Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition
SUMMARY OF OPERATING RESULTS
Analysis of Selected Items from Our Income Statement
| | For the Three Months Ended | | For the Nine Months Ended |
| | October 3, 2010 | | October 4, 2009 | | Percent Change Increase (Decrease) | | October 3, 2010 | | October 4, 2009 | | Percent Change Increase (Decrease) |
| In thousands except per share amounts |
| Net Sales | $ 1,547.1 | | $ 1,484.1 | | 4.2% | | $ 4,188.2 | | $ 3,891.3 | | 7.6% |
| Cost of Sales | 891.9 | | 895.0 | | (0.3) | | 2,392.5 | | 2,408.7 | | (0.7) |
| Gross Profit | 655.2 | | 589.1 | | 11.2 | | 1,795.7 | | 1,482.6 | | 21.1 |
| Gross Margin | 42.4% | | 39.7% | | | | 42.9% | | 38.1% | | |
| SM&A Expense | 357.6 | | 301.5 | | 18.6 | | 1,035.2 | | 874.6 | | 18.4 |
| SM&A Expense as a percent of sales | 23.1% | | 20.3% | | | | 24.7% | | 22.5% | | |
Business Realignment and Impairment (Credits) Charges, net | (2.1) | | 8.0 | | (125.6) | | 83.1 | | 58.8 | | 41.4 |
| EBIT | 299.7 | | 279.6 | | 7.2 | | 677.4 | | 549.2 | | 23.3 |
| EBIT Margin | 19.4% | | 18.8% | | | | 16.2% | | 14.1% | | |
| Interest Expense, net | 22.3 | | 22.3 | | (0.2) | | 68.8 | | 68.9 | | (0.2) |
| Provision for Income Taxes | 97.2 | | 95.3 | | 2.0 | | 234.3 | | 171.1 | | 37.0 |
| Effective Income Tax Rate | 35.0% | | 37.0% | | | | 38.5% | | 35.6% | | |
| Net Income | $ 180.2 | | $ 162.0 | | 11.2 | | $ 374.3 | | $ 309.2 | | 21.0 |
| Net Income Per Share-Diluted | $ .78 | | $ .71 | | 9.9 | | $ 1.63 | | $ 1.35 | | 20.7 |
Results of Operations - Third Quarter 2010 vs. Third Quarter 2009
Net Sales
Net sales increased by 4.2% for the third quarter of 2010 compared with the same period of 2009 reflecting total sales volume increases of approximately 2.5% for core brands in the U.S., incremental sales of new products and sales volume increases for most of our international businesses. Price realization from lower rates of allowances for returns and markdowns and from list price increases contributed approximately 1% to the total increase in net sales. These were offset slightly by higher promotional rates. Favorable foreign currency exchange rates for our international businesses increased total net sales by approximately 0.5%.
Key Marketplace Metrics
Consumer takeaway increased 3.6% during the third quarter of 2010 compared with the same period of 2009. Consumer takeaway is provided for channels of distribution accounting for approximately 80% of our U.S. confectionery retail business. These channels of distribution include food, drug, mass merchandisers, including Wal-Mart Stores, Inc., and convenience stores.
Market share in measured channels increased by 0.1 share point during the third quarter of 2010. The change in market share is provided for measured channels which include sales in the food, drug, convenience store and mass merchandiser classes of trade, excluding Wal-Mart Stores, Inc.
Cost of Sales and Gross Margin
Cost of sales decreased by approximately 0.3% in the third quarter of 2010 reflecting lower supply chain and product obsolescence costs, and a favorable sales mix which reduced cost of sales by a total of approximately 3%. Lower supply chain costs were due to productivity improvements and slightly higher fixed cost deferrals associated with changes in inventories. Higher sales volume increased cost of sales by approximately 2%. Business realignment charges of $6.1 million were included in cost of sales in the third quarter of 2010 compared with $1.3 million in the third quarter of 2009.
