f10q_2q2007.htm



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended   July 1, 2007

OR

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period
from ______to_______

Commission file number 1-183

THE HERSHEY COMPANY
100 Crystal A Drive
Hershey, PA 17033

Registrant's telephone number:  717-534-4200

State of Incorporation
 
IRS Employer Identification No.
Delaware
 
23-0691590


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x     No  o


Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer  x    Accelerated filer  o    Non-accelerated filer  o


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o     No  x


Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
Common Stock, $1 par value – 167,243,374 shares, as of July 20, 2007.  Class B Common Stock,
$1 par value – 60,815,010 shares, as of July 20, 2007.
 


 

 
 
THE HERSHEY COMPANY
INDEX



 
Part I.  Financial Information
Page Number
   
Item 1.  Consolidated Financial Statements (Unaudited)
 
   
Consolidated Statements of Income
 
Three months ended July 1, 2007 and July 2, 2006
3
   
Consolidated Statements of Income
 
Six months ended July 1, 2007 and July 2, 2006
4
   
Consolidated Balance Sheets
 
July 1, 2007 and December 31, 2006
5
   
Consolidated Statements of Cash Flows
 
Six months ended July 1, 2007 and July 2, 2006
6
   
Notes to Consolidated Financial Statements
7
   
   
Item 2.  Management’s Discussion and Analysis of
 
Results of Operations and Financial Condition
21
   
   
Item 3.  Quantitative and Qualitative Disclosures
 
About Market Risk
27
   
   
Item 4.  Controls and Procedures
27
   
   
   
Part II.  Other Information
 
   
Item 2.  Unregistered Sales of Equity Securities and Use
 
of Proceeds
28
   
Item 4.  Submission of Matters to a Vote
 
of Security Holders
28
   
Item 6.  Exhibits
29
 
 


-2-


 
PART I - FINANCIAL INFORMATION
 
Item 1.  Consolidated Financial Statements (Unaudited)
 
THE HERSHEY COMPANY
CONSOLIDATED STATEMENTS OF INCOME
(in thousands except per share amounts)

   
For the Three Months Ended
 
   
July 1,
2007
   
July 2,
2006
 
             
Net Sales
  $
1,051,916
    $
1,051,912
 
                 
Costs and Expenses:
               
Cost of sales
   
722,478
     
644,077
 
Selling, marketing and administrative
   
216,870
     
221,478
 
Business realignment charge, net
   
79,728
     
4,240
 
                 
Total costs and expenses
   
1,019,076
     
869,795
 
                 
Income before Interest and Income Taxes
   
32,840
     
182,117
 
                 
Interest expense, net
   
29,213
     
27,490
 
                 
Income before Income Taxes
   
3,627
     
154,627
 
                 
Provision for income taxes
   
73
     
56,730
 
                 
Net Income
  $
3,554
    $
97,897
 
                 
                 
Earnings Per Share - Basic - Class B Common Stock
  $
.01
    $
.38
 
                 
Earnings Per Share - Diluted - Class B Common Stock
  $
.02
    $
.38
 
                 
Earnings Per Share - Basic - Common Stock
  $
.02
    $
.42
 
                 
Earnings Per Share - Diluted - Common Stock
  $
.01
    $
.41
 
                 
Average Shares Outstanding - Basic - Common Stock
   
168,309
     
175,779
 
                 
Average Shares Outstanding - Basic - Class B Common Stock
   
60,815
     
60,817
 
                 
Average Shares Outstanding - Diluted
   
231,963
     
240,124
 
                 
Cash Dividends Paid per Share:
               
Common Stock
  $
.2700
    $
.2450
 
Class B Common Stock
  $
.2425
    $
.2200
 
                 
 
The accompanying notes are an integral part of these consolidated financial statements.

-3-


 
THE HERSHEY COMPANY
CONSOLIDATED STATEMENTS OF INCOME
(in thousands except per share amounts)
 

   
For the Six Months Ended
 
   
July 1,
2007
   
July 2,
2006
 
             
Net Sales
  $
2,205,025
    $
2,191,419
 
                 
Costs and Expenses:
               
Cost of sales
   
1,461,556
     
1,351,442
 
Selling, marketing and administrative
   
433,303
     
438,272
 
Business realignment charge, net
   
107,273
     
7,571
 
                 
Total costs and expenses
   
2,002,132
     
1,797,285
 
                 
Income before Interest and Income Taxes
   
202,893
     
394,134
 
                 
Interest expense, net
   
57,468
     
52,693
 
                 
Income before Income Taxes
   
145,425
     
341,441
 
                 
Provision for income taxes
   
48,398
     
121,073
 
                 
Net Income
  $
97,027
    $
220,368
 
                 
                 
Earnings Per Share - Basic - Class B Common Stock
  $
.39
    $
.86
 
                 
Earnings Per Share - Diluted - Class B Common Stock
  $
.39
    $
.85
 
                 
Earnings Per Share - Basic - Common Stock
  $
.43
    $
.95
 
                 
Earnings Per Share - Diluted - Common Stock
  $
.42
    $
.91
 
                 
Average Shares Outstanding - Basic - Common Stock
   
169,078
     
174,344
 
                 
Average Shares Outstanding - Basic - Class B Common Stock
   
60,815
     
60,818
 
                 
Average Shares Outstanding - Diluted
   
232,841
     
241,644
 
                 
Cash Dividends Paid per Share:
               
Common Stock
  $
.5400
    $
.4900
 
Class B Common Stock
  $
.4850
    $
.4400
 
                 
 
The accompanying notes are an integral part of these consolidated financial statements.

-4-


 
THE HERSHEY COMPANY
CONSOLIDATED BALANCE SHEETS
(in thousands of dollars)
 
ASSETS
 
July 1,
2007
   
December 31, 2006
 
             
Current Assets:
           
Cash and cash equivalents
  $
38,822
    $
97,141
 
Accounts receivable - trade
   
378,178
     
522,673
 
Inventories
   
813,836
     
648,820
 
Deferred income taxes
   
55,976
     
61,360
 
Prepaid expenses and other
   
138,828
     
87,818
 
Total current assets
   
1,425,640
     
1,417,812
 
Property, Plant and Equipment, at cost
   
3,689,031
     
3,597,756
 
Less-accumulated depreciation and amortization
    (2,100,868 )     (1,946,456 )
Net property, plant and equipment
   
1,588,163
     
1,651,300
 
Goodwill
   
508,849
     
501,955
 
Other Intangibles
   
234,549
     
140,314
 
Other Assets
   
510,035
     
446,184
 
Total assets
  $
4,267,236
    $
4,157,565
 
                 
LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS' EQUITY
               
                 
Current Liabilities:
               
Accounts payable
  $
248,099
    $
155,517
 
Accrued liabilities
   
426,873
     
454,023
 
Accrued income taxes
   
56
     
 
Short-term debt
   
926,262
     
655,233
 
Current portion of long-term debt
   
14,669
     
188,765
 
Total current liabilities
   
1,615,959
     
1,453,538
 
Long-term Debt
   
1,272,504
     
1,248,128
 
Other Long-term Liabilities
   
590,144
     
486,473
 
Deferred Income Taxes
   
200,950
     
286,003
 
Total liabilities
   
3,679,557
     
3,474,142
 
Minority Interest
   
16,378
     
 
Stockholders' Equity:
               
