5 Hershey FoodsCorporation-2005Fred R. DavidFrancis Marion University

HSYwww.hersheys.comHave you ever been to Hershey, Pennsylvania, the home of Hershey FoodsCorporation? Known as Chocolate Town, USA, the air in this city actually smells likechocolate. There you can walk down Chocolate Avenue, see sidewalks lit with lights inthe shape of Hershey's Kisses, visit Hershey's ZooAmerica, and see the chocolate kisstower in HersheyPark. Hershey's Chocolate World is America's most popular corporatevisitor'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, andgrocery products. The company markets confectionery and grocery products in over60 countries worldwide, down from 90 countries a few years ago. Hershey's promi-nent products are chocolate and nonchocolate confectionery products consisting ofbar goods, bagged items, and boxed items. Hershey grocery products include bakingingredients, peanut butter, chocolate drink mixes, dessert toppings, and beverages.Hershey markets these products under more than 50 different brands, such asHershey'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 theUnited States, Mexico, and Canada, even though the candy industry has globalized.Mars, Borden, Nestle, and other competitors all have a growing and effective presencein international markets. Analysts question whether Hershey Foods can continue tosurvive as a domestic producer of candy while its competitors gain economies of scaleand learning inworld markets. Shareholders are becoming concerned, too.

HistoryMilton Hershey's love for candy making began with a childhood apprenticeshipunder candy maker Joe Royer of Lancaster, PennsylvaniaMr, Hershey was eager toown a candy-making business. After numerous attempts and even bankruptcy, hefinally gained success in the caramel business. Upon seeing the first chocolate-makingequipment at the Chicago Exhibition in 1893,Mr. Hershey envisioned endless oppor-tunities for the chocolate industry, .,~

By 1901, the chocolate industry in America was growing rapidly. Hershey'ssales reached $662,000 that year, creating the need for a new factory. Mr. Hersheymoved his company to Derry Church, P;nnsylvania, a town that was renamedHershey in 1906. The new Hershey factory provided a means of mass-producing asingle chocolate product. In 1909, the Milton HersheySchool for Orphans wasfounded.' Mr. and Mrs. Hershey could not have children, so for years the Hershey

Chocolate Company operated mainly to provide funds for the orphanage. Hershey'ssales reached $5 million in 1911.

In 1927, the Hershey Chocolate Company was incorporated under the laws ofthe 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 householdword. The legendary Milton Hershey died in 1945.

In the 1960s, Hershey acquired the H. B. Reese Candy Company, which makesReese's Peanut Butter Cups, Reese's Pieces, and Re!se's Peanut Butter Chips. Hersheyalso acquired San Giorgio Macaroni and Delmonico Foods, both pasta manufactur-ers. In 1968, Hershey Chocolate Corporation changed its name to Hershey FoodsCorporation. Between 1976 and 1984, William Dearden served as Hershey's chiefexecutive officer. An orphan who grew up in the Milton Hershey School for Orphans,Mr. Dearden diversified the company to reduce its dependence on fluctuating cocoaand sugar prices.

In the 1970s, Hershey acquired Y&S Candy Corporation, a manufacturer oflicorice-type products, such as Y&STwizzlers, Nibs, and Bassett's Allsorts. Hersheypurchased Procino-Rossi, a pasta company, and Skinner Macaroni Company.During the 1980s, Hershey acquired A. B. Marabou of Sweden, aswell as theDietrich Corporation; maker of Luden's Throat Drops, Luden's Mellomints,Queen Anne chocolate-covered cherries, and 5th Avenue candy bars. It alsoacquired the Canadian confectionery (chocolate and nonchocolate candy) andsnack nut operations of Nabisco Brands Ltd. Hershey also acquired PeterPaul/Cadbury's U.S. candy operations, which gave them new products, such asMounds, Almond Joy, York Peppermint Pattie, Cadbury Dairy Milk, CadburyFruit & Nut, Cadbury Caramello, and Cadbury Creme Eggs. Hershey has rights tomarket the Peter Paul products worldwide.