Gross margin increased by 2.7%. Lower supply chain costs increased gross margin by approximately 1%, while price realization and lower product obsolescence costs each increased gross margin by about 1%. Business realignment and impairment charges had the effect of decreasing gross margin by 0.2% as compared with 2009.
Selling, Marketing and Administrative
Selling, marketing and administrative costs increased approximately $56.1 million compared with 2009, associated with increased advertising and other marketing expenses. Advertising expense increased approximately 46% from last year. Selling and legal expenses, increased administrative costs for our international businesses, and employee-related costs also contributed to the increase. Business realignment charges of $0.4 million were included in selling, marketing and administrative expenses in the third quarter of 2010 compared with $1.7 million in the third quarter of 2009.
Business Realignment and Impairment Charges
During the third quarter of 2010, we recorded credits of $2.1 million associated with the Project Next Century program. These adjustments related to previously recorded amounts for employee separation costs and reflected lower expected termination costs based on severance elections during the third quarter of 2010. Charges of $8.0 million were recorded in the third quarter of 2009 associated with the Global Supply Chain Transformation program and were primarily related to pension settlement losses and plant closure expenses.
Income Before Interest and Income Taxes and EBIT Margin
EBIT increased in the third quarter of 2010 compared with the third quarter of 2009 as a result of higher gross profit, and lower business realignment and impairment charges, substantially offset by increased selling, marketing and administrative expenses. Net pre-tax business realignment and impairment charges of $4.5 million were recorded in the third quarter of 2010 compared with $11.0 million recorded in the third quarter of 2009.
EBIT margin increased from 18.8% for the third quarter of 2009 to 19.4% for the third quarter of 2010. The increase was attributable to the higher gross margin, offset by higher selling, marketing and administrative expense as a percentage of sales. The impact of net business realignment and impairment charges reduced EBIT margin by 0.3% in 2010 and by 0.8% in 2009.
Interest Expense, Net
Net interest expense in 2010 was essentially even with the prior year. Lower interest expense was offset by a decrease in capitalized interest.
Income Taxes and Effective Tax Rate
Our effective income tax rate was 35.0% for the third quarter of 2010 compared with 37.0% for the same period of 2009. The lower tax rate for the third quarter of 2010 primarily reflected the impact of a more favorable mix of income among various tax jurisdictions. The impact of tax rates associated with business realignment and impairment charges decreased the effective income tax rate by 0.1% in 2010 and decreased the effective income tax rate by 0.2% in 2009.
Net Income and Net Income Per Share
Earnings per share-diluted in the third quarter of 2010 increased $0.07, or 9.9% as compared with the third quarter of 2009. Net income in the third quarter of 2010 was reduced by $2.7 million, or $0.01 per share-diluted, and was reduced by $6.5 million, or $0.02 per share-diluted, in the third quarter of 2009 as a result of business realignment and impairment charges. Excluding the impact of business realignment and impairment charges, earnings per share-diluted increased $0.06 or 8.2% due to lower supply chain costs, sales volume increases and net price realization, along with a lower effective income tax rate, partially offset by higher advertising and other selling, marketing and administrative ex penses.
Results of Operations - First Nine Months 2010 vs. First Nine Months 2009
Net Sales
Net sales increased 7.6% in the first nine months of 2010 compared with the same period of 2009 due to sales volume increases of approximately 4% primarily for core brands in the U.S. and sales of new products. Favorable price realization increased net sales by about 3%. The favorable impact of foreign currency exchange rates also increased net sales by 1%.
Key Marketplace Metrics
Consumer takeaway increased 4.7% during the first nine months of 2010 compared with the same period of 2009. Consumer takeaway is provided for channels of distribution accounting for approximately 80% of our U.S. confectionery retail business. These channels of distribution include food, drug, mass merchandisers, including Wal-Mart Stores, Inc., and convenience stores.
Market share in measured channels improved by 0.2 share points during the first nine months of 2010. The change in market share is provided for measured channels which include sales in the food, drug, convenience store and mass merchandiser classes of trade, excluding Wal-Mart Stores, Inc.