Preferred Stock, shares issued:
               
none in 2007 and 2006
   
     
 
Common Stock, shares issued:  299,086,734 in 2007 and
   299,085,666 in 2006
   
299,086
     
299,085
 
Class B Common Stock, shares issued:  60,815,010 in 2007 and
   60,816,078 in 2006 
   
60,815
     
60,816
 
Additional paid-in capital
   
324,043
     
298,243
 
Retained earnings
   
3,941,644
     
3,965,415
 
Treasury-Common Stock shares at cost:
               
           131,858,178 in 2007 and 129,638,183 in 2006
    (3,951,479 )     (3,801,947 )
Accumulated other comprehensive loss
    (102,808 )     (138,189 )
Total stockholders' equity
   
571,301
     
683,423
 
Total liabilities, minority interest, and stockholders' equity
  $
4,267,236
    $
4,157,565
 
 
The accompanying notes are an integral part of these consolidated balance sheets.

-5-


 
THE HERSHEY COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands of dollars)

   
For the Six Months Ended
 
   
July 1,
2007
   
July 2,
2006
 
Cash Flows Provided from (Used by) Operating Activities
           
Net Income
  $
97,027
    $
220,368
 
Adjustments to Reconcile Net Income to Net Cash
               
Provided from Operations:
               
Depreciation and amortization
   
144,003
     
98,059
 
Stock-based compensation expense, net of tax of $4,377 and
     $10,131, respectively
   
7,988
     
18,487
 
Excess tax benefits from exercise of stock options
    (8,481 )     (3,529 )
Deferred income taxes
   
41,069
     
6,704
 
Business realignment initiatives, net of tax of $61,342 and
     $1,347, respectively
   
103,430
     
3,025
 
Contributions to pension plans
    (7,836 )     (8,592 )
Changes in assets and liabilities, net of effects from business acquisitions:
               
Accounts receivable - trade
   
149,719
     
180,188
 
Inventories
    (166,637 )     (243,715 )
Accounts payable
   
87,044
      (11,389 )
Other assets and liabilities
    (153,821 )     (92,255 )
Net Cash Flows Provided from Operating Activities
   
293,505
     
167,351
 
                 
Cash Flows Provided from (Used by) Investing Activities
               
Capital additions
    (77,905 )     (80,233 )
Capitalized software additions
    (5,259 )     (7,104 )
Business acquisitions
    (76,989 )    
 
Net Cash Flows (Used by) Investing Activities
    (160,153 )     (87,337 )
                 
Cash Flows Provided from (Used by) Financing Activities
               
Net increase in short-term debt
   
264,231
     
315,268
 
Repayment of long-term debt
    (188,800 )     (117 )
Cash dividends paid
    (120,798 )     (113,168 )
Exercise of stock options
   
42,234
     
17,394
 
Excess tax benefits from exercise of stock options
   
8,481
     
3,529
 
Repurchase of Common Stock
    (197,019 )     (346,618 )
Net Cash Flows (Used by) Financing Activities
    (191,671 )     (123,712 )
                 
Decrease in Cash and Cash Equivalents
    (58,319 )     (43,698 )
Cash and Cash Equivalents, beginning of period
   
97,141
     
67,183
 
                 
Cash and Cash Equivalents, end of period
  $
38,822
    $
23,485
 
                 
                 
Interest Paid
  $
62,495
    $
51,677
 
                 
Income Taxes Paid
  $
105,852
    $
154,243
 
 
The accompanying notes are an integral part of these consolidated financial statements.

-6-


 
THE HERSHEY COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
1.        BASIS OF PRESENTATION
 
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 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 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 2007 presentation.  Operating results for the six months ended July 1, 2007 may not be indicative of the results that may be expected for the year ending December 31, 2007, because of the seasonal effects of our business.
 
Items Affecting Comparability
 
Securities and Exchange Commission Staff Accounting Bulletin No. 108, Considering the Effects of Prior Misstatements When Quantifying Misstatements in Current Year Financial Statements (“SAB No. 108”), required companies to change the accounting principle used for evaluating the effect of possible prior year misstatements when quantifying misstatements in current year financial statements. As a result, at December 31, 2006 we changed one of the five criteria of our revenue recognition policy, resulting in a delay in the recognition of revenue on goods in-transit until they are received by our customers. As permitted by SAB No. 108, we adjusted our financial statements for the three-month and six-month periods ended July 2, 2006 to provide comparability. These adjustments were not material to our results of operations for those periods. For more information, refer to the consolidated financial statements and notes included in our 2006 Annual Report on Form 10-K.
 
2.        BUSINESS ACQUISITIONS
 
In May 2007, our Company and Godrej Beverages and Foods, Ltd., one of India’s largest consumer goods, confectionery and food companies, entered into an agreement to manufacture and distribute confectionery products, snacks and beverages across India.  Under the agreement, we invested $58.7 million during the second quarter and own a 51% controlling interest. Total liabilities assumed were $59.0 million. Effective in May 2007, this business acquisition was included in our consolidated results.
 
Also in May 2007, our Company and Lotte Confectionery Co., LTD., entered into a manufacturing agreement in China that will produce Hershey products and certain Lotte products for the market in China.  We invested $18.3 million in the second quarter of 2007 and own a 44% interest.  We will account for this investment under the equity method.
 
Under each of the acquisition agreements, our Company and the other parties are currently obligated to make additional investments.  We expect to invest a total of approximately $23.8 million later this year in these businesses.  The additional investments will not change our ownership interests.

-7-


 
3.        STOCK COMPENSATION PLANS
 
At our annual meeting of stockholders, held April 17, 2007, stockholders approved The Hershey Company Equity and Incentive Compensation Plan (“EICP”).  The EICP is an amendment and restatement of our former Key Employee Incentive Plan, a share-based employee incentive compensation plan, and is also a continuation of our Broad Based Stock Option Plan, Broad Based Annual Incentive Plan and Directors’ Compensation Plan.  Following its adoption on April 17, 2007, the EICP became the single plan under which grants using shares for compensation and incentive purposes will be made.  The following table summarizes our stock compensation costs:
 

 
For the Three
Months Ended
 
For the Six
Months Ended
 
July 1,
2007
 
July 2,
2006
 
July 1,
2007
 
July 2,
2006
 
(in millions of dollars)
   
Total compensation amount charged against income for stock compensation plans, including stock options, performance stock units (“PSUs”) and restricted stock units
$ 5.5
 
$15.5
 
$12.4
 
$ 29.5
Total income tax benefit recognized in Consolidated Statements of Income for share-based compensation
$ 1.9
 
$ 5.7
 
$ 4.4
 
$ 10.5
 
The decrease in share-based compensation expense from 2006 to 2007 was primarily associated with lower performance expectations for the PSUs and the timing of stock option grants in 2007.  The 2007 stock option grants were delayed pending approval by our stockholders of the EICP at the annual meeting in April 2007.
 
