The Long and Short
Adding value by moving from ‘AA’ to ’A’ credits
Meredith Contente | October 27, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The incremental spread and yield picked up by moving from ‘AA’ debt to ‘A’ remains at historic highs. The pick-up is greater than moving from ‘A’ debt to ‘BBB,’ marking an interesting time for investors. Looking at the consumer sector, a swap out of Colgate Palmolive Company (CL: Aa3/AA- (n)) into The Hershey Company (HSY: A1/A) is an attractive move into a credit with both stronger margin and credit profiles. With demand for duration still strong, a swap in the 20-year part of the curve adds roughly 54 bp in g-spread, exceeding the 52 bp added by moving from the average ‘AA’ to ‘A’ credit.
Both HSY and CL have solid balance sheets, but there are some differences (Exhibit 1).
Exhibit 1. CL to HSY LTM Comparison
HSY growth outpaces CL
Both HSY and CL have delivered solid top line growth since the pandemic began, but HSY has been outpacing CL on a percentage basis. Over the last 12 months, CL posted revenue growth of 7.9% compared to 10.6% growth at HSY. In fact, HSY posted double-digit top line growth over the past two years relative to CL’s mid-single digit growth rate. While consensus estimates put full-year revenue growth for CL at a strong 7.4%, HSY is still expected to outpace CL at 7.9%.
Drilling down further, from fiscal 2021 to now, CL has seen 200 bp of EBITDA margin contraction. This compares to nearly 140 bp of EBITDA margin expansion at HSY. HSY is estimated to end fiscal 2023 with an EBITDA margin of 27.5%, 380 bp higher than CL margin estimate of 23.7%. CL’s margins have contracted to a point that they now trail peer Proctor and Gamble (PG – Aa3/AA-). HSY’s stronger margin profile is also reflected in free cash flow conversion as the ratio of free cash flow to sales over the last 12 months was 14.6%, relative to 13.3% at CL.
HSY maintains stronger credit profile
CL’s leverage has been high for the current ratings due to elevated debt levels which were used to fund acquisitions and shareholder remuneration. CL’s leverage had been tracking above 2.0x for most of 2023 but was reduced by three ticks to 1.9x (including S&P adjustments) in the third quarter. S&P has a 2.0x threshold for CL’s current ratings. This compares to S&P adjusted total leverage of 1.5x at HSY. S&P forecasts that CL will end fiscal 2023 with leverage closer to 2.0x, which will remain above HSY’s leverage level. HSY targets leverage in the 1.5x to 2.0x area and S&P has forecasted HSY’s leverage to fall to the 1.5x level by year-end as management remains committed to reducing leverage with free cash flow. HSY hit that target in fiscal 3Q and is forecast to maintain leverage at the low end of it target range.
Additionally, CL’s higher leverage for the rating has earned it a negative outlook by S&P. The agency has noted that it could look to lower the rating if leverage were to remain above 2.0x. Furthermore, S&P cites CL’s margin contraction as concerning as the company has been unable to offset higher inflation and competition with increased pricing. While CL was able to post margin expansion in fiscal 3Q, any softening of the consumer could thwart any further expansion.
HSY reiterates full-year guidance
HSY’s fiscal third quarter results came in ahead of expectations, despite fears of volume declines given higher pricing across food companies. HSY witnessed solid strength in the US market which, particularly Confectionary, which represents over 80% of the top line. North American confection shipments were up 10% in the quarter. Furthermore, volumes were better than anticipated due to timing shifts of seasonal items. Adjusted gross profit witnessed 18% growth in the quarter, translating to a gross margin of 44.9%. The adjusted gross margin came in 110 bp ahead of consensus estimates.
Given the better-than-expected quarter, HSY reaffirmed full-year guidance. Net sales are expected to be up 8% while adjusted EPS is still forecast to growth in the 11% to 12% range. This puts adjusted EPS for the year in a range of $9.46 to $9.54. HSY is expecting capital expenditures to be in the $800 million to $850 million range. This is up from the $520 million capex spend in 2022 as the company increases core confections capacity and upgrades its Enterprise Resource Planning system across the company.
CL Increases sales and EPS guidance
CL’s better-than-expected third quarter sales prompted the company to increase its sales guidance for the year. CL now expects net sales growth to be in the 6% to 8% range, up from 5% to 8%. CL also increased its organic sales growth guidance to the 7% to 8% range, up from 5% to 7%. CL is still forecasting gross margin expansion for the year but did not provide specific guidance. Additionally, CL increased its non-GAAP EPS growth guidance to high-single digits, up from mid-single digit growth.