Hershey purchased Nacional de Dukes (NDD) and renamed this companyHershey Mexico, which today produces, imports, and markets chocolate products forthe Mexican market under the Hershey brand name. In 1996, Hershey acquired LeafNorth America to gain market-share leadership in North America in nonchocolateconfectionery candies. In 2000, Hershey purchased the breath freshener mints andgum 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 LoaMacadamia Nut Corporation. Mauna Loa, which is the leading processor and marketerof macadamia snacks, has annual sales of about $80 billion. The Mauna Loa brandname includes cookie and snack items. Grupo Lorena is the leader in Mexico. in thespicy candy market and haS annual sales of over $30 million. Its Pelon Pelo RIcobrandis especially popular.

Hershey also manufactures and/or markets grocery products in the baking,beverage, peanut butter, and toppings categories. Its grocery products include suchitems as HERSHEY~SSyrup, HERSHEY'S Cocoa, and Reese's Peanut Butter.

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

decentralized in some manner. Another indication of the functional structure isthat Hershey does not provide for its shareholders financial data by segment suchas geographic region or product, again implying centralized control and account-ability. Hershey, in the late 1990s, had operated with two divisions: Hershey NorthAmerica and Hershey International.

Hershey has approximately 13,700 full-time arid 2,300 part-time employees, ofwhom about 5,100 are members of a union. Hershey's stated objectives includeincreasing sales 3 t04 percent annuajly, increasing gross margin 70 to 80 basis pointsannually, increasing earnings before interest and taxes 7 to 9 percent annually, andincreasing earnings per share 9 to 11 percent annually. Hershey's North Americanmanufacturing operations are located in the following cities:

Hershey, PennsylvaniaOakdale, CaliforniaStuarts Draft, VirginiaLancaster, PennsylvaniaRobinson, IllinoisSmith Falls, Ontario, CanadaGuadalajara, MexicoDenver, Colorado (sold in February 2005)

Hershey's North American operations produce an extensive line of chocolateand nonchocolate products sold in the form of single bars, bagged goods, and boxeditems. These products are marketed under more than 50 brarid names and sold in over2 million retail outlets in North America, including grocery wholesalers, chain stores;mass merchandisers, drug stores, vending companies, wholesale clubs, conveniencestores, and food distributors.

Social ResponsibilityHershey Foods Corporation is committed to the values of its founder Milton S..Hershey: the highest standard of quality, honesty, fairness, integrity, and respect. Thefirm makes annual contributions of cash, products, and services to a variety ofnational and local charitable organizations. Hershey is the sole sponsor of theHershey National Track and Field Youth Program. Hershey also makes contributionsto the Children's Miracle Network, a national program benefiting children's hospitalsacross the United States. .

The corporation operates the Milton Hershey School, whose mission is to pro-vide 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 gradeskindergarten through 12. The Hershey School Trust owns over 75 percent of aUHershey 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 productionprocesses.Recently, Hershey's research and development expenditures have declinedsteadily from 1998's level of $28.6 million to $23.2, $24.2, and $23.4 million respec-tively 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 productionprocesses, and develop and implement new technologies to enhance the quality andvalue 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 marshmallowbars; Hershey's SmartZone nutrition bars; TakeS candy bars; Hershey's AlmondJoy, York, and Reese's cookies; Reese's Pieces candy with peanuts; and Reese'sBig Cup.

FinanceHershey's 2004 financial statements are provided at the end of this case. Note thatHershey's sales increased about 6 percent in 2004, and gross margin increased to39.5 percent from 39.0 percent in 2003. Net income was $590.9 million in 2004compared to $457.6 million in 2003. Hershey purchased 11;)8 million shares of itscommon 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 con-sortium of banks and has the option to borrow an additional $600 million ifneeded. Hershey has more than $463 million in goodwill on its balance sheet,which is not good.

MarketingIn 2004, Hershey's sales to McLane Company comprised about 25 percent of all corn-pany sales. McLane is one of the largest wholesale distributors in the United States toconvenience stores, drugstores, wholesale dubs, and mass merchandisers. Hersheyhas developed a. distribution network from its manufacturing plants, distributioncenters, and field warehouses strategically located throughout the United States,Canada, and Mexico.

