Undervalued Dividend Growth Stock of the Week: The Hershey Co. (HSY)

We’re all given 24 hours in a day.

You spend a good chunk of that time sleeping.

Then there’s the time spent showering, grooming, cleaning, and eating.

Of course, one of the biggest drains on our time will be our jobs: the commute, the time at the job, etc.

What’s left to enjoy for ourselves will be very, very little.

Life is short. But it’s really short when you don’t actually end up with very much free time.

This is why financial independence is so important.

If we can own our time, we can spend it how we wish. We can dramatically increase the amount of free time we have, to enjoy life.

The good news is that financial independence isn’t that difficult to attain.

I say that as someone who went from below broke in my late 20s to financially independent in my early 30s, as I’ve laid out in my Early Retirement Blueprint.

Becoming financially free at 33, I am now able to live my life and spend my time however I wish.

That financial freedom was achieved by building a real-life and real-money dividend growth stock portfolio that could pump out enough passive income to pay my bills.

This portfolio is called my FIRE Fund.

And it indeed generates the five-figure and growing passive dividend income I need to cover my expenses.

This portfolio was built on the simple tenets of dividend growth investing, whereby one buys (at appealing valuations) and holds equity in high-quality businesses that have a longstanding track record of sharing growing profit with the shareholders via growing dividend payments.

Once you have enough dividend income to cover your bills in life, you’re home free.

Jason Fieber's Dividend Growth PortfolioBetter yet, because these stocks are regularly and reliably increasing their dividends, you should see your purchasing power slowly but surely increase, year after year.

Said another way, it’s likely that your dividend income will increase at a faster rate than your expenses, creating a runaway snowball of wealth and passive income that will eventually render you incredibly wealthy.

Fortunately, a dividend growth investor is never short on ideas or opportunities, proven out by David Fish’s illustrious Dividend Champions, Contenders, and Challengers list.

The late, great David Fish spent years of his life maintaining this list of several hundred dividend growth stocks.

It currently contains information on more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

It takes a special kind of business to pay out growing dividends for years on end, which is why it shouldn’t be surprising that these stocks tend to be extraordinary long-term investments. 

That said, one has to be mindful before investing.

It’s important to do your full due diligence before making any investment, looking at fundamentals, competitive advantages, and risks.

Perhaps most importantly, you have to make sure you’re paying the right price for a stock.

The “right price” is one that’s as far below estimated intrinsic value as possible.

That would be an undervalued stock.

The valuation at the time of investment plays a key role in the performance of the investment, especially over the short term.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk. 

That’s all relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

The higher yield comes about due to the fact that price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield positively impacts total return right off the bat, as investment income (via dividends or distributions) is one of two components of total return.

More investment income, via the higher yield, can lead to greater long-term total return.

Plus, there’s the additional capital gain (the other component of total return) that’s available due to the “upside” that exists between a lower price paid and higher intrinsic value of a stock.

And that’s on top of whatever natural capital gain is possible as a business naturally becomes worth more as it increases its profit by selling more products and/or services, eventually leading to an increase in the stock price.

While the stock market isn’t terribly good at accurately pricing stocks over the short term, price and value tend to more closely correlate over the long run.

These dynamics have a way of reducing risk, too.

It’s naturally less risky to pay less (rather than more) for a stock.

You’re risking less capital per share, and you’re potentially outlaying less capital overall.

You also end up introducing a margin of safety when you pay much less than a stock is estimated to be worth, as it protects you from ending up with an “upside down” investment (one worth less than you paid) in case the investment thesis is incorrect or something goes wrong with the business.

Increasing possible upside simultaneously decreases possible downside.

These benefits are fantastic, but they require paying less than intrinsic value.

While estimating intrinsic value of a dividend growth stock might seem like a very complicated exercise, it’s actually not.

Fellow contributor Dave Van Knapp has greatly simplified this process for you readers via Lesson 11: Valuation, which is the 11th lesson in his series of lessons on dividend growth investing – an overarching collection of articles that are designed to educate investors on the long-term investment strategy as a whole.

