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Made in America: Chocolate

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Americans didn’t invent chocolate, but we sure know how to consume it in large quantities.  According to the Department of Commerce, domestic chocolate consumption in 2010 was roughly 3.6 billion pounds versus 3.2 billion pounds in 2000.  Cocoa beans, the raw material of processed chocolate, are indigenous to South America, although the northern parts of Africa now account for a majority of the plant’s annual production.  Consumption of the food has been documented back to the Aztec and Mayan civilizations, which incorporated it into their foods and beverages.  Europeans later enhanced chocolate's taste by adding refined sugar and milk to make desserts and sweets.  However, mass consumption of chocolate had to wait until Swiss company Lindt invented the conching process in the late 19th century, enabling the mass production of bars at an affordable price.

The confectionary business is dominated by global multinational corporations, including U.S. based competitors Kraft Foods, Mars, and Hershey that had combined industry sales of approximately $42 billion in 2011.  These companies’ current size masks their often humble roots in America.  Mars was founded by Frank Mars in a Washington kitchen in 1911, which led to the invention of the Milky Way bar in 1923 and the Snickers bar in 1930.  The company’s plant in Chicago, which the company moved into in 1929, is still in existence 83 years later.  Meanwhile, Hershey was founded in 1894 by Milton Hershey in rural Pennsylvania to make chocolate coatings for his caramel business.  His immediate success led to the creation of the Milk Chocolate Bar in 1900 and Kisses in 1907, as well as a host of other treats.  The company’s current operations include plants in Pennsylvania, Virginia, and Illinois.  Even Ghirardelli, despite being bought by Swiss giant Lindt & Sprungli in 1998, still makes their premium chocolate products in California following the principles laid out by Domenico Ghirardelli over 160 years ago.

A Chocolate High

While other U.S. multinational food companies have diversified into other product lines, Hershey (NYSE: HSY) has mainly focused on its North American chocolate business.  International sales account for only about 16% of sales, as the company targets its resources toward selective growth markets, including China, India, and Brazil.  In its most recent fiscal year, it reported sales and adjusted operating income of $6.1 billion and $1.1 billion, increases of 7.2% and 8.3%, respectively, over the prior year.  Average prices for its products rose by 3.5%, while volumes were also higher with a 3.4% gain.  Hershey instituted a 9.7% wholesale price increase in March 2011 to combat rising commodity prices and take advantage of the popularity of their brand.  Despite higher administrative costs, due in part to its facility upgrade initiatives, adjusted operating margins reached their highest levels of the past few years during the period.

In FY2012, Hershey has continued to grow slowly, with increases in revenues and adjusted operating income of 8.4% and 8.1%, respectively, versus the prior year period.  Despite a multi-year rise in cocoa bean prices, the company’s hedging activities have offset much of its commodity price inflation.  Gross and adjusted operating margins remained near recent highs, as Hershey’s 2011 price increase continues to work its way through the marketplace.  Average sales volumes in FY2012 have only increased 0.6% in FY2012, but the company still expects sales growth of 8-9% for the full year.  Meanwhile, Hershey’s strong operating cash flows are supporting dividends and stock buybacks, with $497.6 million of shares repurchased in this year.  While the company’s stock is premium priced at a 23 forward P/E multiple, it will remain a good story as long as people need a chocolate fix.

Additional Opportunities

Investors wanting to participate in the chocolate business might also peer down the distribution chain for opportunities.  McLane, owned by Berkshire Hathaway (NYSE: BRK-B), is a foodservice distribution company for thousands of convenience stores, merchandisers, and restaurants throughout the U.S.  It accounted for $1.4 billion or 23% of Hershey’s total sales in FY2011.  According to the 2011 Berkshire Hathaway annual letter, its business is also doing well, with record pre-tax earnings of $370 million in FY2011.

Alternatively, investors could go to the end of the distribution chain and look at Wal-Mart (NYSE: WMT).  The world’s largest retailer has more than 10,000 stores worldwide and is a major customer of Hershey, accounting for more than 10% of its business in FY2011.  In its latest fiscal year, its reported increases in sales and operating income of 5.9% and 4.0%, respectively, over the prior year.  After a couple of years of declines in same store sales, the company generated positive comparable sales in FY2011 and has continued building on those gains in FY2012.

Follow the Chocolate Road

Americans have eaten chocolate for over 150 years and they will continue to do so in the future, though they may upgrade to organic and premium varieties.  Hershey is synonymous with chocolate in this country and it will continue to earn legions of fans with its innovative products and commitment to community involvement.  The company and its distributors deserve a "sweet" spot in investors' portfolios.

rghanley owns shares of Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services recommend Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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