline.

Moving down the P&L, interest expense of $35 million increased $11 million versus Q2 of last year, driven by the Amplify acquisition. We had a successful bond issuance in May to secure permanent financing for the Amplify acquisition. The issuance was oversubscribed more than three times with very attractive spreads. Full-year 2018 interest expense is expected to be in the $130 million to $140 million range, in line with our previously stated estimates.

The adjusted tax rate for the second quarter was 16% versus 24.8% in the year-ago period, driven by U.S. tax reform. We continue to expect the full-year 2018 adjusted tax rate to be approximately 19% to 20%. Second quarter other income and expense was $20.8 million.

Full-year 2018 expense is estimated to be between $65 million to $70 million, consistent with our previous estimates. The decline versus 2017 is driven primarily by lower non-service related pension costs, which, as you know, are now included in other income and expense and we no longer adjust out. We're continuing with our investment tax credit strategies and expect full-year 2018 expense to be comparable to 2017. Note that we expect most of the full-year other income and expense decline to be realized in Q4.

For the second quarter of 2018, weighted average shares outstanding on a diluted basis were approximately 210 million. The company repurchased $22 million of common shares in the second quarter to replace shares issued in connection with the exercise of stock options. The company did not repurchase any common shares against the $100 million share repurchase authorization approved in October 2017.

There is $60 million remaining on this authorization. Additionally, the board of directors has approved a new $500 million authorization for a total outstanding authorization of $560 million. There is no change to our target leverage or cash flow priorities.

Business growth, including M&A, remains our top priority, followed by dividends, then share buybacks. And as we've shared before, for the right M&A, we consider changing our leverage target. This new authorization enables us to make timely choices based on the outlook for M&A and market conditions.

Total capital additions, including software, were $75.8 million in the second quarter. For the full year 2018, we continue to expect CapEx to be in the $355 million to $375 million range. Our capital spending is focused on high-growth, high-margin brands and on technology we believe is critical for the future of our business growth. The additional Reese's line we installed in Q1 has enabled a strong seasonal order as Michele mentioned. And our new Kit Kat line is on track to start producing volume in Q4 and will be a key enabler of the brand's 2019 growth.

Additionally, we are expanding capacity on our Ice Breakers gum business. Retail sales there have grown over $145 million over the past four years, more than doubling the size of the business to approximately $275 million. Leading velocities have created additional distribution opportunities that this new capacity will enable us to support.

Our ERP initiative is on track. We will be implementing our new planning capability next month that will improve analytics to enable us to make better, faster decisions. It will also free up time for our commercial teams to focus on more value-added work.

To summarize for the full year, full year reported net sales are expected to increase towards the low-end of the updated 3.5% to 5.5% range. This includes an updated net impact from acquisitions and divestitures of approximately 3.5 points versus the previous estimate of 5 points, reflecting recent international business divestitures.

The outlook for organic net sales is reaffirmed towards the low-end of the slightly up to 2% range. Full year reported earnings per share diluted are now expected to be in the $4.76 to $4.96 range. We are reaffirming full year adjusted earnings per share diluted of $5.33 to $5.43, an increase of 14% to 16% versus last year.

Full year adjusted gross margin is still estimated to decline around 125 basis points versus prior year. The adjusted 2018 effective tax rate is approximately 19% to 20% and CapEx spending is estimated $355 million to $375 million, consistent with our previous outlook. We continue to return cash to our shareholders with second quarter dividends of $134 million. This was our 354th consecutive quarterly dividend on the Common Stock.

And we're pleased to have announced earlier today a dividend increase of 10%. We're confident in our ability to deliver strong earnings while taking the necessary steps to transform our business model and ensure a healthy, sustainable business in the future.

Thank you for your time this morning. I'll now turn it back over to Michele for some closing remarks.

[Michele G. Buck, The Hershey Co.]

Thank you, Patricia. Our brands are loved by consumers. And next year, we will celebrate our 125th anniversary. Each of us at Hershey are extremely proud that we can share a little goodness into the lives of our consumers. It's one of the things that makes Hershey so special.

With our success comes opportunity and responsibility that we take to heart. Our consumers and customers can feel good knowing that as we focus on winning in the marketplace, we are doing so in a way that positively impacts our people and our planet. Our investors can feel good knowing that this makes us a stronger business over the long term. We are focused on delivering the back half of the year, but our top priority remains on long-term value creation. We are making meaningful progress in transforming our domestic and international businesses and our multi-year strategic plan will continue to guide our investment decisions.