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:
 

   
For the Six Months Ended
   
July 1,
 2007
 
July 2,
2006
Dividend yields
 
2.0%
 
1.6%
Expected volatility
 
19.5%
 
23.7%
Risk-free interest rates
 
4.6%
 
4.6%
Expected lives in years
 
6.6   
 
6.6   
 
Stock Options
 
A summary of the status of our stock options as of July 1, 2007, and the change during 2007 is presented below:
 

 
For the Six Months Ended July 1, 2007
Stock Options
Shares
Weighted-
Average
Exercise Price
Weighted-Average
Remaining
Contractual Term
Outstanding at beginning of the period
13,855,113 
$40.29
6.3 years
Granted
 2,000,325 
$54.63
 
Exercised
(1,268,528)
$29.61
 
Forfeited
   (127,990)
$54.96
 
Outstanding as of July 1, 2007
14,458,920 
$43.08
6.5 years
Options exercisable as of July 1, 2007
  8,691,849 
$37.11
5.3 years


-8-



   
For the Six Months Ended
   
July 1,
2007
 
July 2,
2006
Weighted fair value of options granted (per share)
 
$ 12.95
 
$ 15.06
Intrinsic value of options exercised (in millions of dollars)
 
$   31.3
 
$   13.5

·
As of July 1, 2007, the aggregate intrinsic value of options outstanding was $140.1 million and the aggregate intrinsic value of options exercisable was $129.2 million.
   
·
As of July 1, 2007, there was $52.1 million of total unrecognized compensation cost related to non-vested stock option compensation arrangements granted under our stock option plans. That cost is expected to be recognized over a weighted-average period of 2.7 years.
 
Performance Stock Units and Restricted Stock Units
 
A summary of the status of our performance stock units and restricted stock units as of July 1, 2007, and the change during 2007 is presented below:
 

Performance Stock Units and Restricted Stock Units
For the Six
Months Ended
July 1, 2007
 
Weighted-average grant date
fair value for equity awards or
market value for liability
 awards
 
Outstanding at beginning of year
1,075,748 
 
$44.89
 
Granted
   273,572 
 
$51.50
 
Performance assumption change
  (145,533)
 
$53.49
 
Vested
  (414,728)
 
$49.08
 
Forfeited
         (350)
 
$49.80
 
Outstanding as of July 1, 2007
   788,709 
 
$42.54
 
 
As of July 1, 2007, there was $16.5 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 2.6 years.
 
   
For the Six Months Ended
 
   
July 1,
2007
 
July 2,
2006
 
Intrinsic value of share-based liabilities paid, combined with the fair
value of shares vested (in millions of dollars)
 
$  21.0
 
$  3.7
 
 
The lower amount in 2006 was primarily associated with the additional three-year vesting term for performance stock unit grants for the 2003-2005 performance cycle (“2003 grants”) which reduced the number of shares that vested in 2006 compared with 2007.  An additional three-year vesting term was imposed on the grant date for the 2003 grants with accelerated vesting for retirement, disability or death.  The compensation cost based on grant date fair value for the 2003 grants is being recognized over a period from three to six years.
 
Deferred performance stock units, deferred restricted stock units, and directors’ fees and accumulated dividend amounts representing deferred stock units totaled 725,705 units as of July 1, 2007. Each unit is equivalent to one share of the Company's Common Stock.
 
No stock appreciation rights were outstanding as of July 1, 2007.
 
For more information on our stock compensation plans, refer to the consolidated financial statements and notes included in our 2006 Annual Report on Form 10-K and our proxy statement for the 2007 annual meeting of stockholders.

-9-


 
4.        INTEREST EXPENSE
 
Net interest expense consisted of the following:

   
For the Six Months Ended
 
   
July 1,
2007
   
July 2,
2006
 
   
(in thousands of dollars)
 
       
Interest expense
  $
58,860
    $
53,531
 
Interest income
    (1,327 )     (817 )
Capitalized interest
    (65 )     (21 )
Interest expense, net
  $
57,468
    $
52,693
 
 
For the first six months of 2007, net interest expense was higher than the comparable period of 2006, primarily due to the financing of share repurchases.  Higher interest rates in 2007 as compared with 2006 also contributed to the increase in net interest expense.
 
5.        BUSINESS REALIGNMENT INITIATIVES
 
In February 2007, we announced a comprehensive, three-year supply chain transformation program (the “2007 business realignment initiatives”).  When completed, this program will greatly enhance our manufacturing, sourcing and customer service capabilities, reduce inventories resulting in improvements in working capital and generate significant resources to invest in our growth initiatives.  These initiatives include accelerated marketplace momentum within our core U.S. business, creation of innovative new product platforms to meet customer needs and disciplined global expansion.  Under the program, which will be implemented in stages over the next three years, we will significantly increase manufacturing capacity utilization by reducing the number of production lines by more than one-third, outsource production of low value-added items and construct a flexible, cost-effective production facility in Monterrey, Mexico to meet current and emerging marketplace needs.  The program will result in a total net reduction of 1,500 positions across our supply chain over the next three years.
 
The estimated pre-tax cost of the program is from $525 million to $575 million over the next three years.  The total includes from $475 million to $525 million in business realignment costs and approximately $50 million in project implementation costs.  The costs will be incurred primarily in 2007 and 2008, with approximately $270 million to $300 million expected in 2007.
 
In July 2005, we announced initiatives intended to advance our value-enhancing strategy (the “2005 business realignment initiatives”).  Charges for the 2005 business realignment initiatives were recorded during 2005 and 2006 and the 2005 business realignment initiatives were completed by December 31, 2006.

-10-


 
Charges (credits) associated with business realignment initiatives recorded during the three-month and six-month periods ended July 1, 2007 and July 2, 2006 were as follows:
 
   
For the Three
Months Ended
   
For the Six
Months Ended
 
   
July 1,
2007
   
July 2,
2006
   
July 1,
2007
   
July 2,
2006
 
   
(in thousands of dollars)
 
Cost of sales
                       
2007 business realignment initiatives
  $
41,307
    $
    $
51,166
    $
 
2005 business realignment initiatives
   
     
     
      (1,599 )
Previous business realignment initiatives
   
      (1,600 )    
      (1,600 )
Total cost of sales
   
41,307
      (1,600 )    
51,166
      (3,199 )
                                 
Selling, marketing and administrative
                               
2007 business realignment initiatives
   
3,347
     
     
6,333
     
 
                                 
Business realignment and asset impairments, net
                               
2007 business realignment initiatives:
                               
Fixed asset impairments and plant closure expenses
   
13,878
     
     
40,098
     
 
Employee separation costs
   
51,534
     
     
52,859
     
 
Contract termination costs
   
14,316
     
     
14,316
     
 
2005 business realignment initiatives
   
     
3,727
     
     
7,058
 
Previous business realignment initiatives
   
     
513
     
     
513
 
Total business realignment and asset impairments, net
   
79,728
     
4,240
     
107,273
     
7,571
 
                                 
Total net charges associated with business realignment initiatives
  $
124,382
    $
2,640
    $
164,772
    $
4,372
 
