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Opinion: A chocolate war is about to heat up in the US

MarketWatch logo MarketWatch 9/21/2016 Michael Brush

When an Oreo-flavored chocolate bar hits the shelves in the U.S. soon, most consumers will look at it as just another treat.

But Wall Street being Wall Street, this innocent indulgence is way more than that.

The little chocolate bar is really a howitzer in a rolling 15-year battle by a parade of suitors to take over one of the great iconic brands: Hershey Co. (HSY)

The latest setback in this age-old saga of failed takeover attempts happened Aug. 30 when East Hanover, N.J.-based Mondelez International (MDLZ) the home of popular brands like Oreo, Cadbury and Toblerone, dropped an attempt to buy Hershey.

Several analysts don’t believe the battle is over, though, and for good reason.

Top on their list: Within a week, Mondelez announced it is launching a major assault on Hershey’s home turf, the U.S. market. For perspective, Mondelez sells sweets mostly abroad, while Hershey, Pa.-based Hershey gets about 90% of its sales in the U.S.

Mondelez is launching the attack on Hershey by rolling out an “Oreo-Milka” chocolate bar in the U.S. Already on the market in 20 countries, that treat blends America’s favorite cookie, the Oreo, with one of Europe’s favorite chocolates, Milka, another Mondelez brand. The company is also adding to its premium chocolate lineup in the U.S., called Green & Black’s.

The product news was accompanied by some fighting words for Hershey. “With our strong brands and global expertise in chocolate, we see enormous potential to grow our U.S. business and expand the category,” said Mondelez chief growth officer Tim Cofer.

The timing was no coincidence. By putting pressure on a struggling Hershey, Mondelez might be able to bring it back to the bargaining table, according to Wall Street’s chocolate-bar-as-takeover-weapon theory. Mondelez also recently announced that it’s stepping up efforts to move into China, where Hershey wants to be the foreign brand of choice. 

“We suspect that the primary objective of these ‘white space’ launches is to increase pressure on Hershey to resume merger talks,” says Credit Suisse analyst Robert Moskow. “It is certainly possible that Hershey’s board could return to the negotiating table next year if Hershey’s sales trends continue to decelerate.”

Tough nut to crack

Many analysts dismiss this theory. After all, it seems virtually impossible to take over Hershey. No fewer than three big hitters have tried and failed since 2002: Nestle (NSRGY) Cadbury back when it was independent, and William Wrigley Jr. Co., which is now part of Mars.

Here’s why Hershey is so tough to take over.

Back in the early 1900s when Hershey was taking off (it was founded in 1894), founder Milton Hershey admirably set up The Hershey Trust to run the Milton Hershey School for underprivileged students. These days, the trust owns a controlling stake in Hershey (81% of the voting rights). Needless to say, that gives it a lot of influence over Hershey’s board. So it can effectively block any merger.

As if that weren’t bad enough, an unusual Pennsylvania law gives the state’s attorney general power to block Hershey takeovers, even when the trust wants to sell. Hershey is a big employer in Pennsylvania. Locals, perhaps rightly, fear that they could lose their jobs in a takeover as a result of cost cutting. Meanwhile, Pennsylvania attorneys general, who oversee the trust by law, have a habit of running for governor. This means they’re often tempted to do what’s “considered expedient locally,” says Harvard Law School professor Robert Sitkoff, an expert on charitable trusts. In short, Hershey is a political football, and promising to block takeovers is a way to win votes.

Change on the way

Now, though, there are three reasons to think the state attorney general and The Hershey Trust are losing their grip, which will clear the way for a takeover. Mondelez knows this. So it’s deploying the chocolate bar weapon.

Click ahead to see the three reasons.

R© Provided by Dow Jones & Company, Inc.eason 1: Consumers are realizing that sugar is a poison

Sure, like many poisons, in small doses this one won’t hurt you. But eat too many sugar-laden products and you gain weight. Obesity, of course, can shorten your life.

