The Hershey Company - 10-Q quarterly report FY2010 Q1

The accompanying notes are an integral part of these consolidated financial statements.

THE HERSHEY COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands of dollars)

Our unaudited consolidated financial statements provided in this report include the accounts of the Company and our majority-owned subsidiaries and entities in which we have a controlling financial interest after the elimination of intercompany accounts and transactions.  We have a controlling financial interest if we own a majority of the outstanding voting common stock and the noncontrolling shareholders do not have substantive participating rights, or we have significant control over an entity through contractual or economic interests in which we are the primary beneficiary. We prepared these statements in accordance with the instructions to Form 10-Q.  These statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles (“GAAPR 21;) for complete financial statements.

We included all adjustments (consisting only of normal recurring accruals) which we believe were considered necessary for a fair presentation. We reclassified certain prior year amounts to conform to the 2010 presentation.  Operating results for the three months ended April 4, 2010 may not be indicative of the results that may be expected for the year ending December 31, 2010, because of the seasonal effects of our business. For more information, refer to the consolidated financial statements and notes included in our 2009 Annual Report on Form 10-K.

In March 2009, the Company completed the acquisition of the Van Houten Singapore consumer business.  The acquisition from Barry Callebaut, AG provides the Company with an exclusive license of the Van Houten brand name and related trademarks in Asia and the Middle East for the retail and duty free distribution channels.  The purchase price for the acquisition of Van Houten Singapore and the licensing agreement was approximately $15.2 million.

We included results subsequent to the acquisition date in the consolidated financial statements.  If we had included the results of the acquisition in the consolidated financial statements for each of the periods presented, the effect would not have been material.

The decrease in noncontrolling interests in subsidiaries from $39.9 million as of December 31, 2009 to $36.8 million as of April 4, 2010 reflected the noncontrolling interests’ share of losses of these entities, partially offset by the impact of currency translation adjustments. The noncontrolling interests’ share of losses in subsidiaries increased income by $3.7 million for the three months ended April 4, 2010 and by $1.2 million for the three months ended April 5, 2009 and was included in selling, marketing and administrative expenses.

The Hershey Company Equity and Incentive Compensation Plan (“EICP”) is the plan under which grants using shares for compensation and incentive purposes are made.  The following table summarizes our stock compensation costs:

 

The increase in share-based compensation for the first quarter of 2010 resulted from higher performance expectations for our PSU awards.

We estimated the fair value of each stock option grant on the date of the grant using a Black-Scholes option-pricing model and the weighted-average assumptions set forth in the following table:

A summary of the status of our stock options as of April 4, 2010, and the change during 2010 is presented below:

A summary of the status of our performance stock units and restricted stock units as of April 4, 2010, and the change during 2010 is presented below:

 

As of April 4, 2010, there was $49.5 million of unrecognized compensation cost relating to non-vested performance stock units and restricted stock units.  We expect to recognize that cost over a weighted-average period of 2.5 years.

 

Deferred performance stock units, deferred restricted stock units, and directors’ fees and accumulated dividend amounts representing deferred stock units totaled 414,984 units as of April 4, 2010.  Each unit is equivalent to one share of the Company’s Common Stock.

 

No stock appreciation rights were outstanding as of April 4, 2010.

 

For more information on our stock compensation plans, refer to the consolidated financial statements and notes included in our 2009 Annual Report on Form 10-K and our proxy statement for the 2010 annual meeting of stockholders.

Net interest expense consisted of the following:

In February 2007, we announced a comprehensive, three-year supply chain transformation program (the “global supply chain transformation program” or “GSCT”).  Total pre-tax charges and non-recurring project implementation costs were $629.1 million for the GSCT which was essentially complete as of December 31, 2009.  Total costs of $99.1 million were recorded during 2009, costs of $130.0 million were recorded in 2008 and costs of $400.0 million were recorded in 2007 for this program.  The current trends of employee lump sum withdrawals from the defined benefit pension plans could result in additional non-cash pension settlement losses of $12 million to $18 million in 2010.  In addition, the manufacturing facilities in Naugatuck, Connecticut; Reading, Penns ylvania; and Smiths Falls, Ontario have been closed and are being held for sale.  The carrying value of these facilities was $11.7 million at April 4, 2010.  Actual proceeds from the sale of these facilities could differ from expected proceeds which could cause additional charges or credits in 2010.

 

We compute Basic and Diluted Earnings Per Share based on the weighted-average number of shares of the Common Stock and the Class B Common Stock outstanding as follows:

 

The Class B Common Stock is convertible into Common Stock on a share for share basis at any time.  The calculation of earnings per share-diluted for the Class B Common Stock was performed using the two-class method and the calculation of earnings per share-diluted for the Common Stock was performed using the if-converted method.