Cost of Sales and Gross Margin
The cost of sales decrease of 0.7% in the first nine months of 2010 compared with 2009 was associated with cost decreases resulting from a favorable sales mix and lower supply chain costs, primarily reflecting productivity improvements, which reduced cost of sales by approximately 4%. Lower input and product obsolescence costs reduced cost of sales by a total of approximately 1%. These decreases were offset by sales volume increases resulting in higher cost of sales of about 4%. Lower business realignment and impairment charges included in cost of sales in 2010 compared with 2009 also contributed to the cost of sales decrease. Business realignment and impairment charges of $7.1 m illion were included in cost of sales in the first nine months of 2010, compared with $8.5 million in the prior year.
The gross margin improvement of 4.8% resulted from favorable price realization of about 2%, supply chain productivity improvements of approximately 2% and lower product obsolescence costs of 1%. The impact of business realignment and impairment charges recorded in 2010 compared with 2009 also contributed to the gross margin increase.
Selling, Marketing and Administrative
Selling, marketing and administrative expenses in the first nine months of 2010 increased primarily as a result of higher advertising and other marketing expenses which increased $107.9 million, or 35.8%. Advertising expense for the first nine months of 2010 increased 53.5% compared with the same period of 2009. An increase in other selling, marketing and administrative expenses was associated with investments to improve our selling capabilities, increased administrative expenses for our international businesses, higher legal expenses, employee-related expenses and costs related to the consideration of a transaction with Cadbury plc. Business realignment charges of $5.4 million were include d in selling, marketing and administrative expenses in 2009 compared with $0.5 million in 2010.
Business Realignment and Impairment Charges
Total pre-tax business realignment and impairment charges of $83.1 million were recorded in the first nine months of 2010, including a non-cash goodwill impairment charge of $44.7 million related to our Godrej Hershey Ltd. joint venture and net charges of $38.4 million associated with the Project Next Century program related to estimated employee severance and asset retirement costs. Charges of $58.8 million were recorded in the first nine months of 2009 associated with the Global Supply Chain Transformation program related to pension settlement charges, plant closure expenses, fixed asset impairment and employee separation costs.
Income Before Interest and Income Taxes and EBIT Margin
EBIT increased in the first nine months of 2010 compared with the first nine months of 2009 as a result of higher gross profit, partially offset by increased marketing and selling investments and other increases in administrative expenses. Net pre-tax business realignment and impairment charges of $90.7 million were recorded in the first nine months of 2010 compared with $72.7 million recorded in the first nine months of 2009, an increase of $18.0 million.
EBIT margin increased from 14.1% for the first nine months of 2009 to 16.2% for the first nine months of 2010. The increase in EBIT margin was the result of the higher gross margin, partially offset by increased brand investment and higher selling, marketing and administrative expense as a percentage of sales. Business realignment and impairment charges in the first nine months of 2010 reduced EBIT margin by 2.1% and in the first nine months of 2009 reduced EBIT margin by 1.9%.
Interest Expense, Net
Net interest expense in the first nine months of 2010 was essentially even with the comparable period of 2009 as lower interest expense was offset by a decrease in capitalized interest.
Income Taxes and Effective Tax Rate
Our effective income tax rate was 38.5% for the first nine months of 2010 compared with 35.6% for the first nine months of 2009. The effective income tax rate was increased by 2.5% as a result of the effective tax rate associated with business realignment and impairment charges recorded during the first nine months of 2010. The effective income tax rate related to business realignment and impairment charges recorded in 2009 reduced the rate by 0.7%. We expect our effective income tax rate for the full year 2010 to be approximately 37.0%. Excluding the impact of tax rates associated with business realignment and impairment charges during the year, we expect the effective income ta x rate to be approximately 35.2% for 2010.