 
The charge of $41.3 million recorded in cost of sales during the second quarter of 2007 for the 2007 business realignment initiatives related to the accelerated depreciation of fixed assets over a reduced estimated remaining useful life and costs related to inventory reductions.  The $3.3 million recorded in selling, marketing and administrative expenses related primarily to project administration.  In determining the costs related to fixed asset impairments, fair value was estimated based on the expected sales proceeds.  Certain real estate with a net realizable value of $5.4 million was being held for sale as of July 1, 2007.  The employee separation costs included $22.3 million for involuntary terminations at six North American manufacturing facilities which are being closed.  The facilities are located in Naugatuck, Connecticut; Reading, Pennsylvania; Oakdale, California; Smiths Falls, Ontario; Montreal, Quebec; and Dartmouth, Nova Scotia.  The employee separation costs also included $29.2 million for charges relating to pension and other post-retirement benefits curtailments and special termination benefits.
 
Charges (credits) associated with previous business realignment initiatives which began in 2003 and 2001 resulted from the finalization of the sale of certain properties, adjustments to liabilities which had previously been recorded, and the impact of the settlement as to several of the eight former employees who had filed a complaint alleging that the Company had discriminated against them on the basis of age in connection with the 2003 business realignment initiatives.  The $3.7 million charge associated with the 2005 business realignment initiatives was related primarily to the U.S. Voluntary Workforce Reduction Program (“VWRP”), in addition to costs for streamlining the Company’s international operations and facility rationalization relating to the closure of the Las Piedras, Puerto Rico plant.  The business realignment charge included $2.1 million for involuntary terminations.
 
The charge of $51.2 million recorded in cost of sales during the first six months of 2007 for the 2007 business realignment initiatives related to the accelerated depreciation of fixed assets over a reduced estimated remaining useful life and costs related to inventory reductions.  The $6.3 million recorded in selling, marketing and administrative expenses related primarily to project administration.  In determining the costs related to fixed asset impairments, fair value was estimated based on the expected sales proceeds.  The employee separation costs

-11-


 
included $23.7 million for involuntary terminations and $29.2 million for charges relating to pension and other post-retirement benefits curtailments and special termination benefits.
 
A credit of $1.6 million recorded in cost of sales for the 2005 business realignment initiatives related to higher than expected proceeds from the sale of equipment from the Las Piedras plant.  The $7.1 million charge associated with the 2005 business realignment initiatives related primarily to the U.S. VWRP, along with costs for streamlining the Company’s international operations and facility rationalization relating to the closure of the Las Piedras plant.  The business realignment charge included $2.9 million for involuntary terminations.  Charges (credits) associated with previous business realignment initiatives which began in 2003 and 2001 resulted from the finalization of the sale of certain properties, adjustments to liabilities which had previously been recorded, and the impact of the settlement as to several of the eight former employees who had filed a complaint alleging that the Company had discriminated against them on the basis of age in connection with the 2003 business realignment initiatives.
 
The July 1, 2007 liability balance relating to the 2007 business realignment initiatives was $23.5 million for employee separation costs.  The July 1, 2007 liability balance relating to the 2005 business realignment initiatives was $8.7 million.
 
6.        EARNINGS PER SHARE
 
In accordance with Statement of Financial Accounting Standards No. 128, Earnings Per Share, 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:
 
   
For the Three Months
Ended
   
For the Six Months
Ended
 
   
July 1,
2007
   
July 2,
2006
   
July 1,
2007
   
July 2,
2006
 
   
(in thousands except per share amounts)
 
             
Net income
  $
3,554
    $
97,897
    $
97,027
    $
220,368
 
                                 
Weighted-average shares - Basic
                               
Common Stock
   
168,309
     
175,779
     
169,078
     
177,344
 
Class B Common Stock
   
60,815
     
60,817
     
60,815
     
60,818
 
Total weighted-average shares - Basic
   
229,124
     
236,596
     
229,893
     
238,162
 
                                 
Effect of dilutive securities:
                               
Employee stock options
   
2,330
     
2,847
     
2,367
     
2,848
 
Performance and restricted stock units
   
509
     
681
     
581
     
634
 
Weighted-average shares - Diluted
   
231,963
     
240,124
     
232,841
     
241,644
 
Earnings Per Share - Basic
                               
Class B Common Stock
  $
.01
    $
.38
    $
.39
    $
.86
 
Common Stock
  $
.02
    $
.42
    $
.43
    $
.95
 
Earnings Per Share - Diluted
                               
Class B Common Stock
  $
.02
    $
.38
    $
.39
    $
.85
 
Common Stock
  $
.01
    $
.41
    $
.42
    $
.91
 
 
The Class B Common Stock is convertible into Common Stock on a share for share basis at any time. In accordance with proposed Financial Accounting Standards Board (“FASB”) Staff Position No. FAS 128-a, Computational Guidance for Computing Diluted EPS under the Two-Class Method, 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 and six-month periods ended July 1, 2007, 5.6 million stock options were not included in the diluted earnings per share calculation because the effect would have been antidilutive. In the second quarter and

-12-


 
first six months of 2006, 3.6 million stock options were not included in the diluted earnings per share calculation because the effect would have been antidilutive.
 
7.        DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
 
We account for derivative instruments in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (“SFAS No. 133, as amended”).  SFAS No. 133, as amended, requires us to recognize all derivative instruments at fair value. We classify the derivatives as assets or liabilities on the balance sheet. As of July 1, 2007 and July 2, 2006, all of our derivative instruments were classified as cash flow hedges.
 
Summary of Activity
 
Our cash flow hedging derivative activity during the three months and six months ended July 1, 2007 and July 2, 2006 was as follows:

 
 
For the Three Months
Ended
 
For the Six Months
Ended
 
July 1,
2007
 
July 2,
2006
 
July 1,
2007
 
July 2,
2006
 
(in millions of dollars)
   
Net after-tax (losses) gains on cash flow hedging derivatives
$(1.0)
 
$7.7
 
$4.9
 
$14.3
Reclassification adjustment of losses from accumulated other comprehensive income to income, net of tax
  1.2
 
   .7
 
1.1
 
    1.3
Hedge ineffectiveness gains recognized in cost of sales, before tax
   –  
 
 2.0
 
–  
 
    2.0


·
Net gains and losses on cash flow hedging derivatives were primarily associated with commodities futures contracts.
   
·
Reclassification adjustments from accumulated other comprehensive income (loss) to income related to gains or losses on commodities futures contracts and were reflected in cost of sales.  Reclassification adjustments for gains on interest rate swaps were reflected as an adjustment to interest expense.
   
·
We recognized no components of gains or 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 contracts, expected to be reclassified into earnings in the next twelve months was approximately $1.4 million after tax as of July 1, 2007. This amount was primarily associated with foreign exchange forward contracts.
 