 

For the three-month period ended April 4, 2010, 8.7 million stock options were not included in the diluted earnings per share calculation because the effect would have been antidilutive.  In the first quarter of 2009, 17.1 million stock options were not included in the diluted earnings per share calculation because the effect would have been antidilutive.

We account for derivative instruments in accordance with Financial Accounting Standards Board accounting standards, which require us to recognize all derivative instruments at fair value.  We classify derivatives as assets or liabilities on the balance sheet. As of April 4, 2010 and December 31, 2009, all of our derivative instruments were classified as cash flow hedges.

The fair value of derivative instruments in the Consolidated Balance Sheet as of April 4, 2010 was as follows:

 

The fair value of derivative instruments in the Consolidated Balance Sheet as of December 31, 2009 was as follows:

 

The fair value of the interest rate swap agreements represents the difference in the present values of cash flows calculated at the contracted interest rates and at current market interest rates at the end of the period.  We calculate the fair value of interest rate swap agreements quarterly based on the quoted market price for the same or similar financial instruments.

We define the fair value of foreign exchange forward contracts and options as the amount of the difference between the contracted and current market foreign currency exchange rates at the end of the period.  We estimate the fair value of foreign exchange forward contracts and options on a quarterly basis by obtaining market quotes of spot and forward rates for contracts with similar terms, adjusted where necessary for maturity differences.  As of April 4, 2010, the fair value of foreign exchange forward contracts with gains totaled $2.3 million and the fair value of foreign exchange forward contracts with losses totaled $9.6 million.

As of April 4, 2010, prepaid expense and other current assets associated with commodity contracts were related to cash transfers receivable on commodities futures contracts reflecting the change in quoted market prices on the last trading day for the period.  We make or receive cash transfers to or from commodity futures brokers on a daily basis reflecting changes in the value of futures contracts on the IntercontinentalExchange or various other exchanges.  These changes in value represent unrealized gains and losses.

The effect of derivative instruments on the Consolidated Statements of Income for the three months ended April 4, 2010 was as follows:

 

The effect of derivative instruments on the Consolidated Statements of Income for the three months ended April 5, 2009 was as follows:

 

All gains (losses) recognized in earnings were related to the ineffective portion of the hedging relationship.  We recognized no components of gains and losses on cash flow hedging derivatives in income due to excluding such components from the hedge effectiveness assessment.

 

The amount of net gains on cash flow hedging derivatives, including foreign exchange forward contracts, interest rate swap agreements and commodities futures and options contracts, expected to be reclassified into earnings in the next twelve months was approximately $25.2 million after tax as of April 4, 2010.  This amount was primarily associated with commodities futures and options contracts.

 

For more information, refer to the consolidated financial statements and notes included in our 2009 Annual Report on Form 10-K.

A summary of the components of comprehensive income (loss) is as follows:

The components of accumulated other comprehensive income (loss) as shown on the Consolidated Balance Sheets are as follows:

We value the majority of our inventories under the last-in, first-out (“LIFO”) method and the remaining inventories at the lower of first-in, first-out (“FIFO”) cost or market. Inventories were as follows:

 

The decrease in finished goods inventories was primarily associated with seasonal sales patterns.

As a source of short-term financing, we utilize commercial paper or bank loans with an original maturity of three months or less. Our five-year unsecured revolving credit agreement expires in December 2012. The credit limit is $1.1 billion with an option to borrow an additional $400 million with the concurrence of the lenders. The unsecured revolving credit agreement contains certain financial and other covenants, customary representations, warranties and events of default. As of April 4, 2010, we complied with all covenants pertaining to the credit agreement. There were no significant compensating balance agreements that legally restricted these funds. For more information, refer to the consolidated financial statements and notes included in our 2009 Annual Report on Form 10-K.

In May 2006, we filed a shelf registration statement on Form S-3 that registered an indeterminate amount of debt securities. This registration statement was effective immediately upon filing under Securities and Exchange Commission regulations governing “well-known seasoned issuers” (the “WKSI Registration Statement”).  The May 2006 WKSI Registration Statement expired in May 2009.  Accordingly, in May 2009, we filed a new registration statement on Form S-3 to replace the May 2006 WKSI Registration Statement.  The May 2009 WKSI Registration Statement registered an indeterminate amount of debt securities and was effective immediately.