Hershey has steadily reduced its advertising expenses from $187.5 million in1998 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 inmanufacturing costs, the competitive environment, and profit objectives. InDecember 2004, Hershey announced an increase in the wholesale prices of about halfof its domestic confectionery line. A weighted average increase of about 6 percent ofHershey's standard bar, king-size bar, six-pack, and vending lines was effective inJanuary 2005. A weighted average price increase of about 4 percent on packagedcandy 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 expensesdecreased 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 foodstoday 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 thesame candy bar twice in a row; consequently, product variety is crucial to success.Marketing issues relative to health, nutrition, and weight consciousness areimportant. The media Hershey uses most for advertising are network television,followed by syndicated television, spot television, magazines, and network andspot radio.

Confectionery sales are generally lowest during the second quarter of the yearand 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 and30 percent of annual salesduring the fourth quarter of each year.

Global IssuesHershey exports confectionery and grocery products worldwide but not with vigor.Europeans have the highest per-capita chocolate consumption rates in the world, butHershey has no plans to overtake or even threaten Nestle or Mars in Europe. In the FarEast, Hershey has signed licensing agreements with Selecta Dairy Products to manu-facture Hershey's ice cream products in the Philippines and with Kuang Chuan Dairyin Taiwan to manufacture Hershey's beverages. Hershey introduced its products intoRussia, the Philippines, and Taiwan. Overall in the Far East, however, Hershey is notplanning sustained efforts due to perceived high political and economic risks coupledwith the company's lack of experience.

The most significant raw material used in the production of Hershey chocolateproducts is cocoa beans. This ~ommodity is imported principally from West African,South American, and Far Eastern equatorial regions. West Africa accounts forapproximately 70 percent of the world's crop. Cocoa beans are not uniform, and thevarious grades and varieties reflect the diverse agricultural practices and natural-con-ditions found in the many growing areas. Hershey buys a mix of cocoa beans to meetits manufacturing requirements. Cocoa prices hit an I8-year high in February 2003and since then have remained high, averaging 67.7 cents per pound in 2004, downfrom 77.8 cents in 2003.

Hershey's second most important commodity for its domestic chocolate andconfectionery products is sugar. Due to import quotas and duties imposed to supportthe price of-sugar, sugar prices paid by United States users are currently substantiallyhigher than prices on the world sugar market. The average wholesale list priceof refined sugar has remained in a range of 25 to 32 cents per pound for the past10 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 highin 2004 and moderated down some in 2005. .

The chocolate/cocoa products industry is SIC 2066, while candy/confec-tionery is SIC 2064. The main distribution channels for chocolate are grocery,drug, and department stores as well as vending machine operators. Almost ill ofthese distributors are local, regional, or national; only a few are multinational.While chocolate producers have not yet developed globally uniform marketingprograms, the situation is changing. European unification extended grocery anddepartment store channels of distribution. For example, Safeway, a U.S. grocerychain, now operates stores in Canada, Britain, Germany, and Saudi Arabia.:As global channels of distribution become more available for chocolate manufac-turers, global marketing uniformity will become more prevalent in the industry.Global cultural convergence is accelerating the need for more global marketinguniformity in the confectionery industry. Hershey's competitors are taking advan-tage of this globalization trend.

The confectionery industry is characterized by high. manufacturing economiesof scale. Hershey's main chocolate factory, for example, occupies more than 2 millionsquare feet, is highly automated, and contains much heavy equipment, vats, and con-tainers. It is the largest chocolate plant in the world. High manufacturing costs in anyindustry encourage global market expansion, globally standardized products, andglobally centralized production.

The confectionery industry is also characterized by high transportation costsfor moving milk and sugar, the primary rawmaterials. This fact motivates compa-nies, such as Hershey, to locate near their sources of supply. Since milk can beobtained in large volumes in many countries, chocolate producers have many options

in locating plants. Also, producing chocolate is not labor intensive, nor does it requirehighly skilled labor.

Industry analysts expect the candy industry to continue to grow. Consumptionof chocolate, according to industry analysts, is closely related to national income,although the Far East is an exception to this rule. Candy consumption varies inthe major markets of the developed nations. Americans annually consume about22 pounds of candy per person and Europeans consume about 27 pounds of candyper person .