In February 2006, we terminated a forward swap agreement hedging the anticipated execution of $250 million of term financing because the transaction was no longer expected to occur by the originally specified time period or within an additional two-month period of time thereafter.  A gain of $1.0 million was recorded in the first quarter of 2006 as a result of the discontinuance of this cash flow hedge.  No other gains or losses on cash flow hedging derivatives were reclassified from accumulated other comprehensive income (loss) into income as a result of the discontinuance of a hedge because it became probable that a hedged forecasted transaction would not occur.
 
For more information, refer to the consolidated financial statements and notes included in our 2006 Annual Report on Form 10-K.

-13-


 
8.        COMPREHENSIVE INCOME
 
A summary of the components of comprehensive income (loss) is as follows:

 
 
For the Three Months Ended July 1, 2007
 
 
 
Pre-Tax Amount
   
Tax
(Expense) Benefit
   
After-Tax Amount
 
   
(in thousands of dollars)
 
       
Net income
              $
3,554
 
                     
Other comprehensive income (loss):
                   
Foreign currency translation adjustments
  $
24,714
    $
     
24,714
 
Pension and post-retirement benefit plans
   
2,425
      (1,073 )    
1,352
 
Cash flow hedges:
                       
Losses on cash flow hedging derivatives
    (1,649 )    
600
      (1,049 )
Reclassification adjustments
   
1,819
      (644 )    
1,175
 
Total other comprehensive income
  $
27,309
    $ (1,117 )    
26,192
 
Comprehensive income
                  $
29,746
 

   
For the Three Months Ended July 2, 2006
 
   
Pre-Tax Amount
   
Tax
(Expense) Benefit
   
After-Tax Amount
 
   
(in thousands of dollars)
 
       
Net income
              $
97,897
 
                     
Other comprehensive income (loss):
                   
Foreign currency translation adjustments
  $
8,686
    $
     
8,686
 
Cash flow hedges:
                       
Gains on cash flow hedging derivatives
   
12,113
      (4,390 )    
7,723
 
Reclassification adjustments
   
1,122
      (399 )    
723
 
Total other comprehensive income
  $
21,921
    $ (4,789 )    
17,132
 
Comprehensive income
                  $
115,029
 

   
For the Six Months Ended July 1, 2007
 
   
Pre-Tax Amount
   
Tax
(Expense) Benefit
   
After-Tax Amount
 
   
(in thousands of dollars)
 
       
Net income
              $
97,027
 
                     
Other comprehensive income (loss):
                   
Foreign currency translation adjustments
  $
27,318
    $
     
27,318
 
Pension and post-retirement benefit plans
   
3,720
      (1,592 )    
2,128
 
Cash flow hedges:
                       
Gains on cash flow hedging derivatives
   
7,647
      (2,768 )    
4,879
 
Reclassification adjustments
   
1,626
      (570 )    
1,056
 
Total other comprehensive income
  $
40,311
    $ (4,930 )    
35,381
 
Comprehensive income
                  $
132,408
 


-14-



   
For the Six Months Ended July 2, 2006
 
   
Pre-Tax
Amount
   
Tax
(Expense) Benefit
   
After-Tax Amount
 
   
(in thousands of dollars)
 
       
Net income
              $
220,368
 
                     
Other comprehensive income (loss):
                   
Foreign currency translation adjustments
  $
8,202
    $
     
8,202
 
Minimum pension liability adjustments
   
118
      (42 )    
76
 
Cash flow hedges:
                       
Gains on cash flow hedging derivatives
   
22,402
      (8,135 )    
14,267
 
Reclassification adjustments
   
2,037
      (731 )    
1,306
 
Total other comprehensive income
  $
32,759
    $ (8,908 )    
23,851
 
Comprehensive income
                  $
244,219
 
 
The components of accumulated other comprehensive income (loss) as shown on the Consolidated Balance Sheets are as follows:
 
   
July 1,
2007
   
December 31,
2006
 
   
(in thousands of dollars)
 
       
Foreign currency translation adjustments
  $
27,283
    $ (35 )
Pension and post-retirement benefit plans, net of tax
    (135,844 )     (137,972 )
Cash flow hedges, net of tax
   
5,753
      (182 )
Total accumulated other comprehensive loss
  $ (102,808 )   $ (138,189 )
 
Effective December 31, 2006, we adopted Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132 (R) (“SFAS No. 158”).  The provisions of SFAS No. 158 require that the funded status of our pension plans and the benefit obligations of our post-retirement benefit plans be recognized in our balance sheet.  Appropriate adjustments were made to various assets and liabilities as of December 31, 2006, with an offsetting after-tax effect of $138.0 million recorded as a component of other comprehensive income rather than as an adjustment to the ending balance of accumulated other comprehensive loss.
 
Excluding the impact of the adoption of SFAS No. 158, total other comprehensive income for the year ended December 31, 2006 was $9.1 million after-tax, compared with the reported other comprehensive loss of $128.9 million after-tax.  The presentation of other comprehensive income for the year ended December 31, 2006 will be adjusted to exclude the impact of the adoption of SFAS No. 158 in our Annual Report on Form 10-K for the year ending December 31, 2007.
 
9.        INVENTORIES
 
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:

   
July 1,
2007
   
December 31,
2006
 
   
(in thousands of dollars)
 
       
Raw materials
  $
252,767
    $
214,335
 
Goods in process
   
116,595
     
94,740
 
Finished goods
   
524,621
     
418,250
 
Inventories at FIFO
   
893,983
     
727,325
 
Adjustment to LIFO
    (80,147 )     (78,505 )
Total inventories
  $
813,836
    $
648,820
 
 


-15-


 
The increase in raw material inventories as of July 1, 2007 resulted from the timing of deliveries to support manufacturing requirements, reflecting the seasonality of our business, and higher costs in 2007. The increase in finished goods inventories was primarily associated with seasonal sales patterns and the introduction of new products.
 
10.      SHORT-TERM DEBT
 
As a source of short-term financing, we utilize commercial paper or bank loans with an original maturity of three months or less. In December 2006, we entered into a new five-year unsecured revolving credit agreement. The credit limit is $1.1 billion with an option to borrow an additional $400 million with the concurrence of the lenders. These funds may be used for general corporate purposes.  This unsecured revolving credit agreement contains certain financial covenants and customary representations and warranties, and events of default. As of July 1, 2007 we complied with all covenants pertaining to our 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 2006 Annual Report on Form 10-K.
 
11.      LONG-TERM DEBT
 
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"). In August 2006, we issued $500 million of Notes under the WKSI Registration Statement.  Proceeds from the debt issuances and any other offerings under the WKSI Registration Statement may be used for general corporate requirements. These may include reducing existing borrowings, financing capital additions, funding contributions to our pension plans, future business acquisitions and working capital requirements.
 
12.      FINANCIAL INSTRUMENTS
 
The carrying amounts of financial instruments including cash and cash equivalents, accounts receivable, accounts payable and short-term debt approximated fair value as of July 1, 2007 and December 31, 2006, because of the relatively short maturity of these instruments.
 