The carrying amounts of financial instruments including cash and cash equivalents, accounts receivable, accounts payable and short-term debt approximated fair value as of April 4, 2010 and December 31, 2009, because of the relatively short maturity of these instruments.

The carrying value of long-term debt, including the current portion, was $1,516.0 million as of April 4, 2010, compared with a fair value of $1,668.2 million, an increase of $152.2 million over the carrying value, based on quoted market prices for the same or similar debt issues.

In order to minimize financing costs and to manage interest rate exposure, the Company, from time to time, enters into interest rate swap agreements.  In March 2009, the Company entered into forward starting interest rate swap agreements to hedge interest rate exposure related to the anticipated $250 million of term financing expected to be executed during 2011 to repay $250 million of 5.3% Notes maturing in September 2011.  The weighted-average fixed rate on the forward starting swap agreements was 3.5%.  The fair value of interest rate swap agreements was a net asset of $6.9 million as of April 4, 2010.  The Company’s risk related to interest rate swap agreements is limited to the cost of replacing such agreements at prevailing market rates.  For more inf ormation see Note 8. Derivative Instruments and Hedging Activities.

The following table summarizes our foreign exchange activity:

 

We use certain derivative instruments, from time to time, to manage interest rate, foreign currency exchange rate and commodity market price risk exposures, all of which are recorded at fair value based on quoted market prices or rates.

A summary of our cash flow hedging derivative assets and liabilities measured at fair value on a recurring basis as of April 4, 2010, is as follows:

The number of years with open tax audits varies depending on the tax jurisdiction.  Our major taxing jurisdictions include the United States (federal and state), Canada and Mexico.  During the second quarter of 2009, the U.S. Internal Revenue Service (“IRS”) completed its audit of our U.S. income tax returns for 2005 and 2006, resulting in the resolution of tax contingencies associated with the 2004, 2005 and 2006 tax years.  During the fourth quarter 2009, the IRS commenced its audit of our U.S. income tax returns for 2007 and 2008.  Tax examinations by various state taxing authorities could generally be conducted for years beginning in 2004. We are no longer subject to Canadian federal income tax examinations by the Canada Revenue Agency (“CRA”) for ye ars before 1999, and we are no longer subject to Mexican federal income tax examinations by Servicio de Administracion Tributaria (“SAT”) for years before 2004.  U.S., Canadian and Mexican federal audit issues typically involve the timing of deductions and transfer pricing adjustments.  We work with the IRS, the CRA and the SAT to resolve proposed audit adjustments and to minimize the amount of adjustments.  We do not anticipate that any potential tax adjustments will have a significant impact on our financial position or results of operations.

For 2010, there are no significant minimum funding requirements for our pension plans and planned voluntary funding of our pension plans in 2010 is not material.

A summary of cumulative share repurchases and issuances is as follows:

In 2009, the Company recorded GAAP charges, including non-cash pension settlement charges, of $99.1 million, or $0.27 per share-diluted, attributable to the GSCT program. Except for possible non-cash pension settlement charges, the Company does not expect any significant charges related to the GSCT program in 2010.

Below is a reconciliation of GAAP and non-GAAP items to the Company’s 2009 adjusted earnings per share-diluted:

Possible adjustments to exclude business realignment charges for 2010 are not known at this time; therefore, the Company is unable to provide a reconciliation of adjusted earnings per share-diluted for 2010.

We are subject to changing economic, competitive, regulatory and technological conditions, risks and uncertainties because of the nature of our operations. In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we note the following factors that, among others, could cause future results to differ materially from the forward-looking statements, expectations and assumptions that we have discussed directly or implied in this report.  Many of the forward-looking statements contained in this report may be identified by the use of words such as “intend,” “believe,” “expect,” “anticipate,” “should,” “planned,” “projected,” “estimated,” and “potential, 8221; among others.

The potential net loss in fair value of interest rate swap agreements of ten percent resulting from a hypothetical near-term adverse change in market rates was $4.8 million as of April 4, 2010 and was $4.9 million as of December 31, 2009.  The potential net loss in fair value of foreign exchange forward contracts and options of ten percent resulting from a hypothetical near-term adverse change in market rates was $13.6 million as of April 4, 2010 and was $10.9 million as of December 31, 2009.  The market risk resulting from a hypothetical adverse market price movement of ten percent associated with the estimated average fair value of net commodity positions increased from $36.3 million as of December 31, 2009, to $42.7 million as of April 4, 2010.   Market risk represents ten percent of the estimated average fair value of net commodity positions at four dates prior to the end of each period.

PART II - OTHER INFORMATION

Issuer Purchases of Equity Securities

The following items are attached or incorporated herein by reference: