Hershey: Candy Is Dandy, but...

Can the company cook up some tasty new snacks?

Richard H. Lenny's first two years running Hershey Foods (HSY ) Corp., based in Hershey, Pa., have been anything but a stroll through Candyland. In the spring of 2002, a year after Lenny became CEO, Hershey was hit with a nasty labor strike. Then, just weeks after settling that dispute, Lenny acknowledged that the trust that controls the company, established by founder Milton S. Hershey, wanted to sell it. "It's been a wild ride," Lenny says now.

The sale was called off a year ago, in the face of massive community and political opposition. But now Lenny has to prove that he's up to the mounting competitive challenges facing the chocolate maker. Hershey is under relentless pressure in the $60 billion U.S. snack market from bigger and richer food giants -- all with the global reach Hershey lacks -- that are working to woo customers away from candy. Hershey dominates the U.S. chocolate candy business. But chocolate is less than 15% of the total snack market, which is growing at twice the clip of the candy market. Shoppers increasingly are passing up Hershey sweets in favor of chips, sports bars, or granola-coated munchies.

The first outsider to run the company in its 109-year history -- Lenny made his name turning around Nabisco (KFT ) Biscuit Co. before it was acquired by Kraft Foods (KFT ) Inc. in 2000 -- has undeniably made some headway. Over the past two years, he has orchestrated an ambitious overhaul, slashing costs, shuttering facilities, and cutting layers of middle management. He got rid of weak product lines, such as Luden's throat drops, and dropped hundreds of slow-selling package sizes. Lenny improved distribution, boosting Hershey's presence in convenience stores, where margins are higher than in supermarkets. He also introduced much-needed new products. Now, Lenny is devising a plan to push Hershey beyond candy and grab a piece of the faster-growing snack market.

The moves so far have increased Hershey's margins, which were among the lowest in the industry, and its stock price. Morgan Stanley analyst David J. Adelman now figures net income from continuing operations will be up 8.2% this year, to $472 million, compared with the low single-digit increases of the late 1990s. But sales, he predicts, will rise a scant 1.2%, to $4.2 billion. Hershey's stock price, recently $72.57, is up about 12% since Mar. 9, 2001, the day before the announcement that Lenny would take over, vs. a 4.6% gain for the Standard & Poor's packaged-food index.

But the big problem before Lenny arrived is still there, sitting as shiny as a neatly wrapped Hershey's Kiss: How can the company grow? On Wall Street, skepticism remains that Lenny can hit his promised sales-growth goals of 3% to 4% per year. That's well above the 1.3% compound annual growth rate the company generated from 1997 to 2002, and higher than the recent 2% to 3% growth in the chocolate candy market. Many analysts think Hershey's goals are a stretch. "To do that I think they have to broaden beyond chocolate candy," says Prudential Securities (PRU ) Inc. analyst John M. McMillin.

Lenny's rejuvenation of the Hershey sales force should help. The company has beefed up the number of sales reps servicing customers. That helped it gain ground in convenience stores. Derek J. Schmitt, category manager for candy at 7-Eleven (SE ) Inc., says Hershey is better now at providing displays that work with 7-Eleven's limited shelf space and at giving more advance warning of new product launches. "I know what I'm going to be doing [with Hershey] next June," says Schmitt. "Before, they'd usually drop [a new product] on your desk about a month before it became available."

In fact, before Lenny came, the company's new-product machine had sputtered. Instead of launching one big product every year or two, Hershey now has a steady stream of new products and line extensions, such as Reese's Inside Out Cups -- peanut butter on the outside, chocolate inside -- and the upcoming Swoops, chip-shaped versions of some Hershey candy bars. Hershey has even begun making sugar-free chocolates this year, though they are a minuscule part of total sales. Overall, Hershey has managed to gain market share in recent years in the U.S. chocolate candy segment. Its 43% dwarfs the 27% share of Mars Inc. and the 9% of Nestlé (NSRGY )

But dominance in chocolate will only take Hershey so far. The overall snack business, which is growing at about 5% a year, according to Prudential's McMillin, is becoming more competitive. General Mills (GIS ) Inc. and Kellogg (K ) Co. are nibbling away at the candy market with snacks like their Honey Nut Cheerios Milk 'n Cereal Bars and Nutri-Grain bars, respectively.

The best way into the broader snack market, say some experts, may be the path Lenny is taking, which is to build on existing brands rather than creating new ones from scratch. "Rather than launching new brands, which are expensive and destined to fail," says Gary M. Stibel, founder of New England Consulting Group, "Lenny is focusing more time, people, and money on power brands and smartly extending them."

The company has done extensive market research and testing of possible new products under its existing brands, which include Almond Joy and York Peppermint Patties. While he won't get specific, Lenny says new snacks could include cookies, crackers, or snack bars. "We know our brands can travel," says Lenny.

Hershey's options for traveling outside the U.S. are limited, however. Tentative moves to expand in Europe in the 1990s were stymied by entrenched competition and the high cost of potential acquisitions. Lenny says Hershey will look at "creative" ways to expand in such markets as Asia and Latin America, where it already has a toehold. But even joint ventures have limited appeal, given that rivals such as Mars and Nestlé are already established globally.

Lenny is clear about one thing: Hershey won't be on the block again. The trust has said so. That provides some sense of stability for management, and for the town of Hershey, Pa. But it also means investors have to trust Lenny's overhaul to sweeten their returns.

By Amy Barrett in Hershey, Pa.

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