The carrying value of long-term debt, including the current portion, was $1,287.2 million as of July 1, 2007, compared with a fair value of $1,327.3 million, an increase of $40.1 million over the carrying value, based on quoted market prices for the same or similar debt issues.
 
Foreign Exchange Forward Contracts
 
The following table summarizes our foreign exchange activity:
 
 
July 1, 2007
 
 
Contract
Amount
 
Primary
Currencies
 
 
(in millions of dollars)
 
         
Foreign exchange forward contracts to
purchase foreign currencies
 
$           25.8
 
Mexican pesos
British sterling
Australian dollars
Euros
 
         
Foreign exchange forward contracts to
sell foreign currencies
 
$           31.8
 
Canadian dollars
Brazilian reais Mexican pesos
 
 
Our foreign exchange forward contracts mature in 2007 and 2008.
 
We define the fair value of foreign exchange forward contracts as the amount of the difference between contracted and current market foreign currency exchange rates at the end of the period. On a quarterly basis, we estimate the fair value of foreign exchange forward contracts by obtaining market quotes for future contracts with

-16-


 
similar terms, adjusted where necessary for maturity differences. We do not hold or issue financial instruments for trading purposes.
 
The total fair value of our foreign exchange forward contracts included in prepaid expenses and other current assets and in other non-current assets, as appropriate, on the Consolidated Balance Sheets were as follows:
 
   
July 1,
2007
 
December 31,
2006
   
(in millions of dollars)
     
Fair value of foreign exchange forward contracts - asset
 
$   2.2
 
$   1.5
 
13.      INCOME TAXES
 
In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (“FIN No. 48”). FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. FIN No. 48 describes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.
 
We adopted the provisions of FIN No. 48 as of January 1, 2007.  The adoption of FIN No. 48 did not result in a significant change to the liability for unrecognized tax benefits.  Upon adoption, we had unrecognized tax benefits of $79.0 million of which $45.5 million would impact the effective income tax rate if recognized.  The entire amount of unrecognized tax benefits was classified as other long-term liabilities on the balance sheet since we do not expect to make any payments to taxing authorities related to such tax positions in the next twelve months.  We report accrued interest and penalties related to unrecognized tax benefits in income tax expense.  Upon adoption, we had accruals of approximately $17.4 million for the payment of interest and penalties.
 
We file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions.  A number of years may elapse before an uncertain tax position, for which we have unrecognized tax benefits, is audited and finally resolved. While it is often difficult to predict the final outcome or the timing of resolution of any particular uncertain tax position, we believe that our unrecognized tax benefits reflect the most likely outcome.  We adjust these unrecognized tax benefits, as well as the related interest, in light of changing facts and circumstances. Settlement of any particular position would usually require the use of cash.  Favorable resolution would be recognized as a reduction to our effective income tax rate in the period of resolution.
 
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) and Canada.  We are no longer subject to U.S. federal examinations by the Internal Revenue Service (“IRS”) for years before 2004 and various tax examinations by state taxing authorities could be conducted for years beginning in 2000.  We are no longer subject to Canadian federal income tax examinations by the Canada Revenue Agency (“CRA”) for years before 1999. U.S. and Canadian federal audit issues typically involve the timing of deductions and transfer pricing adjustments.  We work with the IRS and the CRA 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.

-17-


 
14.      PENSION AND OTHER POST-RETIREMENT BENEFIT PLANS

Components of net periodic benefits (income) cost consisted of the following:

   
Pension Benefits
   
Other Benefits
 
   
For the Three Months Ended
 
   
July 1,
2007
   
July 2,
2006
   
July 1,
2007
   
July 2,
2006
 
   
(in thousands of dollars)
 
       
Service cost
  $
10,809
    $
13,855
    $
1,177
    $
1,414
 
Interest cost
   
14,551
     
15,129
     
4,714
     
4,928
 
Expected return on plan assets
    (28,554 )     (27,067 )    
     
 
Amortization of prior service cost
   
748
     
1,141
      (35 )     (118 )
Amortization of unrecognized transition balance
   
     
5
     
     
 
Recognized net actuarial loss
   
154
     
3,489
     
433
     
1,084
 
Administrative expenses
   
128
     
101
     
     
 
Net periodic benefits (income) cost
    (2,164 )    
6,653
     
6,289
     
7,308
 
Special termination benefits
   
6,166
     
     
     
 
Settlement
   
     
28
     
     
 
Curtailment
   
4,215
     
31
     
18,862
     
 
Total amount reflected in earnings
  $
8,217
    $
6,712
    $
25,151
    $
7,308
 
 
We made contributions of $2.7 million and $5.9 million to the pension plans and other benefits plans, respectively, during the second quarter of 2007.  The Special termination benefits and Curtailment losses recorded in the second quarter of 2007 related to the 2007 business realignment initiatives.  The Settlement and Curtailment losses recorded during the second quarter of 2006 related to the termination of a small non-qualified plan.  In the second quarter of 2006, we made contributions of $.6 million and $6.8 million to our pension and other benefits plans, respectively.  The contributions in 2007 and 2006 also included benefit payments from our non-qualified pension plans and post-retirement benefit plans.
 
In the second quarter of 2007, there was net periodic pension benefits income of $2.2 million, compared with net periodic benefits cost of $6.7 million in the second quarter of 2006.  The net periodic pension benefits income resulted from the changes to the U.S. pension plans announced in October 2006, the higher actual return on pension assets during 2006 and a higher discount rate.
 
   
Pension Benefits
   
Other Benefits
 
   
For the Six Months Ended
 
   
July 1,
2007
   
July 2,
2006
   
July 1,
2007
   
July 2,
2006
 
   
(in thousands of dollars)
 
       
Service cost
  $
21,966
    $
28,364
    $
2,349
    $
2,856
 
Interest cost
   
29,219
     
29,254
     
9,461
     
9,539
 
Expected return on plan assets
    (57,142 )     (52,635 )    
     
 
Amortization of prior service cost
   
1,127
     
2,287
      (74 )    
95
 
Amortization of unrecognized transition balance
   
     
9
     
     
 
Recognized net actuarial loss
   
910
     
6,758
     
975
     
1,852
 
Administrative expenses
   
301
     
403
     
     
 
Net periodic benefits (income) cost
    (3,619 )    
14,440
     
12,711
     
14,342
 
Special termination benefits
   
6,166
     
     
     
 
Settlement
   
     
28
     
     
 
Curtailment
   
4,215
     
31
     
18,862
     
 
Total amount reflected in earnings
  $
6,762
    $
14,499
    $
31,573
    $
14,342
 
 


-18-


 
We made contributions of $7.8 million and $10.4 million to the pension plans and other benefits plans, respectively, during the first six months of 2007. In the first six months of 2006, we made contributions of $8.6 million and $13.2 million to our pension and other benefits plans, respectively.  The contributions in 2007 and 2006 also included benefit payments from our non-qualified pension plans and post-retirement benefit plans.
 