The rapidly changing retail environment is driven by the consumer and we will continue to drive our business forward by focusing on core brand growth and portfolio expansion, retaining and attracting the best talent to build the capabilities needed to delight our consumers, winning across the total commerce landscape and operating our businesses efficiently and effectively.

Patricia, Melissa and I are now available to take any of your questions.

[Operator]

Thank you. We'll take our first question from Ken Goldman from JPMorgan. Please go ahead.

[Kenneth B. Goldman, JPMorgan Securities LLC]

Hi. Thank you. Patricia, your accounts receivable were up fairly meaningfully, I think, around 20% year-on-year. And I realize last year's receivables level was unusually low. But beyond the comparison, was there any reason for the sizable increase in 2Q 2018? I guess really the larger question is whether you feel your shipments and consumption timing were more or less in line with each other this quarter, if there'll be any reversals next quarter or so forth? Just trying to get a sense of that whole environment, so to speak.

[Michele G. Buck, The Hershey Co.]

Go ahead, Patricia.

[Patricia A. Little, The Hershey Co.]

Yes. So, the biggest reason for the changes in receivables was clearly the Amplify acquisition as we acquired their receivables. So, that drove that increase. As we look overall to inventories at retail levels, it's always a changing environment. We have some customers where our inventories are up. We have some customers where our inventories are down.

Those that are up are focused really on service levels. I think, especially in this tight freight environment, the focus is making sure that they have enough safety stock to get products on shelf in this environment. And there was some inventory out where there was consolidation. And besides that, what we saw was sort of the normal patterns of inventory shifting that you'd expect from seasons and promotions similar to what we had last year.

[Kenneth B. Goldman, JPMorgan Securities LLC]

Okay. Thanks very much.

[Operator]

Thank you. We'll go next to the line of Alexia Howard from Bernstein. Please go ahead. Your line is open.

[Alexia Jane Howard, Sanford C. Bernstein & Co. LLC]

Thank you very much. Good morning, everyone.

[Michele G. Buck, The Hershey Co.]

Good morning, Alexia.

[Alexia Jane Howard, Sanford C. Bernstein & Co. LLC]

So, can I ask about the gross margin trends going forward? Obviously, you've been under a lot of pressure for the last year. It looks as though we're getting back to flattish, I guess, in the back half, given the guidance for the full year. What's enabling that sequential improvement as we move through into the second half? Thank you and I'll pass it on.

[Michele G. Buck, The Hershey Co.]

Patricia, do you want to take that one?

[Patricia A. Little, The Hershey Co.]

Yeah. So, some of it, Alexia, is just frankly lapping the fact that we saw the inflation really start to bite last year at this time especially and I think this was well covered in our call as well as frankly other people around some of the freight inflationary pressures that we had as well as some of the things that we highlighted in our call around the cost of complexity, some of the logistical costs that that drives. So, as we're lapping those, that's a big reason that we see those sequential improvements year-over-year.

But beyond that and I think more foundationally, we're really tackling the root causes of a lot of the impacts of what was driving that inflation. So, really working hard on freight optimization, making sure that we're trying to avoid buying in the spot market, we contract our freight in advance and then really pushing hard on complexity, both from what we've talked about before with our SKU rationalization, but getting at some of the even deeper root causes of planning better, which is something we mentioned on this call, using some of our analytics tool. If we can plan it on a more granular level, it avoids some of those costs.

So, those are things we're working on. And then, the third benefit that we really see driving that year-over-year improvement in the very back of the year is a strong improvement in international, which continues, as Michele, I think, really highlighted in her remarks, to drive to a profitable growth (33:18) margin.

[Alexia Jane Howard, Sanford C. Bernstein & Co. LLC]

Great. Thank you very much. I'll pass it on.

[Operator]

Thank you. We'll go next to the line of Andrew Lazar from Barclays. Please go ahead.

[Andrew Lazar, Barclays Capital, Inc.]

Morning, everybody.

[Michele G. Buck, The Hershey Co.]

Hi, Andrew.

[Andrew Lazar, Barclays Capital, Inc.]