The 11th lesson focuses on valuation specifically, and it contains great information that anyone can use to easily estimate the value of just about any dividend growth stock out there.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

The Hershey Co. (HSY)

The Hershey Co. (HSY) manufactures and markets a range of chocolate, confectionery, and snack products.

People like chocolate and candy.

That was true 100 years ago. It’s true today. And it’ll likely be true 100 years from now.

With a dominant share of the US chocolate market and brands like Hershey’s, Reese’s, and Kit Kat backing that up, Hershey should continue to profit off of that basic craving for many years to come.

Meanwhile, Hershey has spent time and money in recent years diversifying itself via acquisitions, while simultaneously expanding its international reach.

Recent acquisitions include bolt-on brands in snacking like Amplify Snack Brands (maker of SkinnyPop), Ripple Brand Collective (maker of barkTHINS), and Krave Pure Foods (maker of KRAVE jerky).

And in early 2016, they completed the acquisition of Shanghai Golden Monkey, which is designed to give it the supply chain strength it needs to expand its presence throughout China.

Even with these moves, though, Hershey remains largely a US-focused chocolate company. The North American market accounts for almost 90% of sales (as of fiscal year 2017)

And that’s perfectly fine, as that’s more than suitable enough to provide for continued growth in profit and dividends. They have the scale and brand power to make the most of that strong and time-tested business model.

The rest is just, well, icing on the candy cake.

Of course, as a dividend growth investor (and a shareholder in this company), the sustainability, size, and growth of the dividend is of paramount concern to me.

Hershey doesn’t disappoint here.

The company has increased its dividend for eight consecutive years.

Other than a static dividend through the Great Recession, their dividend history is excellent and dates back many years.

The five-year dividend growth rate stands at 10.3%, which is certainly well in excess of inflation (relating back to the point on increasing purchasing power).

And the stock yields an attractive 2.86%.

That’s higher than the broader market. It’s higher than the industry average.

And it’s more than 60 basis points higher than the stock’s own five-year average yield.

The dividend is also very healthy, evidenced by the 55.5% payout ratio.

That payout ratio is pretty close to my “ideal” payout ratio of 50% – a perfect balance between retaining profit for future business growth and rewarding shareholders (the collective owners of any publicly traded company) with their fair share of current profit.

Furthermore, The Hershey Trust acts as the company’s controlling shareholder via its holdings in voting (B) stock. Since The Hershey Trust largely relies on the dividends from Hershey to fund its philanthropic ventures, any dividend cut is highly unlikely.

Of course, what’s more important than where a dividend is at or has been is where the dividend will be in the future. We don’t invest in where a company is at; we invest in where a company is going.

In order to estimate the future growth of this business, which will help us ascertain that estimate of intrinsic value, we’ll first look at what Hershey has done over the last decade (using that as a proxy for the long term).

And we’ll compare that 10-year growth to a near-term forecast for future profit growth.

By looking at what the company is done, and then comparing that to what they’ll likely do going forward, we should have a very good idea of the growth trajectory.

Hershey has increased its revenue from $5.133 billion to $7.515 billion between fiscal years 2008 and 2017. That’s a compound annual growth rate of 4.33%.

That’s right about in line with what I’d expect from a fairly mature company like Hershey.

Mid-single-digit top-line growth allows for a baseline of very solid bottom-line and dividend growth. And excess growth opportunities exist via a number of levers that can be pulled.

Indeed, we see a lot of excess bottom-line growth over the last decade.

The company expanded earnings per share from $1.36 to $3.66 over this period, which is a CAGR of 11.63%.

A marked improvement in profitability was the prime reason for this.

Part of that is due to running a better and more efficient business. But part of it is timing, too – it was difficult to pump out profit during the Great Recession.

What’s great about the growth here is that it’s been almost completely secular. There’s very little volatility from the company’s results. They basically just move along and grow like clockwork, which is obviously just what you want to see when you’re talking about collecting and living off of growing dividends.