In the first six months of 2007, there was net periodic pension benefits income of $3.6 million, compared with net periodic benefits cost of $14.4 million in the first six months of 2006.  The net periodic pension benefits income resulted from the changes to the U.S. pension plans announced in October 2006, the higher actual return on pension assets during 2006 and a higher discount rate.
 
For 2007, there are no minimum funding requirements for the domestic plans and minimum funding requirements for the non-domestic plans are not material.  We do not anticipate any significant contributions during the remainder of 2007.
 
For more information, refer to the consolidated financial statements and notes included in our 2006 Annual Report on Form 10-K.
 
15.      SHARE REPURCHASES
 
Repurchases and Issuances of Common Stock
 
A summary of cumulative share repurchases and issuances is as follows:
 
   
For the six months ended
July 1, 2007
 
   
Shares
 
Dollars
 
(in thousands)
     
       
Shares repurchased in the open market under pre-approved
share repurchase programs
 
1,862 
 
$  99,998 
 
           
Shares repurchased to replace Treasury Stock issued for stock options
and incentive compensation
 
1,824 
 
97,020 
 
           
Total share repurchases
 
3,686 
 
197,018 
 
           
Shares issued for stock options and incentive compensation
 
(1,466)
 
(47,486)
 
           
Net change
 
2,220 
 
$149,532 
 

·
We intend to continue to repurchase shares of Common Stock in order to replace Treasury Stock shares issued for exercised stock options. The value of shares purchased in a given period will vary based on stock options exercised over time and market conditions.
   
·
In December 2006, our Board of Directors approved an additional $250 million share repurchase program. As of July 1, 2007, $150.0 million remained available for repurchases of Common Stock under this program.
 
16.      PENDING ACCOUNTING PRONOUNCEMENTS
 
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”).  SFAS No. 157 establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements.  SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements.  SFAS No. 157 is effective for our Company beginning January 1, 2008.  We have not yet determined the impact of the adoption of this new accounting standard.
 
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS No. 159”). SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for our Company beginning January 1, 2008. We have not yet determined the impact, if any, from the adoption of SFAS No. 159.

-19-

 
 
17.      SUBSEQUENT EVENTS
 
In July 2007, our Company and Barry Callebaut AG, entered into a long-term global strategic supply and innovation agreement under which Barry Callebaut will supply Hershey with chocolate and chocolate products. Under the agreement, Barry Callebaut will construct and operate a facility to provide chocolate and chocolate products for our new plant in Monterrey, Mexico, and will also lease a portion of our Robinson, Illinois, plant and operate chocolate-making equipment at that facility.
 
Also in July 2007, our Company and Starbucks Coffee Company entered into a development and distribution agreement that will help transform the premium chocolate segment. The companies will create and market a new Starbucks-branded premium chocolate platform in the United States starting in the fall of 2007.



-20-


 
Item 2.  Management's Discussion and Analysis of Results of Operations and Financial Condition
 
SUMMARY OF OPERATING RESULTS
 
Analysis of Selected Items from Our Income Statement

 
 
For the Three Months Ended
 
For the Six Months Ended
 
July 1,
2007
 
July 2,
2006
 
Percent
Change
Increase
(Decrease)
 
July 1,
2007
 
July 2,
2006
 
Percent
Change
 Increase
(Decrease)
 
 (in thousands except per share amounts)
   
Net Sales
$ 1,051.9 
 
$ 1,051.9
 
— 
 
$ 2,205.0
 
$ 2,191.4
 
0.6%
Cost of Sales
722.5 
 
644.1
 
12.2%
 
1,461.5
 
1,351.4
 
8.1%
Gross Profit
329.4 
 
407.8
 
(19.2)%
 
743.5
 
840.0
 
(11.5)%
Gross Margin
31.3%
 
38.8%
     
33.7%
 
38.3%
   
SM&A Expense
216.9 
 
221.5
 
(2.1)%
 
433.3
 
438.3
 
(1.1)%
SM&A Expense as a percent of sales
20.6%
 
21.1%
     
19.7%
 
20.0%
   
Business Realignment  Charge, net
79.7 
 
4.2
 
N/A
 
107.3
 
7.6
 
N/A
EBIT
32.8 
 
182.1
 
(82.0)%
 
202.9
 
394.1
 
(48.5)%
EBIT Margin
3.1%
 
17.3%
     
9.2%
 
18.0%
   
Interest Expense, net
29.2 
 
27.5
 
6.3%
 
57.5
 
52.6
 
9.1%
Provision for Income Taxes
— 
 
56.7
 
N/A
 
48.4
 
121.1
 
(60.0)%
Effective Income Tax Rate
— 
 
36.7%
     
33.3%
 
35.5%
   
Net Income
$  3.6 
 
$ 97.9
 
(96.4)%
 
$ 97.0
 
$220.4
 
(56.0)%
Net Income Per Share-Diluted
$0.01 
 
$ 0.41
 
(97.6)%
 
$ 0.42
 
$  0.91
 
(53.8)%

Results of Operations - Second Quarter 2007 vs. Second Quarter 2006
 
U.S. Price Increases
 
In April 2007, we announced an increase of approximately 4% to 5% in the wholesale prices of our domestic confectionery line, effective immediately.  The increase applies to our standard bar, king-size bar, 6-pack and vending lines.  These products represent approximately one-third of our portfolio.  This action was implemented to help offset increases in input costs, including raw and packaging materials, fuel, utilities and transportation.  We expect minimal financial impact from the pricing changes for the full year 2007.
 
Net Sales
 
Net Sales for the second quarter of 2007 was essentially equal to the second quarter of 2006 as sales volume increases from the introduction of new products were more than offset by lower sales of existing products in the U.S., primarily of single serve items. The sales volume decline in the U.S. was offset by sales volume increases for our international businesses, primarily Mexico and exports to Asia and Latin America. Decreased price realization from higher rates of promotional spending, including increases for trial-driving consumer coupons, and higher returns, discounts and allowances were only partially offset by higher list prices.  Favorable foreign currency exchange rates also contributed modestly to net sales. The acquisition of the Godrej Hershey Foods and Beverages Company increased net sales by $7.4 million.
 
Key Marketplace Metrics
 
Consumer takeaway decreased 0.4% during the second quarter of 2007 compared with the same period of 2006.  Consumer takeaway is provided for channels of distribution accounting for approximately 80% of our U.S. confectionery retail business. These channels of distribution include food, drug, mass merchandisers, including Wal-Mart Stores, Inc., and convenience stores.

-21-


 
Market share in measured channels declined by 1.5 share points during the second quarter of 2007. The change in market share is provided for measured channels which include sales in the food, drug, convenience store and mass merchandiser classes of trade, excluding sales of Wal-Mart Stores, Inc.
 
Cost of Sales and Gross Margin
 
Business realignment charges of $41.3 million were included in cost of sales in the second quarter of 2007, compared with a credit of $1.6 million in the second quarter of 2006.  The remainder of the cost of sales increase was primarily associated with higher input costs, particularly for dairy products, and business acquisitions, offset partially by improved supply chain productivity.
 