Hi. I think you mentioned that volume in North America was up 1% and that's a bit better than, I think, what we've seen in some of the scanner. And then, I also thought last quarter that the SKU rationalization you talked about to start to limit some of the complexity, maybe would be a bit more of a drag to North America organic growth in this quarter as well. So, I'm trying to get a sense of whether those things, those programs were the drag that you expected or I guess maybe it's just all the untracked channels at the end of the day, but maybe that differential between what we saw in North America volume with the other aspects I mentioned would be helpful.

[Michele G. Buck, The Hershey Co.]

Yeah. Andrew, so I will start with, as you know, we said that we expected the first half to be our softer half and second half to be stronger. Certainly, as we look at Q2, we did see retail takeaway a little softer and that was partially offset by strength above what we anticipated in non-measured channels as the consumer continues to be fluid relative to where they're purchasing products. And that's very important for us to focus on.

I would say that the real impact from SKU rationalization is really going to go much more forward versus Q2. So, we really just kicked the program off in the middle – first part of the year. And so, we're going to see more of that impact come later. I guess, as you think about takeaway for the year, what I would say is, as we look to the back half, the key levers that really are going to accelerate growth are, first of all, seasons, which you know is about a third of our business. We have strong visibility into seasonal orders, as you know, because customers commit way in advance and we produce in advance and we have very strong commitments on the season, both Halloween and Holiday.

Secondly, we have also visibility to customer resets in the fall. And we know, through our partnership with retailers, we have a real a focus on making the shelf as productive as possible and that will lead to some distribution gains for us in the back half of the year. We also have the launch of Reese's Outrageous! which really just began in June, but it really accelerates and we gain full distribution in the second half of the year. So, our instant consumable innovation lap, it's much stronger what we have in place this year than prior year. And I'd say those are some of the biggest factors.

[Patricia A. Little, The Hershey Co.]

The only thing I wanted to add on the SKU rationalization is, as you'd expect, the first things that we take out are frankly SKUs with very small volume. So, they're not the ones that you see a big impact of and we also focused a lot on merch units, which, again, you don't see coming through in the scanner data.

[Andrew Lazar, Barclays Capital, Inc.]

Right. Thanks very much.

[Michele G. Buck, The Hershey Co.]

Thank you.

[Operator]

Thank you. We'll go next to the line of David Driscoll from Citi. Please go ahead.

[Michele G. Buck, The Hershey Co.]

Hi, David.

[David Cristopher Driscoll, Citigroup Global Markets, Inc.]

Great. Hi. Good morning. I wanted to ask some questions just around pricing, but I wanted to start with inflation. Could you guys just quantify your expectations for inflation in 2018? And then, one piece of complexity that's a little unusual, but I think we need to know is, is how much of the inflation is system-wide or industry-wide versus Hershey specific? And I'm really thinking about the stand-up packaging, because I know that that's been a big issue. So, there's a question there on inflation and then, I have a follow-up on pricing.

[Michele G. Buck, The Hershey Co.]

Okay. Patricia, do you want to handle the inflation question?

[Patricia A. Little, The Hershey Co.]

Yeah. I guess if I take it in some buckets, we're seeing a standard inflation that we always see going through on wages and benefits that again, what I think, is industry-wide throughout the country. Second, the freight inflation is hitting us and we do see that impact as well. Again, I think, that's industry-wide. In fact, I think, our guys have done a really good job of managing that, frankly better than probably the industry.

In terms of commodities inflation, I think it's a constantly changing landscape out there. It's not a huge driver for us this year. We have seen some volatility in some of our input costs, like cocoa, but, frankly, we think our hedging program really does a great job of smoothing some of the very short-term swings that we see there.

So, those are things that I would say everybody in the industry is seeing, wage, freight, whatever their commodities piece is. And then, you're right, we do have some impacts that are specific to us. I think the ones that I would call out are some of the inflations that we see as just being driven from some of this complexity that we've talked about, which drives some internal logistics costs as well as the packaging, which we have talked a lot about over the last several quarters. And we think that that investment that we've made in more expensive packaging though will really deliver, especially going forward, a better value proposition and impression on shelf to our consumer.

[David Cristopher Driscoll, Citigroup Global Markets, Inc.]

And then, on pricing, can you guys quantify the magnitude and timing of the pricing? And then, one question specifically, I think pricing in the quarter is down. So, Michele, if you could just kind of put this together for me, we're taking a price increase, but yet in the second quarter, pricing was down and it's not even immaterial. I think it's at 1.6%. So, kind of why is pricing so weak in the second quarter, yet there is pricing announcements coming? It's just a little bit of a – it kind of seems a little bit off in terms of kind of second quarter results and what they suggest versus what it is that you need, but maybe you could pick it up and take it from there.

