Hershey's Arrested Development

The chocolate maker's innovation cupboard is bare. Some wonder about what might happen to the company when consumers tire of the same old standbys

Buried within Hershey's (HSY) Web site is a section that invites consumers to pitch their own ideas for new products. "We are seeking innovative concepts," it reads. "What's your big idea?"

Hershey could certainly use the help. The innovation cupboard at the $5.1 billion chocolate maker has grown bare. In the mid-2000s, Hershey regularly launched over 200 products a year, according to consumer-product tracker Mintel. Last year that number fell to 146, and through the first three quarters of 2009, just 40 items have made their debuts. Hershey's R&D budget comes to just 0.5% of sales.

To be sure, Hershey isn't the only big food company to react to the recession by dialing down new product development, which is expensive and risky. "This is not the time to be overly aggressive in new product design," says Robert Boutin, owner and president of confectionery development firm Knetchel Labs in Skokie, Ill. "The risks are very high." Instead, companies from Kraft Foods (KFT) to Campbell Soup (CPB) to Kellogg (K) are pushing standbys that date back decades.

"If people are going to spend money in this market, they are going to spend money on something they really are comfortable with," Hershey CEO David West told Wall Street analysts on Apr. 23. (Hershey declined to comment, citing a quiet period in advance of its Oct. 22 earnings announcement.) Hershey's focus, West says, will be on "core brands" like Reese's, Kit Kat, and Hershey's Kisses. To promote those, Hershey has beefed up its advertising spending this year by 45%.

A sales lift from price hikes

At first glance, that approach has served Hershey well. Net sales were up 6.2% in the first half of 2009, to $2.4 billion, while earnings rose 15.6%, to $147.2 million, and the company's stock price is up 17% this year, to around $40 a share, after three consecutive annual declines.

But the sales lift, measured in dollars, is due almost entirely to big price hikes taken over the past year or so, which have masked a 3% decline in units sold. Hershey raised prices to counter higher costs for raw ingredients such as milk and cocoa, although commodity prices have eased in 2009, helping to widen margins. Jacking up prices for snazzy new products is one thing, but consumers usually tire of having to pay more for the same old thing.

Unfortunately, that's all Hershey is offering right now. This does not bode well for the company when the economy improves and chocolate lovers are eager for something new. "We question the ability of the company to perform when consumer conditions improve," says Deutsche Bank analyst Eric Katzman, especially as Hershey faces aggressive—and bigger—global rivals Nestlé (NESN.DE), Cadbury (CBY), and Kraft. (On Sept. 7 Kraft proposed to pay $16.7 billion to acquire Cadbury, whose board rejected the offer.) "They are lagging behind, and that gap will grow after the recession," adds Boutin.

Meanwhile, privately held Mars, which leapfrogged Hershey as the top candymaker in the U.S. after its $23 billion purchase of Wm. Wrigley Jr. last year, has been more active in product development, introducing items like last year's premium M&Ms with a softer shell in flavors such as raspberry almond, or Wrigley's 5 chewing gum line.

Premium chocolate mess

The results of Hershey's few recent attempts at innovation have been mixed. The company scored last year with its Bliss line of bite-size indulgent chocolates, targeted at women, though Hershey was trailing Mars with its female-focused Dove Promises line. Hershey's high-end Cacao Reserve product, meanwhile, flopped and was discontinued this summer. "They never quite distinguished it," says Mintel analyst Marcia Mogelonsky in Chicago. A partnership with coffee giant Starbucks (SBUX) to create and market Starbucks-branded premium chocolates was recently shuttered as well.

Hershey has also tried to buy its way into the premium chocolate market, with limited success. In 2005 it paid about $60 million for high-end chocolate makers Joseph Schmidt and Scharffen Berger, and the following year it purchased organic chocolatier Dagoba of Oregon. But Hershey stopped selling Schmidt in June, and Credit Suisse analyst Robert Moskow says Hershey is "still trying to figure out what to do" with the others. "The few things we have tried in premium frankly weren't all that successful," West told analysts in July.

Not helping matters is the stubbornly conservative stance of the Hershey Trust, the local entity founded by Milton Hershey in 1905, which controls about 80% of the voting shares of the company and which forced out former CEO Richard Lenny along with most of Hershey's directors in a 2007 power struggle. Creative minds are loath to work in such a stifling environment, and one high-profile defection was Andrea Thomas, a new-product guru who joined Wal-Mart Stores (WMT) in 2007.

Hershey had earned admiration for innovation since Milton Hershey had the novel idea to put sweet chocolate coatings on his caramels in 1894. With low-cost production methods and clever advertising, Hershey made milk chocolate a mainstream product, and products like Hershey's Kisses were true novelties. But it's been 102 years since the first Kiss appeared. Hershey is long overdue for a breakthrough.

"I don't think the company is troubled, but they are frittering away a great brand name," says William Madway, a marketing lecturer at the Wharton School of the University of Pennsylvania. "They're still stuck in the 1800s."

Here, take a look at the most popular candies in the U.S.

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