.Chocolate accounts for about 54 percent of all candy consumed. NorthernEuropeans consume almost twice as much chocolate per capita as Americans. AmongEuropean countries, Switzerland, Norway, and the United Kingdom consume the m stchocolate, while Finland, Yugoslavia, and Italy consume the.least. The Japanese also con-sume very little chocolate-about 1.4 kilos per capita. Throughout Asia and SouthernEurope, there is a preference for types of sweets other than chocolate, partly because ofthe high incidence of lactose intolerance (difficulty in digesting dairy products) .

•CompetitorsThe $10-billion U.S. confectionery industry is composed of six major competitorswho 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 dividedamong 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 rev-enues come from international sales. Hershey's other competitors also do much oftheir business outside North America. For example, Cadbury Schweppes obtains50 percent from international sales, and Mars 50 percent, while Hershey has the leastwith 1o percent. Hershey's two major candy competitors are Mars and Nestle.

MarsMars has a stronger presence than Hershey in Europe, Asia, Mexico, and Japan. Marsgained 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 aEuropean candy, into the United States without prior test marketing. Mars, unlikeHershey, globally uses uniform marketing. For example, the company's M&M candiesslogan, "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 secretivecompany, unwilling to divulge financial information and corporate strategies. UnlikeHershey, Mars has historically relied upon extensive marketing and advertisingexpenditures to gain market share, rather than on product innovation. Mars has beenrepackaging, restyling, and reformulating its leading brands, including Snickers,.M&M's, Milky Way, and 3 Musketeers, but that strategy is now being supplementedwith extensive product development. NewMars products include Bounty, Balisto,and PB Max. It also successfully developed and marketed frozen Snickers ice creambars, a product that was so successful it dislodged Eskimo Pie and Original Klondikefrom the number-one ice cream snack slot without any assistance from promotionaladvertising. 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 todayvirtually owns the chocolate market there.

NestleWith annual sales exceeding $9 billion in the U.~., Nestle is the largest food com-pany in the world. Nestle's U.S. operations are headquartered in Glendale, .California. With corporate headquarters in Vevey, Switzerland, Nestle is a majorcompetitor in Europe, the Far East, and South America. Nestle sells products inover 360 countries on all seven continents, many in the Third World. It is theworld's largest instant coffee manufacturer, with Nescafe the dominant product.Nestle alsd produces and markets chocolate and malt drinks and is the world'slargest producer of milk powder and condensed milk.

Nestle's chocolate and confectionery products carry some popular brandnames, including Callier, Crunch, and Yes.With the acquisition of Rowntree, addi-tional notable brands were added to the product line, including Smarties, After Eight,and Quality Street. The Perugina division produces Baci. Through the RJR Nabiscoacquisition, Nestle acquired Curtiss Brand, a U.S. confectionery producer with suchproducts as Baby Ruth and Butterfinger. Nestle manufactures chocolate in 23 coun-tries, particularly in Switzerland and Latin America. Each factory is highly auto-mated, employing an average of 250 people ..

Another major product concentration for Nestle is frozen foods and otherrefrigerated products. Findus in Europe and Stouffer in the United States representthe bulk of the group's frozen food sales with well-known brands such as LeanCuisine. Nestle also manufactures a fast-developing range of fresh pasta and sauces inEurope and the United States under the name Contadina.

ConclusionHershey's global market share in the chocolate confectionery industry is less thanlO percent, lowest a~ong its competitors. A major strategic issue facing Hershey todayis where, when, and how to best expand geographically. Perhaps Hershey shouldexpand into the Far East, since economies of those countries are growing so rapidly,China and India are huge untapped markets. Malaysia, Indonesia, Vietnam, andThailand 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 manu-facturing and service delivery processes. Environmentally responsible firms marketthemselves and their products as being "green-sensitive," Concern for the naturalenvironment is an issue Hershey should address before competitors seize the initia-tive. Developing environmentally safe products and packages, reducing industrialwaste, recycling, and establishing an environmental audit process are strategies thatcould benefit Hershey. .. Some analysts contend that Hershey's functional structure is an ineffective struc-tural design. Would a divisional structure by product be more effective? The productdivisions could be Chocolate, Nonchocolate, and Grocery. Or would a divisional struc-ture by geographic reason be moreeffectivei Can you recommend an improvedorga-nizational design that.could enhance Hershey's lackluster international operations?