[Michele G. Buck, The Hershey Co.]

Yeah. Absolutely. So, let me start with the first part of your question relative to the price increase. If you look at our total price increase, the weighted average increase of the total of all the actions we took is about 2.5% across our total business. If you really break that out, as I mentioned in my comments, we've utilized a couple different pricing levers and so, the entire portfolio is impacted by terms. There are select pieces of the portfolio impacted by price-pack optimization.

And then, about a third of the portfolio experienced just a straight price increase. So, that's kind of how you can think about it relative to across the portfolio. We announced it this past week as is the case with what we've done historically. We do need to price protect for promotions that are already committed to customers.

So, really the prime benefit of that comes closer to next year. As you know, there's a little bit of a conversion on the way to realizing the price. And obviously, we have seasons in the back half of the year that are about a third of our back half where we have prices protected as well.

As you look at the second quarter and price realization there, Patricia, do you want to talk a little bit about that?

[Patricia A. Little, The Hershey Co.]

Yeah. So, as we shared before, we have been shifting some dollars into trade this year to support some incremental in-store activity. And then, I think, it's also important to say that there are a number of things going on in our trade line. Some of it did show through on the scanner to the consumer, but it was actually fairly small amount. There's other pieces, which really supported more just in-store activity and then, actually a fair amount of it also was frankly some costs that just shifted from below the gross sales – the net sales line into net sales for some accounting reasons as well as some prior-year true-ups. So, it was a mix of different things.

And I think that, as we go forward, we just always are looking at our trade, making sure that we evaluate the effectiveness of it versus advertising and working with our retailers and making sure that we're really driving the best value possible from those dollars.

[Michele G. Buck, The Hershey Co.]

Yeah. Remember, I guess, I would say, in our category, as you know, one of the most important things to generate from our trade is merchandising. So, we continuously balance how much goes into price. And as Patricia mentioned, there was a relatively smaller amount that really showed up as a retail price decline.

[David Cristopher Driscoll, Citigroup Global Markets, Inc.]

Thank you so much.

[Operator]

Thank you. We'll go next to the line of Jonathan Feeney from Consumer Edge. Please go ahead.

[Jonathan Feeney, Consumer Edge Research LLC]

Good morning. Thanks very much.

[Michele G. Buck, The Hershey Co.]

Hi, Jonathan.

[Jonathan Feeney, Consumer Edge Research LLC]

How are you?

[Michele G. Buck, The Hershey Co.]

Very good. How are you?

[Jonathan Feeney, Consumer Edge Research LLC]

I'm doing great. So, I wanted to – you gave us the top line impact, but a real simple question, trying to understand any color you can give us around what Amplify did both, in total, in North America to margin trend year-over-year and the operating profit trend year-over-year? So, it seems to be there'll be somewhat of a positive impact. Any quantification you can give us or – directionally would be very helpful?

[Michele G. Buck, The Hershey Co.]

Yeah. I mean we feel good about what – the profit that we're delivering on the business and it is actually ahead of our expectations. So, we are feeling good that we're over delivering on our acquisition model on the top and bottom line. And so, it's having an impact in line with what we had shared with you earlier relative to, if you look at EPS accretion, we are in line with the range that we had provided and are seeing strong profitability.

In fact, the team has been focused on really very strong discipline about leveraging the value of that brand and actually spent some time this year eliminating non-productive promotions to further focus on profitable growth. But really if you look overall, the gross margin impact of that business on our total North America business, just given the size of it, is pretty minimal.

[Jonathan Feeney, Consumer Edge Research LLC]

Okay. Thank you very much.

[Operator]

Thank you. And we'll go next to the line of Bryan Spillane from Bank of America. Please go ahead.

[Bryan D. Spillane, Bank of America Merrill Lynch]

Hey. Good morning, everyone.

[Michele G. Buck, The Hershey Co.]

Good morning.

[Bryan D. Spillane, Bank of America Merrill Lynch]

Got a follow-up question just on price increase. I think in the past, when the pricing in the category has been more episodic, retailers, my recollection of it, has pretty much applied it across the board to everyone. Where here, it's a little bit more dynamic, I guess, right? Your – part of it is list price, some of it is price pack. So, I guess I'm trying to get a sense from your expectations. Will retailers sort of look at what Hershey is doing in isolation or will they try to sort of apply it across the whole category?