Net Income and Net Income Per Share
Earnings per share-diluted for the first nine months of 2010 increased $0.28, or 20.7% compared with the same period of the prior year. Net income in the first nine months of 2010 was reduced by $73.1 million, or $0.31 per share-diluted, and was reduced by $43.3 million, or $0.19 per share-diluted, in the first nine months of 2009 as a result of business realignment and impairment charges. Excluding the impact of business realignment and impairment charges in each period, earnings per share-diluted in the first nine months of 2010 increased $0.40 or 26.0% as compared with the first nine months of 2009.
Liquidity and Capital Resources
Historically, our major source of financing has been cash generated from operations. Domestic seasonal working capital needs, which typically peak during the summer months, generally have been met by issuing commercial paper. Commercial paper may also be issued from time to time to finance ongoing business transactions such as the repayment of long-term debt, business acquisitions and for other general corporate purposes. During the first nine months of 2010, cash and cash equivalents decreased by $8.7 million to $244.9 million.
Cash provided from operations and other cash inflows during the first nine months of 2010 were sufficient to fund dividend payments of $212.6 million, the repurchase of Common Stock of $133.4 million and capital additions and capitalized software expenditures of $123.7 million.
Net cash provided from operating activities was $388.2 million in 2010 and $635.5 million in 2009. The decrease was attributable to the change in cash used by other assets and liabilities in 2010 as compared with cash provided in 2009 as well as an increase in cash used by working capital, partially offset by higher net income in 2010. Cash used by changes in other assets and liabilities was $33.4 million for the first nine months of 2010 as compared with cash provided of $153.1 million for the same period of 2009. The change in the amount of cash (used by) provided from other assets and liabilities from 2009 to 2010 reflected the effect of hedging transactions of $202.8 mill ion. Cash used by working capital was $193.3 million in 2010 and $58.3 million in 2009. The increase was principally related to higher accounts receivable resulting from higher sales in 2010. Higher inventories resulting from seasonal sales patterns also contributed to the increase.
In March 2009, the Company completed the acquisition of the Van Houten Singapore consumer business. The acquisition from Barry Callebaut, AG provides the Company with an exclusive license of the Van Houten brand name and related trademarks in Asia and the Middle East for the retail and duty-free distribution channels. The purchase price for the acquisition of Van Houten Singapore and the licensing agreement was approximately $15.2 million.
Interest paid was $90.7 million during the first nine months of 2010 versus $91.5 million for the comparable period of 2009. Income taxes paid were $236.6 million during the first nine months of 2010 versus $140.8 million for the comparable period of 2009. The increase in taxes paid in 2010 was primarily related to the impact of higher annualized taxable income in 2010.
The ratio of current assets to current liabilities decreased to 1.3:1.0 as of October 3, 2010 from 1.5:1.0 as of December 31, 2009. The capitalization ratio (total short-term and long-term debt as a percent of stockholders' equity, short-term and long-term debt) decreased to 64% as of October 3, 2010 from 67% as of December 31, 2009.
Generally, our short-term borrowings are in the form of commercial paper or bank loans with an original maturity of three months or less. However, at the end of the third quarter of 2010, no commercial paper borrowings were outstanding. Our five-year unsecured revolving credit agreement expires in December 2012. The credit limit is $1.1 billion with an option to borrow an additional $400 million with the concurrence of the lenders.
Outlook
The outlook section contains a number of forward-looking statements, all of which are based on current expectations. Actual results may differ materially. Refer to the Safe Harbor Statement below as well as Risk Factors and other information
contained in our 2009 Annual Report on Form 10-K for information concerning the key risks to achieving future performance goals.
We expect the economic environment to continue to be challenging for the remainder of 2010. In this environment, we will continue to build our business by focusing on a consumer-driven approach to core brand investment and new product innovation in North America, along with investments in our strategic international businesses.
For the full year 2010, we continue to expect net sales growth of about 7%, including an approximate 1% benefit from foreign currency exchange rates.
We now expect to increase advertising investment by 50% to 60% in 2010 behind our core brands and new product introductions. We will also continue to invest in consumer insights, additional selling and go-to-market strategies in both the U.S. and international markets, new innovation on our Reese’s and Hershey’s franchises and quality merchandising and programming to drive profitable growth for both our Company and our customers.
We expect our cost structure to remain at elevated levels in 2010. Key commodity markets remain volatile, however, we have good visibility into our full-year cost structure for 2010. We also expect to continue to achieve productivity and efficiency improvements, resulting in enhanced margins for the full year, but slightly less than the rates achieved in the first nine months of the year. Specifically, the comparison of expected results for the remainder of 2010 to results for the last three months of 2009 will reflect a shift in seasonal orders out of the fourth quarter of 2010 into the first quarter of 2011 due to the timing and refinement of logistical requirements. We expect higher input costs in the last three months of 2010 compared with the same period of 2009 and we do not expect year-end LIFO inventory to be favorable in 2010 as it was in 2009. Earnings per share-diluted is expected to be in the $2.09 to $2.16 range for 2010. Excluding business realignment and impairment charges, we expect to achieve adjusted gross margin and adjusted EBIT margin expansion for the full year that will result in adjusted earnings per share-diluted in the $2.52 to $2.56 range, an increase of mid-to-high teens on a percentage basis, versus adjusted earnings per share-diluted for 2009.
We expect total capital additions to be in the $190 million to $210 million range for 2010, with $140 million to $160 million for operating capital additions and approximately $50 million for Project Next Century.
We will continue to focus on our core brands and leverage the Company’s scale at retail during 2011. We expect advertising expense to increase in 2011, however, the year-over-year percentage increase will be lower than in the previous two years. We expect net sales growth in 2011 to be within our 3% to 5% long-term target. While we anticipate higher input costs in 2011, productivity and cost savings initiatives are in place to help mitigate the impact. Therefore, we expect 2011 growth in adjusted earnings per share-diluted to be in the 6% to 8% range, consistent with our current long-term target.
Note: In the Outlook above, the Company has provided income measures excluding certain items, in addition to net income determined in accordance with GAAP. These non-GAAP financial measures are used in evaluating results of operations for internal purposes. These non-GAAP measures are not intended to replace the presentation of financial results in accordance with GAAP. Rather, the Company believes exclusion of such items provides additional information to investors to facilitate the comparison of past and present operations.
In 2009, the Company recorded GAAP charges, including non-cash pension settlement charges, of $99.1 million, or $0.27 per share-diluted, attributable to the GSCT program. The Company does not expect any significant charges related to the GSCT program in 2010. In 2010, the Company expects to record total GAAP charges of about $75 million to $85 million, or $0.20 to $0.23 per share-diluted, attributable to Project Next Century. Additionally, in the second quarter of 2010, the Company recorded a non-cash goodwill impairment charge of $44.7 million, or $0.20 per share-diluted, related to the Godrej Hershey Ltd. joint venture. For more information, see Note 6. Business Realignment and Impairment Charges.
Below is a reconciliation of GAAP and non-GAAP items to the Company’s 2009 and projected 2010 and 2011 adjusted earnings per share-diluted:
| | | 2009 | | | 2010 (Projected) | | | 2011 (Projected) | |
| Reported EPS-Diluted | | $ | 1.90 | | | $ | 2.09 - $2.16 | | | $ | 2.55 - $2.67 | |
Total Business Realignment and Impairment Charges | | $ | 0.27 | | | $ | 0.40 - $0.43 | | | $ | 0.09 - $0.12 | |
| Adjusted EPS-Diluted * | | $ | 2.17 | | | $ | 2.52 - $2.56 | | | $ | 2.67 - $2.76 | |
* Excludes business realignment and impairment charges.
Outlook for Project Next Century
In June 2010, we announced Project Next Century as part of our ongoing efforts to create an advantaged supply chain and competitive cost structure. We expect total pre-tax charges and non-recurring project implementation costs for the Project Next Century program of $140 million to $170 million. During 2010, we expect to record $75 million to $85 million in program charges. For the full year 2010, we expect capital expenditures for Project Next Century to be approximately $50 million, with accelerated depreciation and amortization estimated to be $10 million to $15 million.
Subsequent Event
On November 1, 2010, the Company's Board of Directors elected John P. Bilbrey Executive Vice President, Chief Operating Officer, effective November 2, 2010. Mr. Bilbrey, age 54, joined our Company in November 2003 as Senior Vice President, President Hershey International. He was promoted to the position of Senior Vice President, President International Commercial Group in November 2005, and to Senior Vice President, President Hershey North America in December 2007, the position he held at the time of his promotion on November 2, 2010.
Safe Harbor Statement
We are subject to changing economic, competitive, regulatory and technological conditions, risks and uncertainties because of the nature of our operations. In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we note the following factors that, among others, could cause future results to differ materially from the forward-looking statements, expectations and assumptions that we have discussed directly or implied in this report. Many of the forward-looking statements contained in this report may be identified by the use of words such as “intend,” “believe,” “expect,” “anticipate,” “shou ld,” “planned,” “projected,” “estimated,” and “potential,” among others.
The factors that could cause our actual results to differ materially from the results projected in our forward-looking statements include, but are not limited to the following:
· | Issues or concerns related to the quality and safety of our products, ingredients or packaging could cause a product recall and/or result in harm to the Company’s reputation, negatively impacting our operating results; |
| · | Increases in raw material and energy costs, along with the availability of adequate supplies of raw materials could affect future financial results; |
| · | Market demand for new and existing products could decline; |
| · | Increased marketplace competition could hurt our business; |
| · | Price increases may not be sufficient to offset cost increases and maintain profitability, or may result in sales volume declines associated with pricing elasticity; |
| · | Disruption to our supply chain could impair our ability to produce or deliver our finished products, resulting in a negative impact on our operating results; |
| · | Our financial results may be adversely impacted by the failure to successfully execute acquisitions, divestitures and joint ventures; |
| · | Changes in governmental laws and regulations could increase our costs and liabilities or impact demand for our products; |
| · | Political, economic, and/or financial market conditions could negatively impact our financial results; |
| International operations could fluctuate unexpectedly and adversely impact our business; |
| · | Disruptions, failures or security breaches of our information technology infrastructure could have a negative impact on our operations; |
| · | Future developments related to the investigation by government regulators of alleged pricing practices by members of the confectionery industry could impact our reputation, the regulatory environment under which we operate, and our operating results; |
| · | Pension costs or funding requirements could increase at a higher than anticipated rate; |
| · | Implementation of our Project Next Century program may not occur within the anticipated timeframe and/or may exceed our cost estimates; |
| · | Annual savings from initiatives to transform our supply chain and advance our value-enhancing strategy may be less than we expect; and |
| · | Such other matters as discussed in our Annual Report on Form 10-K for 2009. |
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The potential net loss in fair value of interest rate swap agreements resulting from a hypothetical near-term adverse change in market rates of ten percent was $9.1 million as of October 3, 2010 and was $4.9 million as of December 31, 2009. The potential net loss in fair value of foreign exchange forward contracts and options resulting from a hypothetical near-term adverse change in market rates of ten percent was $15.4 million as of October 3, 2010 and was $10.9 million as of December 31, 2009. The market risk resulting from a hypothetical adverse market price movement of ten percent associated with the estimated average fair value of net commodity positions increased from $36.3&# 160;million as of December 31, 2009, to $46.9 million as of October 3, 2010. Market risk represents ten percent of the estimated average fair value of net commodity positions at four dates prior to the end of each period.
Item 4. Controls and Procedures
Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 (the "Exchange Act") is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to management, including the Company's Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
As of the end of the period covered by this quarterly report, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as required by Rule 13a-15 under the Exchange Act. This evaluation was carried out under the supervision and with the participation of the Company's management, including our Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective. There has been no change during the most recent fiscal quarter in our internal control over financial reporting identified in c onnection with the evaluation that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Items 1, 1A, 3 and 5 have been omitted as not applicable.