Should Hershey acquire firms in other foreign countries? Analysis is needed toidentify and value specific acquisition candidates. In developing an overall strategicplan, what recommendations would you present to CEO Kenneth Wolfe? ShouldHershey diversify. more into nonchocolate candies since that segment is growingmost 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 exportsof chocolate. Should Hershey increase its debt further or dilute ownership of its stockfurther to raise the capital needed to implement your recommended strategies?Develop projected financial statements to fully assess and evaluate the impact of yourproposed strategies. «

EX H I BIT 1 Hershey's Income Statements (in $ thousands, except per share amount)

FOR THE YEARS ENDED DECEMBER3l2004 2003 2002

Net Sales 4,429,24 4,110,31

Costs and Expenses:Cost of SalesSelling, Marketing, and AdministrativeBusiness Realignment and Asset Impairments, NetGain on Sale of BusinessTotal Costs and Expenses

Income Before Interest and Income TaxesInterest Expense, Net

Income Before Income TaxesProvision for Income Taxes

2,679,53847,540

3,527,07

902,177

66,533

835,644

244,765

Income Before Cumulative Effect .of Accounting ChangeCumulative Effect of Accounting Change,Net of $4,933 TaxBenefit

590,879

Net Income 590,879

'"Source: Hershey's Form 10K, 2004, p. 38.

4,172,55

2,544,72816,44223,357(8,330)

3,376,19

796,356

63,529

732,8Z7

267,875

464,952

7,368

457,584

2,561,05833,42627,552

3,422,03

698,287

60;722

637,565

233,987

403,578

403,578

EXHIBIT 2 Hershey's Balance Sheets (in $ thousands)

December 31,2004

December 31,2003

AssetsCurrent Assets:Cash and Cash EquivalentsAccounts Receivable-TradeInventoriesDeferred Income TaxesPrepaid Expenses and OtherTotal Current AssetsProperty, Plant, and Equipment, NetGoodwillOther IntangiblesOther AssetsTotal Assets

Liabilities and Stockholders' EquityCurrent Liabilities:Accounts PayableAccrued LiabilitiesAccrued Income TaxesShort-term DebtCurrent Portion of Long-term DebtTotalCurrent LiabilitiesLong-term DebtOther Long-term LiabilitiesDeferred Income TaxesTotal Liabilities

Stockholders' Equity: .

Preferred Stock, Shares Issued: None in 2004."and 2003Common Stock, Shares Issued: 299,060,235 in2004 and 149,528,776 on a Pre-Split Basisin 2003Class B Common Stock, Shares Issued:60,841,509 in 2004 and 30,422,096 ona Pre-Split Basis in 2003Additional Paid-In CapitalUnearned ESOP CompensationRetained EarningsTreasury-Common Stock Shares, at Cost:113,313,827 in 2004 and 50,421,139 ona Pre-Split Basis in 2003Accumulated Other Comprehensive Income (Loss)Total Stockholders' Equity

Total Liabilities and Stockholders' Equity

54,837408,9,30557,18046,503

114,9911,182,4411,682,698

463,947125,233343,212

3,797,531

114,793407,612492,85913,285

103,020.1,131,5691,661,939

388,96038,511

361,5613,582,540

..148,686472,09642,280

343,277279,043

1,285,382690,602403,356328,889

2,708,229

132,222416,18124,89812,032

477585,810968,499370,776 .377,589

2;302,674

299,060 149,528

60,841 30,42228,614 4,034(6,387) (9,580)

3,469,169 3,263,988

(2,762,30) (2,147,44)309 (11,085)

·1,089,302 1,279,866-

3,797,531 3,582,540

Source: Hershey's Fot71iIOK, 2004, p. 39.

EX HI BIT 3 Hershey's Income Statements (in $ thousands)

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

2,114,861 1,906,777Net SalesCosts and Expenses:

Cost of SalesSelling, Marketing, and AdministrativeTotal

Income Before Interest and TaxesInterest

Income Before TaxesTaxes

Net IncomeEPS

1,289,830446,036

1,735,866378,99540,029338,966123,384215,582

0.90

1,158,836413,694

1,572,530334,24730,342303,905.49,541

254,3641.00

Cj

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

•EX HI BIT 4 Hershey's Organizational Chart -

SeniorVPandPresident,Hershey

International

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