[Michele G. Buck, The Hershey Co.]

I really could only speculate on that. So, at this point in time, I really don't know. I'm not sure what their plans will be there. That really rests in their hands.

[Bryan D. Spillane, Bank of America Merrill Lynch]

I guess as you have factored in elasticities (44:28), have you, I guess, thought about that differently maybe than you had in the past?

[Michele G. Buck, The Hershey Co.]

Well, we always look at where our pricing is. And in some parts of the portfolio, there's a lot of similarity in our portfolio and competitive portfolios. In some parts of our portfolio, there's not. So, we've continued to do a very detailed analytic price elasticity models and evaluate all the learnings across, but we can't really share the specifics behind that.

[Bryan D. Spillane, Bank of America Merrill Lynch]

Okay. All right. Thank you.

[Operator]

Thank you. We'll go next to the line of Rob Dickerson from Deutsche Bank. Please go ahead.

[Rob Dickerson, Deutsche Bank Securities, Inc.]

Great. Thank you. I just had a bit of a bigger picture question on international. You've divested the two businesses. So, congratulations on doing that. But just in terms of overall profitability expectations, as we think forward into 2019, but say three years forward, how should we – or how would you like them the market to be thinking about the operating margin potential on that segment?

And I just asked, because I think a lot of us can remember dating back, let's call it, five years when there was an expectation for low-double-digit operating margin on the business. A lot kind of happened in the interim. That kind of went away to an extent. And then, in Q2, you're putting up almost 9% in op margin and that's I'm assuming before some hopefully positive effect that would be coming from the divestments. Thanks.

[Michele G. Buck, The Hershey Co.]

Sure. So, we feel very good about the profitable growth that we are deriving and how we've reset the markets. And we also see continued opportunity going forward. So, I think without getting into tremendous specificity, I think it would be fair to say that we believe low-double-digit margins will be possible – could be possible going forward. And I think that's a good way to think about it.

[Rob Dickerson, Deutsche Bank Securities, Inc.]

Thank you.

[Operator]

Thank you. And we'll go next to the line of Steve Strycula from UBS. Please go ahead.

[Steven Strycula, UBS Securities LLC]

Hi. Good morning. Quick clarification, just wanted to see whether – when you talked about the industry price increases and your price increases, across the portfolio, is this in line with some of the peers are doing? Lindt had commented that Ferrero and some others who are out there in the marketplace also taking price. So, first question, I just want to say, is that pretty much at parity with what you're seeing across the landscape?

[Michele G. Buck, The Hershey Co.]

I'm not sure that I'm in a position to really comment on others' pricing actions in the marketplace. I think I'd prefer to stay away from that and I'm not sure honestly that I have full knowledge of what others have done, given the actions have been relatively recent.

[Steven Strycula, UBS Securities LLC]

Okay. Great.

[Michele G. Buck, The Hershey Co.]

I know there are some of them out there.

[Steven Strycula, UBS Securities LLC]

And then, how should we think strategically about M&A going forward? It seems like, a few times on the call today, you called out the lower leverage of the balance sheet and the appetite to looking at different types of assets in the marketplace. Are you seeing anything out there in terms of the landscape that's more appealing today versus what it was 6, 12 months ago, whether it's asset prices or anything you can kind of speak to?

[Michele G. Buck, The Hershey Co.]

Yeah. We remain committed, as we laid out in our strategy in March of 2017, that M&A is a critical pillar of growth. We see that as an opportunity to capture more snacking occasions, given our strengths and core capabilities in the area of snacking. And so, I would say, we continue to be committed and you can look at our activity and see that we're taking action probably at an increasing rate versus perhaps where we were in the past, at least relative to size and scale of assets.

I would say that probably the biggest thing influencing our actions is, I think that we have learned a lot and are applying a lot of lessons from past acquisitions. And so, we have perhaps even tighter screening criteria that allow us, I believe, to move more dynamically to capture opportunity.

[Steven Strycula, UBS Securities LLC]

Great. Thank you.

[Operator]

Thank you. We'll go next to the line of Pablo Zuanic from SIG. Please go ahead.

