Beating Buffett

Hershey [NYSE:HSY] June 16, 2008 close: $35.89 /share
52-week range: $33.54 [Jan. 25, 2008] - $51.78 [June 18, 2007]
Dividend = $0.2975 quarterly = 3.32% current yield

Hershey shares jumped up not too long ago when M&M Mars Candy Company agreed to a buyout of Wrigley. Shares were down big today after a Hershey’s Board member seemed to indicate they were not looking to sell at this time.

With the drop back to < $36 most of the risk seems to be out of these high-quality shares.

Value Line rates HSY with a B++ financial strength, 100th percentile in ‘stock price stability’, and gives them a 95th percentile score for ‘earnings predictability’.

Management has raised prices recently to offset commodity price increases in their raw materials. They have also implemented supply chain improvements which should cut costs in the future.

Earnings will likely be down to about $1.82 this year from $2.08 in 2007. A rebound to about $1.94 is expected for 2009. Thus, Hershey shares now trade for 19.7x and 18.5x this year’s and next year’s projections. That compares with a 10-year median P/E of 23x and an almost identical 5-year average multiple of 22.8x.

Shareholders of these low beta [0.75] shares have typically received a current yield of between 1.8% and 2.2%. At today’s close it’s well above that at 3.31%.

Hershey : Key Ratios
Jun. 16, ‘08Close: $35.89

……………………………………Today ……………5-year average
Trailing P/E Ratio*………………18.5 ……………………22.8
P/E Ratio 5-Year High …………29.6 …………………… n/a
P/E Ratio 5-Year Low ………… 16.4 ……………………n/a
Price/Sales Ratio ………………..1.58 ………………….. 2.48
Price/Book Value ……………… 13.1 …………………. 12.96
Price/Cash Flow Ratio ……….. 11.97 ……………….. 15.48
*excludes non-recurring loss ($1.15) in 2007

Hershey shares look to be good value with or without a buyout based on historical valuations. Even a lower than average 22 multiple on 2008 estimates would bring these shares back to $40.04 by year-end. Add in the two remaining quarterly dividends and the 6-month total return could be over 13%.

For me, though, I see a better play by using options sales along with the purchase of HSY shares.

…………………………………………………..………Cash Outlay ……………. Cash Inflow
Buy 1000 HSY shares @ $35.89 ………..…… $35,890
Sell 10 HSY Jan. $35 Calls @ $3.70 ………………………………………….. $3,700
Sell 10 HSY Jan. $35 Puts @ $2.80 ………….………………..……………… $2,800
Net Cash Outlay …………………………….………. $29,390

At expiration [Jan. 16, 2009] if Hershey shares are at > $35 [as they are today]:

Your shares will be called (sold) for $35,000.
Your puts will expire worthless (a good thing for you as a seller).
You will have collected $595 in dividends (if the calls are not exercised early).
You will have no option liabilities.

You will have no stock, no options and $35,595 cash for your $29,390 cash outlay.

That’s a net profit of $6,205 or 21.11% in six months on shares that did not have to go up from the day you started the trade. In fact, you would get this same return even if the shares fall by $0.89 or 2.4% from the starting price.

Risk?

Break-even on the shares you bought is $35.89 less the $3.70 call premium = $32.19/sh.
Break-even on the puts is the strike price of $35 less the $2.80 put premium = $32.20/sh.

If HSY closed below $35 on expiration date you would end up with 2000 shares total at an average cost of $32.20 or 10.2% below today’s closing quote.

Hershey shares have not traded as low as $32.20 since early 2003.

HSY shares have hit peak prices between $39.30 - $67.40 at some point in each calendar year from 2003 right through this year.

Disclosure: Author put on this trade today in his personal account.