Bitter days in Chocolatetown

The premier US confectionery maker is having a difficult time adapting to the harsh realities of modern business
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They call it the Sweetest Place on Earth, but the atmosphere in Hershey, Pennsylvania, has turned distinctly bitter.

Hershey, of course, is the historic home of America's premier chocolate maker, a "model community" set up by the company's founder to include affordable housing, schools, churches and recreational facilities for its workers, and where Hershey remains to this day its dominant employer. It is known throughout the country as Chocolatetown, USA, where the air is rich with the smell of cocoa butter and sugar and where the streetlamps are shaped like Hershey's Chocolate Kisses.

Busloads of tourists still arrive in the town to drink in its quaint charm, to gorge themselves at the Kit Kat Café and to have their family portraits superimposed on a souvenir wrapper of the iconic Hershey bar.

But off the path of the guided tours, up in the executive suites and the boardroom, a battle over the future of the Hershey company is getting nastier by the day. The charitable trust which controls the firm has been so furious about the anaemic share price performance that it has just forced out the entire board, replacing it with an almost completely new slate of candidates. Some executives, though, and much of Wall Street, are just as furious with the trust, blaming its staid, "dividends-first" approach for letting Hershey slip behind the competition. The boardroom cull on Sunday is probably not the last of the drama, since Hershey's problems look intractable and the UK's Cadbury is salivating at the prospect that it may finally win the controversial merger deal for which it has long hungered.

The Hershey bar is one great slab of American history, produced out of Pennsylvania since the religious dissenter Milton Hershey imported European chocolate-making equipment in 1894. The company dominates chocolate sales in the US, taking $2bn annually, compared to $1.4bn by Mars, its nearest rival. Its Reese's Peanut Butter Cups and Hershey's Kisses, the cone-shaped chocolate drops, are iconic brands, and in the US it also makes and distributes Crème Eggs for Cadbury and Kit Kats for Nestle.

The trouble is that sales of traditional milk chocolate favourites have been stagnating in the US, while public tastes have shifted in favour of dark chocolate and more expensive brands. This has left Hershey exposed, since it has neither invested heavily in those sorts of products, nor achieved the sort of international expansion that rivals have used to compensate for lacklustre US profits. Where Hershey appears in a downward spiral, Mars is in the ascendancy, chipping a couple of percentage points of market share from Hershey each year.

"Hershey is paying the price for years of underspending behind its brands and sales infrastructure as well as not adequately adjusting its product portfolio to changing consumer trends in the domestic confectionery market," Morningstar analyst Mitchell Corwin has been telling his clients, adding that soaring dairy prices are exacerbating the pressure on Hershey's profits. The company has lowered its earnings forecasts three times this year and looks set to abandon long-term growth goals, too.

"It appears to us that the magnitude of the difficulties Hershey is facing in generating any sort of top-line momentum will spill over into the next fiscal year," said Mr Corwin.

No wonder the Hershey Trust is up in arms. The value of its controlling stake in the Hershey company has fallen by $1.9bn in two years. Boardroom tensions first surfaced last month when Richard Lenny said he was quitting as chairman and chief executive – to be replaced by his No 2, David West – and it was revealed that the trust had gone behind his back in an attempt to revive merger talks with Cadbury.

Then on 10 October, the trust issued an extraordinary public rebuke to the company, calling its performance unsatisfactory. "The trust has communicated to the company board – which is solely responsible and accountable for the company's management and performance – that the trust is not satisfied with the company's results," wrote LeRoy Zimmerman, chairman of the trust. "The company has been underperforming both the market and its own stated expectations. As a result, as controlling shareholder, the trust is actively engaged in an ongoing process, the goal of which has been to ensure vigorous company board focus on resolving the company's current business challenges and on implementing new growth strategies."

That last sentence, at first cryptic, is now quite clear, given the boardroom bloodletting. Out go the six board members directly elected by the trust and two others who tended their resignations on Sunday, too. In comes a new slate that includes a Goldman Sachs banker, a private equity industry executive and former executives from both Hershey and its food industry peer Kellogg. A spokesman yesterday declared the trust "thrilled" at the new talent it is injecting, and optimistic the new board will kickstart a recovery.

Wall Street rather took the view that the proof of the chocolate pudding will be in the eating, sending Hershey shares up barely 1 per cent. Many analysts blame the trust itself for fostering a low-risk, low-reward strategy at the company, focusing instead on harvesting reliable dividends. The trust exists to use its control of the company to provide "life altering education and assistance" to 1,700 children in need, through the Milton Hershey School, the largest residential primary school in the US – set up when Mr Hershey discovered his wife was unable to bear children. There are other complicating factors, too, such as the paternalistic culture in Chocolatetown itself which has made it difficult to negotiate even limited job cuts with local unions. When the Hershey Trust considered putting the company up for sale in 2002, the outcry prompted Pennsylvania to enact legislation effectively giving the attorney-general a veto over a deal.

Eric Katzman, analyst at Deutsche Bank, is already worried whether the new boss David West can adapt Hershey's culture to the various competing visions, and the recent upheavals make a job at Hershey seem pretty unappetising for the talented senior executives that are needed. "In our view, most potential candidates for these positions are aware of the conflict between the Trust's relatively narrow vision of the company and a professional manager's view of what needs to be done to revitalize a company in an increasingly competitive, global category. We believe this strategic disconnect may hinder Hershey's ability to lure top management," he told clients.

Mr Zimmerman's extraordinary attack on the board last month reopened speculation about a deal with Cadbury, but while the trust continues to insist it cannot dilute its control over the company, a full-blown merger looks a non-starter. However much the UK firm's chief executive, Todd Stitzer, might want to combine Hershey's US dominance with his own powerful presence in Europe and emerging markets, only a more limited version of co-operation appears currently to be on the table – and there have been few signs of any progress in talks.

Mr Stitzer will be sniffing the atmosphere, though, as enthusiastically as any visitor to Chocolatetown. If the bombshell strategy of ousting the entire board fails to do the trick, the Hershey Trust might yet be forced to turn to him.