[Aatish Shah, Susquehanna Financial Group LLLP]

Hi. Good morning. This is actually Aatish Shah on for Pablo. On a more of a structural level for the quarter specifically, just want to know if there's a change in attitude by retailers regarding the chocolate category, specifically if you could touch on this by channel, space allocation, promotional environment, et cetera, that will be helpful. Thank you.

[Michele G. Buck, The Hershey Co.]

Yeah. I would say that the chocolate category and the confection category overall continue to be a category that's very important to pretty much all of our retail base, because it is a category with pretty high profitability and it has produced well for retailers over time.

So, certainly, in terms of the level of priority and shelf space, that does vary a bit by different classes of trade and different retailers, depending on their strategies. But overall, I would tell you that we have continued to work with key retailers, some of whom are looking to expand space in the category as they look at other categories in their box and say how do they best master the space allocation. And if you just look at category growth across all categories in store, you know that confection continues to grow faster than many.

So, there certainly are many that are looking at that. And then, as we know, there are a couple who have strategies that head in a different direction, and so they probably aren't prioritizing it, but I would say, overall, we continue to feel good about the role of this category and how retailers are viewing it as very important.

[Aatish Shah, Susquehanna Financial Group LLLP]

Great. Thank you.

[Operator]

Thank you. We'll go next to Jason English from Goldman Sachs. Please go ahead.

[Jason English, Goldman Sachs & Co. LLC]

Hey. Good morning, folks. Thank you for allowing me to ask a question. I appreciate it. A few housekeeping details, I guess, first, the disposal of Tyrrells and Golden Monkey, what's the anticipated revenue drag on both the tail-end of this year and on a 12-month basis?

[Michele G. Buck, The Hershey Co.]

Patricia, you want to – yeah.

[Patricia A. Little, The Hershey Co.]

Yeah. So, you can see that that's really the delta between the 5 points that we talked about from acquisition down to the 3.5 [points].

[Jason English, Goldman Sachs & Co. LLC]

Okay. That math sort of implies if we annualize it that those businesses are about a third smaller than they were when you bought them. Is that right?

[Patricia A. Little, The Hershey Co.]

I don't think you can do it that way, because for Amplify, Tyrrells is a piece of their business, but for Golden Monkey, it's been changing dramatically as we go.

[Jason English, Goldman Sachs & Co. LLC]

And a quick back of the math envelope, we get about a 15, 20 basis point gross margin tailwind from exiting those businesses, reasonable?

[Patricia A. Little, The Hershey Co.]

I'd have to look quickly. There's a small gross margin improvement, but it's very small.

[Jason English, Goldman Sachs & Co. LLC]

And then, last question, I'll pass it on. You mentioned – a two-parter question. On the pricing components, can you specify what that third of the portfolio is where you took a straight price increase? I am assuming it's sort of single serve. And can you give us the magnitude? And you mentioned investment in packaging. Can you contextualize that for us? Give us a sense of what exactly you're referring to.

[Michele G. Buck, The Hershey Co.]

So, I can tell you that some of the specific price increases were primarily in the Take Home Packs. And I think that's about as much detail as I want to go into on that. And then, relative to investments in packaging, that's really about the refresh to create strong impactful packaging graphics and structure at retail to capture shelf impact. And that's one of the areas where we look at the total value proposition to the consumer and really try and optimize that value proposition. And that's part of what you see in our broad pricing action.

[Jason English, Goldman Sachs & Co. LLC]

What's that mean? Is that like more retail-ready packaging? Is that more stand-up pouches? I'm not sure what your comments refer to.

[Michele G. Buck, The Hershey Co.]

Yeah. So, it's across the board. There are multiple components. A piece of that is retail-ready packaging. A piece of that is a change in the structure of our laydown bags to be standing up and to have more of an impact from that perspective. So, it makes them easier for consumers to use, allows for much greater shelf impact. And as always, when we look at adding value to consumers, we always look at making sure that we're aligning the price value and getting price realization as we invest more in some of our packaging.

[Jason English, Goldman Sachs & Co. LLC]

Thanks a lot. I really appreciate it.

[Operator]

Thank you. And we'll go next to the line of Robert Moskow from Credit Suisse. Please go ahead.

