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The following segment was excerpted from this fund letter.
Upslope is long Barry Callebaut and Hershey (HSY).
Switzerland-based Barry Callebaut (‘BC’) is the biggest chocolate company Americans have never heard of. It is the largest global outsourced processor and manufacturer of cocoa and chocolate products – serving “the entire food industry,” including premium chocolatiers, bakeries, pastry chefs, and restaurants. The company is vertically integrated, with expertise in cocoa bean sourcing and processing, as well as chocolate manufacturing.
The investment theses have some obvious similarities and notable differences. The key similarity: both are ideally positioned to capture market share during the current cocoa crisis, setting them up well to emerge even stronger. Hershey and BC are also both quality, defensive consumer staples-like businesses trading at relative discounts. Shares for each have sharply lagged the market and are down on an absolute basis over the last two years, impacted by the unprecedented surge in cocoa prices (see below), worries about the impact from GLP-1 weight-loss drugs, and a general contraction in consumer staples valuations. By far the most important factor weighing on shares today is daily updates in the financial and mainstream press on cocoa prices.
Exhibit 4: Cocoa Futures ($/MT)
Barry Callebaut
Barry Callebaut is a defensive, reasonably high-quality business facing several temporary challenges. The troubles can partly be traced back to a plant contamination scare in late 2022. This was a catalyst for change at the company, ultimately resulting in a CEO transition and implementation of a multi-year streamlining and modernization program. These changes had just begun when cocoa prices started to take off. As an outsourced chocolate producer, BC appears more directly in the line of fire of cocoa prices. However, recent results (covering the early ramp in prices) and outlook have not quite shown this and are aligned with Upslope’s key thesis points:
BC’s vertically integrated model and role as the largest global manufacturer of cocoa and chocolate products, position it better than any competitor to navigate the crisis. Simply put, BC has a major competitive advantage in times of supply crisis due to better sourcing and financing capabilities. This should enable share gains that should at least partly offset market and volume headwinds. Recent results also show the company’s cost pass-through mechanisms working very well.
With cocoa prices catching financial and mainstream press headlines daily, valuation at decade+ lows, and EPS estimates already down sharply, such worries seem extremely well-known. Bottoms (or tops, in the case of cocoa prices) are impossible to time; but, it’s hard to argue the pendulum hasn’t already swung sharply in one direction.
While not an original view, it seems highly likely the great cocoa squeeze will end like virtually every other extreme commodity squeeze in history. We don’t know the timing or trigger, but ultimately cocoa prices should revert and collapse. Forward-looking markets should only need to see a way out of the crisis – not an immediate exit. Should this coincide with BC’s efficiency efforts already underway, it could provide a strong tailwind to free cash flow for years to come.
Exhibit 5: Barry Callebaut’s Business Model
Valuation and Risks
Shares of Hershey and Barry Callebaut trade at attractive valuations on both an absolute basis and relative to their own history. Each trades near decade-low earnings multiples (with depressed consensus estimates) and normalized free cash flow yields of 6-7%. This seems reasonable considering depressed sentiment and the economically defensive nature of both companies. Note that actual 2024 free cash flow estimates are currently depressed, as Hershey begins winding down a multi-year investment program and BC faces temporary working capital headwinds from the cocoa surge.
Major risks include: significant uncertainty regarding extreme cocoa prices and impacts on margins, volumes, and (for BC in particular) balance sheet; potential long-term headwinds from proliferation of weight-loss drugs (Upslope’s view is that the effects on these businesses are years away – at worst); M&A execution risks (Hershey has been acquisitive in the past); short-term operational challenges as Hershey wraps up a multi-year ERP transition.
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