The Hershey Company (HSY - Analyst Report) reported dismal third-quarter 2014 results following a weak first-half performance.

The chocolate giant missed the Zacks Consensus Estimate for earnings while only managing to meet the top-line estimate. Moreover, the company cut its 2014 earnings and revenue outlook and provided a muted outlook for 2015. Shares declined almost 6% in pre-market trading.

Earnings Discussion

Hershey’s third-quarter adjusted earnings of $1.05 per share missed the Zacks Consensus Estimate of $1.08 by almost 3%.

Earnings grew 1% from the prior-year quarter as lower-than-expected brand building and advertising costs made up for softer-than-expected international sales and weak gross margins.

The adjusted earnings mainly exclude expenses related to Hershey’s supply chain and cost savings program — Project Next Century — and an impairment charge related to a non-chocolate brand.

The Hershey Company - Earnings Surprise | FindTheBest

Revenues Improve from 1H; International Sales Soft

Net sales of $1.96 million were in line with the Zacks Consensus Estimate. Net sales increased 5.8% year over year. Currency hurt revenues by 0.2 percentage points, lower than the last quarter. Organically, sales increased 6% in the quarter. Positive volume growth, improved retail takeaway and market share gains pulled up the top line. Hershey gained market share across all its segments — chocolate, non-chocolate candy, gum and mint.

Hershey’s first-half performance was below expectations due to abnormal shopping patterns, increased competition in the confectionery category, and challenging macro environment and soft international growth.

Though sales improved sequentially from a weaker first half gaining from better-than expected Halloween seasonal orders in North America, international sales fell short of management expectations. Moreover, management continued to witness irregular trends in store traffic and consumer trips in the food channels in the U.S. which hurt sales of everyday non-seasonal candy products.

Net sales increased 4.2% in North America. International sales increased 18.4% in the quarter.

High Dairy Costs Continue to Hurt Gross Margins

Hershey’s adjusted gross margin for the quarter declined 240 basis points (bps) to 43.8%, due to higher input costs, mainly dairy, unfavorable sales mix and supply chain costs, which offset productivity gains and cost savings.

The costs of Hershey’s key ingredients like dairy, nuts, cocoa and sugar have increased dramatically this year denting the company’s gross margins. The costs of other inputs — packaging, fuel, utilities and transportation — are also on the rise.

These costs are expected to rise further in the coming quarters which will continue to hurt gross margins.

In fact, in 2014/2015, the overall cost environment for food commodities is expected to be under pressure due to domestic and worldwide agricultural supply and demand imbalance and other macroeconomic factors.

Excluding advertising, selling, marketing and administrative expenses (SM&A) declined 1% in the third quarter of 2014. SM&A includes investments in non-advertising brand-building and go-to-market capabilities in both the U.S. and international markets.

Advertising spend increased 1% from the prior-year quarter, lower than management’s expectations. Management expected advertising expenses to increase in a mid single-digit range in the second half with a greater increase in the third quarter.

Despite lower-than-expected advertising costs, operating margin declined 90 bps in the quarter to 19.4% due to weak gross margins.

2014 Outlook Lowered

2014 net sales growth guidance was reduced to 4.75% from prior expectations of the lower end of the long-term target range of 5–7%. The guidance includes currency impact and contribution from acquisitions of 0.75 percentage points.

Weak year-to-date results coupled with softer-than-previously-expected international sales growth led to the sales guidance cut.

Organically, international sales are now expected to increase in a low double-digit range in 2014 comparing unfavorably with prior expectation of around 15%. Though China continues to do well, macroeconomic challenges in some international markets, like Mexico and Brazil, are hurting international sales growth.

Moreover, 2014 adjusted gross margins are expected to decline 75 bps from the 2013 levels, comparing unfavorably to management’s expectation of a slight year-over-year decline. Greater-than-anticipated commodity cost headwinds and an unfavorable mix compelled Hershey to reduce gross margin expectations thrice this year. At the beginning of the year, the company expected gross margins to grow 50 bps this year.

Adjusted earnings guidance for 2014 is now expected to range between $4.01 and $4.03. Previously, the company expected it to be at the lower end of the previously provided range of $4.05–$4.13. 2014. Adjusted earnings per share growth will now be around 8%, comparing unfavorably with prior expectation of its being at the lower end of the long-term target of 9–11%. Gross margin pressures and higher trade spending related to greater merchandising activities resulted in the earnings guidance slash.

2015 Outlook Muted

In 2015, net sales are expected to increase 7% to 9%, including the impact of currency and a contribution from acquisitions of around 2.5 percentage points. Gross margins are expected to increase next year gaining from the increase in prices that Hershey announced in July this year.

Earnings per share are expected to be within the company's long-term target of 9% to 11%. Management expects earnings in the range of $4.37–$4.47 which fell short of the Zacks Consensus Estimate of $4.48.

Other Stocks to Consider

Hershey carries a Zacks Rank #3 (Hold). Better-ranked food stocks include ConAgra Foods, Inc.(CAG - Analyst Report), Post Holdings, Inc. (POST - Snapshot Report) and McCormick & Company, Incorporated (MKC - Analyst Report).While Post Holdings sports a Zacks Rank #1 (Strong Buy), ConAgra and McCormick have a Zacks Rank #2 (Buy).

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