Next, eating refined sugar spikes the blood sugar and overwhelms the body’s system for processing sugar. Over time, this system just breaks down from the constant work. This outcome is known as “adult onset,” or type 2, diabetes, an emerging epidemic. (For a detailed overview of the growing use of sugar in our foods, watch the documentary “Sugar Coated” on Netflix (NFLX))

Autonomous robots in the grocery warehouse Robotics company Symbotic is trying to change the food distribution industry. The company has developed a system to automate warehouse jobs formerly done by humans. Video: Robert Libetti. Photo: Michael Rubenstein for The Wall Street Journal

The upshot in all of this: Consumers are finally wising up and cutting back on products with refined sugar. This helps explain why Hershey sales were flat last year, when net income fell by 39%. The company is forecasting sales growth of just 2% this year.

Mondelez faces similar challenges. It has posted several quarters of sales declines, by volume, relying on cost cutting to support earnings. But there is a limit to cost cutting. The end of gross margin gains in the second quarter at Mondelez suggests the company may be “approaching the later stages of its margin expansion,” says Goldman Sachs analyst Jason English.

In short, it makes a lot of sense now for Hershey and Mondelez to team up. For one thing, they could both boost sales by using each other’s distribution platforms to sell into each other’s markets, points out Morningstar analyst Erin Lash.

The combined company could also save by cutting overlapping costs, and trimming overhead at Hershey, which has yet to be dialed back the way it has at Mondelez. Cost cutting and sales gains could boost earnings at the new company by more than 20%, estimates Susquehanna Financial Group analyst Pablo Zuanic, who has done a great job of covering recent twists and turns in the latest takeover attempt.

Without a merger, Hershey results could continue to languish. And the stock could fall. This would hurt The Hershey Trust. And it could hurt the state’s attorney general — if voters conclude that blocking a merger contributed to Hershey weakness that cost them their jobs. So both of these parties may be changing their view on a merger.

A Hershey merger makes sense as part of a bigger trend, too. Packaged-goods companies in general are facing sluggish growth because consumers are eating differently. To deal with this, they’re teaming up. Last year, for example, Kraft Foods merged with H.J. Heinz. The new company, Kraft Heinz (KHC) has since posted double-digit profit gains.

Reason 2: The Hershey Trust is changing

The Hershey Trust has come under criticism for excessive spending, board pay and travel expenses. These issues came to a head this summer when Pennsylvania’s attorney general’s office imposed reform — improving board governance by setting pay and term limits, introducing performance evaluation, and expanding the number of board members.

These changes may well make the trust more amenable to a Hershey takeover, says BMO Capital Markets analyst Kenneth Zaslow. True, the board membership overhaul won’t finish playing out until the end of 2017, suggesting a merger decision is less likely before then. But Hershey’s stock could move up on renewed takeover speculation before then, since the markets often anticipate news and price it in ahead of time.

And regardless of how fast the trust changes, Hershey is under pressure to do something to combat weak sale growth. Serious cost cutting could move the stock without a takeover. So could product launches, though I’m not sure about the prospects for a new “meat-based” protein bar, called Kraze. Tellingly, though, the flavor theme has nothing to do with sugar.

Reason 3: Hershey signaled it is open to a takeover

During takeover talks, Hershey told Mondelez it wouldn’t consider any offers under $125 a share, according to the Wall Street Journal. (The stock traded at $96 on Sept. 20.)

That exchange, if true, tells us something about whether Hershey will soon change hands.

“It appears that there was, in fact, a price at which Hershey was willing to start talks,” says Barclays analyst Andrew Lazar. Stifel Nicolaus analyst Christopher Growe calculates that Mondelez could pay as much as $130 a share for Hershey and still make the deal work via sales gains and cost cutting.

Whatever Mondelez does, other buyers could step up, says Zuanic, the Susquehanna Financial Group analyst. Potential contenders include Nestle and Kellogg (K) he says.

At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested MDLZ in his stock newsletter, Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.


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