[Robert Moskow, Credit Suisse Securities (NYSE:USA) LLC]

Hi. A couple of follow-up questions, regarding the e-commerce strategy, it's encouraging to see the sales up 30%, but I'm having trouble figuring out how to think about the mix impact it might have away from higher margin single serve and maybe more towards Take Home. Have you done any math to determine if this dynamic would shift – would also be a drag on mix?

And then, also I think you've said in the past that you can shift spending from one bucket to another to fund all of this e commerce investment that needs to take place, but my concern is that you kind of have to invest in both brick-and-mortar and e-commerce at the same time. Can you elaborate a little bit on those things?

[Michele G. Buck, The Hershey Co.]

Yeah. So, as you look at e-commerce as a channel, we won a bigger business in e-commerce and on the other hand, we're somewhat fortunate that food and especially condition distribution has been a little bit slower than some other categories. So, we've been able to capture some of the learning that those categories have experienced in terms of really thinking about the packs that we want to sell the price points and what the portfolio looks like in that channel. And I think that is helpful to us as we look at continuing to drive margins.

And as we look at the investment in e-commerce, we have really had programs underway to look at how we want to reallocate our resources strategically across the portfolio. So, if you look at the increase in profitability that we have in international, that was a choice to improve profitability to be able to fund some of our other critical strategic initiatives. So, that freed up money.

We had a major initiative to reorganize internally to drive even greater commercial value. We took dollars out of SG&A on our corporate functions. And that's another source of funds that we could reallocate. So, what we've tried to do is prioritize all commercial value, which is really bricks-and-mortar and e-commerce as users of funds and then, some of those other areas that I spoke to as sources of funds.

[Robert Moskow, Credit Suisse Securities (NYSE:USA) LLC]

Got it. Thank you.

[Melissa A. Poole, The Hershey Co.]

Erica, we have time for one more question.

[Operator]

Thank you. And for the final question, we'll go to John Baumgartner with Wells Fargo. Please go ahead.

[John Joseph Baumgartner, Wells Fargo Securities LLC]

Thanks. Good morning. Thanks for fitting me in. Michele, just on the international side, the profit recovery has been pretty good, but I'd like to hear more about your vision for the topline. And that, I guess, Brazil and Mexico, India, they're strong, but they're pretty small relative to the U.S. So, do you see Hershey being more of an America-centric business going forward, you lean more on the export business going forward? Is there an opportunity for version 2.0 in China? How do you think about the resource allocation going forward?

[Michele G. Buck, The Hershey Co.]

So, as we think about the international business, our goal is on driving profitable growth. And as we've talked a little bit about our strategy in the past, we have an algorithm that basically says we want to get about 0.5 point of profitable growth from the international business and I think there is a possibility that could go up a bit over time.

Canada and Mexico, our scale markets, where we have scale positions, strong businesses that kind of fit one role in the portfolio. And then, as we mentioned, export is highly profitable business. So, we'll continue to run that to leverage our brands in key markets. And then, we're placing some bets when you look at China and India in particular on the huge growth that's going to incur in the future and is occurring in those markets and really focused on building sustainable business models.

And pending the outcome of that, we'll determine how much more investment we put there, but I think it's clear that we feel good that those businesses have gotten to a point where their profitability is very good. And we'll continue to make choices as we see the success on individual bets in those markets.

[John Joseph Baumgartner, Wells Fargo Securities LLC]

Just given the experience to Golden Monkey and then, I guess, there's another example of the Bauducco JV elsewhere in the world. I mean what's your appetite for taking on more M&A in emerging markets? I mean do you go with a partner or do you do more JVs? How do you think about that?

[Michele G. Buck, The Hershey Co.]

I'd say right now that is not our focus for M&A activity. Our focus is in the U.S. market. So, I feel very good about – we have enough scale in Canada and Mexico. And I think that we're making really good progress on our own in China and India, not ruling out any potential strategic partnership going forward, but feeling good about our focus on The Hershey brand, on a higher margin portfolio and local talent, doing all the right things to accelerate our business. And I think we've got good success or good proof points that in the past when we've stuck with that, it has worked for us pretty well.

[John Joseph Baumgartner, Wells Fargo Securities LLC]

Thanks for your time.

[Melissa A. Poole, The Hershey Co.]

Thank you all for joining us this morning. I look forward to connecting with you all later today to answer any additional questions you may have.

[Michele G. Buck, The Hershey Co.]

Thank you.

[Operator]

We'd like to thank everybody for their participation on today's conference call. Please feel free to disconnect your line at any time.