Looking forward, CFRA predicts that Hershey will compound its EPS at an annual rate of 7% over the next three years.

It’s interesting they’re forecasting a drop in growth. Part of that forecast is rooted in a belief that margins will compress a bit due to international expansion, additional freight costs, and increased input costs.

But Hershey is looking at a much lower tax rate due to US tax reform. And recent acquisitions are still being integrated. Plus, the international expansion offers plenty of long-term growth opportunities.

Even if they were to slow down EPS growth, though, that could still support dividend growth that is at least in that range.

So even a company-wide slowdown would set you up for high-single-digit dividend growth. That’s not bad when you’re talking this simple business model with very little volatility.

The balance sheet is leveraged, but I don’t think it’s overly concerning.

The long-term debt/equity ratio stands at 2.25, but the elevated number is more a function of low common equity (due to a lot of treasury stock) than a high amount of long-term debt.

Meanwhile, the interest coverage ratio is just over 12, which is more than acceptable.

Profitability has, as noted earlier, improved quite a bit over the last decade, to the point of being quite robust now.

Over the last five years, the firm has averaged annual net margin of 9.99% and annual return on equity of 66.42%.

The ROE is boosted by the low common equity, but the margin is very solid.

Overall, I really like Hershey. It’s a company I personally own stock in.

There’s not much to dislike.

It’s a business model that’s incredibly simple. People like to eat chocolate and candy. And Hershey caters to that better than just about anyone else – controlling about 45% of the US chocolate market.

With smart diversification that’s occurring through complementary bolt-on brands, a lower tax rate going forward, and with the company becoming more international, there’s even more to like, in my view.

The fundamentals are very good, the dividend is about as secure as they come, and this is the kind of investment you can just kind of put away for a decade and go about your life.

Of course, there are risks.

The candy and chocolate space is competitive, which is even more true when you get in snacks. And international expansion has thus far not been as smooth as you’d like to see.

But it’s a very low-risk business model, in my view.

And that risk is made to be even lower when you look at this valuation…

The stock is trading hands for a P/E ratio of 19.40, which is a below-market number for one of the lowest-risk business models you’ll ever run across.

That number also compares extremely favorably to the stock’s own five-year average P/E ratio, but that average has been artificially skewed higher.

Nonetheless, investors are paying a little over 14 times cash flow, which is in comparison to the three-year average P/CF ratio of 21.5.

And the yield is also measurably higher than its own recent historical average, as shown earlier.

So the stock looks cheap on a relative basis, but how cheap might it be? What would a reasonable estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate.

And I assumed a long-term dividend growth rate of 7.5%.

That DGR is admittedly on the higher end of what I allow for, but I think this stock deserves it when you look at the payout ratio, historical DGR, long-term EPS growth rate, forecast for future EPS growth, and numerous tailwinds shaping up.

The DDM analysis gives me a fair value of $112.56.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

The stock thus looks at least moderately undervalued from my perspective.

But my perspective is but one of many.

Let’s compare that with what two select professional stock analysis firms have come up with for the stock’s valuation.

This will add depth to our bottom line.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates HSY as a 4-star stock, with a fair value estimate of $116.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates HSY as a 4-star “BUY”, with a 12-month target price of $105.00.

I came out somewhere in the middle there, but you can see the general agreement on this stock being worth more than its price. Averaging the three numbers out gives us a final valuation of $111.19, which would indicate the stock is potentially 22% undervalued right now.

Bottom line: The Hershey Co. (HSY) offers a business model that is very simple and low risk. You’re betting on people’s continued desire for chocolate, candy, and snacks, which is a very easy bet to make. An above-market yield, a below-market valuation, strong fundamentals, a sustainable dividend, and the possibility that shares are 22% undervalued means dividend growth investors would be wise to take a good look at this delicious dividend growth stock here.

-Jason Fieber

Note from DTA: How safe is HSY’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 92. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, HSY’s dividend appears very safe and extremely unlikely to be cut. Learn more about Dividend Safety Scores here.

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