Over half of the gross margin decline was attributable to the impact of business realignment initiatives recorded in 2007 compared with 2006.  The rest of the decline reflected higher input costs, along with reduced net price realization.  Favorable supply chain productivity partially offset the impact of these cost increases.
 
Selling, Marketing and Administrative
 
Selling, marketing and administrative expenses decreased primarily as a result of lower administrative costs associated with incentive compensation. Higher marketing expenses, primarily related to advertising, were offset by lower consumer promotional expenses. Expenses of $3.3 million for project implementation related to our 2007 business realignment initiatives were included in selling, marketing and administrative expense for the second quarter of 2007.
 
Business Realignment Initiatives
 
Business realignment charges of $79.7 million were recorded in the second quarter of 2007 associated with the 2007 business realignment initiatives.  The charges were primarily associated with employee separation costs, along with expenses for asset impairments, the closure of certain manufacturing facilities and the termination of certain contracts.
 
During the second quarter of 2006, we recorded charges related to previous business realignment initiatives.  The $4.2 million business realignment charge included $2.6 million related to a U.S. VWRP, $0.9 million related to streamlining our international operations and $0.2 million for facility rationalization relating to the closure of the Las Piedras plant. An additional charge of $.5 million was recorded to finalize transactions related to business realignment initiatives which began in 2003 and 2001.
 
Income Before Interest and Income Taxes and EBIT Margin
 
EBIT decreased in the second quarter of 2007 compared with the second quarter of 2006 principally as a result of higher net business realignment charges associated with our business realignment initiatives. Net pre-tax business realignment charges of $124.4 million were recorded in the second quarter of 2007 compared with $2.6 million recorded in the second quarter of 2006, an increase of $121.8 million. The remainder of the decrease in EBIT was attributable to lower gross profit resulting primarily from higher input costs which were only slightly offset by lower selling, marketing and administrative expenses.
 
EBIT margin decreased from 17.3% for the second quarter of 2006 to 3.1% for the second quarter of 2007.  The impact of net business realignment charges reduced EBIT margin by 11.5 percentage points.  The remainder of the decrease resulted from the lower gross margin offset partially by lower selling, marketing and administrative expense as a percentage of sales.
 
Interest Expense, Net
 
Net interest expense was higher in the second quarter of 2007 than the comparable period of 2006 primarily reflecting the financing of share repurchases. Higher interest rates in the second quarter of 2007 as compared to the second quarter of 2006 also contributed to the increase in interest expense.

-22-


 
Income Taxes and Effective Tax Rate
 
Our effective income tax rate was 2.0% for the second quarter of 2007 and benefited by 34.2 percentage points as a result of the higher effective tax rate associated with business realignment charges recorded during the quarter.
 
Net Income and Net Income Per Share
 
Net Income in the second quarter of 2007 was reduced by $78.1 million, or $0.34 per share-diluted, and was reduced by $1.8 million, or $0.01 per share-diluted, in the second quarter of 2006 as a result of net charges associated with our business realignment initiatives. After considering the impact of business realignment charges in each period, earnings per share-diluted in the second quarter of 2007 decreased $0.07 as compared to the second quarter of 2006.
 
Results of Operations – First Six Months 2007 vs. First Six Months 2006
 
Net Sales
 
The increase in net sales was attributable to sales volume increases from the introduction of new products, primarily in the U.S., and higher sales for our international businesses, primarily Canada, Mexico and exports to Asia.  Sales volume increases from new product introductions were substantially offset by lower sales of existing products in the U.S. The acquisition of the Godrej Hershey Foods and Beverages Company increased net sales by $7.4 million in the first six months of 2007.  These increases were substantially offset by decreased price realization from higher rates of promotional spending, including trial-driving consumer coupons, and higher returns, discounts and allowances for products at retail.
 
Key Marketplace Metrics
 
Consumer takeaway increased 0.4% during the first six months of 2007.  Consumer takeaway is provided for channels of distribution accounting for approximately 80% of our U.S. confectionery retail business. These channels of distribution include food, drug, mass merchandisers, including Wal-Mart Stores, Inc., and convenience stores.
 
Market Share in measured channels declined by 1.3 share points during the first six months of 2007. The change in market share is provided for measured channels which include sales in the food, drug, convenience store and mass merchandiser classes of trade, excluding sales of Wal-Mart Stores, Inc.
 
Cost of Sales and Gross Margin
 
Business realignment charges of $51.2 million were included in cost of sales in the first six months of 2007, compared with a credit of $3.2 million in the prior year.  The remainder of the cost of sales increase was primarily associated with significantly higher input costs, particularly for dairy products, offset partially by favorable supply chain productivity.
 
Approximately half of the gross margin decline was attributable to the impact of business realignment initiatives recorded in 2007 compared with 2006.  The rest of the decline reflected much higher costs for raw materials, somewhat offset by improved supply chain productivity. Also contributing to the decrease was lower net price realization due to higher promotional costs along with increased obsolescence costs.
 
Selling, Marketing and Administrative
 
Selling, marketing and administrative expenses decreased primarily as a result of lower administrative costs associated with incentive compensation. Higher advertising expense was substantially offset by lower consumer promotional expenses. Project implementation costs related to our 2007 business realignment initiatives of $6.3 million were included in selling, marketing and administrative expenses.

-23-


 
Business Realignment Initiatives
 
Business realignment charges of $107.3 million were recorded in the first six months of 2007 associated with our 2007 business realignment initiatives. The charges were primarily related to employee separation costs, fixed asset impairments and the closure of certain manufacturing facilities, along with the termination of certain contracts.
 
During the first six months of 2006, we recorded charges related to previous business realignment initiatives.  The $7.6 million charge for these business realignment initiatives related primarily to a U.S. VWRP, along with facility rationalization relating to the closure of the Las Piedras plant and streamlining our international operations.
 
Income Before Interest and Income Taxes and EBIT Margin
 
EBIT decreased in the first six months of 2007 compared with the first six months of 2006 principally as a result of higher net business realignment charges associated with our 2007 business realignment initiatives. Net pre-tax business realignment charges of $164.8 million were recorded in the first six months of 2007 compared with $4.4 million recorded in the first six months of 2006, an increase of $160.4 million. The decrease in EBIT was slightly offset by lower selling, marketing and administrative expenses.
 
EBIT margin decreased from 18.0% for the first six months of 2006 to 9.2% for the first six months of 2007.  The impact of net business realignment charges reduced EBIT margin by 7.3 percentage points.  The remainder of the decrease resulted from the lower gross margin offset partially by lower SM&A expense as a percentage of sales.
 
Interest Expense, Net
 
Net interest expense was higher in the first six months of 2007 than the comparable period of 2006 primarily reflecting the financing of share repurchases. Higher interest rates in the second quarter 2007 as compared to the first six months 2006 also contributed to the increase in interest expense.

Income Taxes and Effective Tax Rate
 
Our effective income tax rate was 33.3% for the first six months of 2007 and benefited by 2.1 percentage points as a result of the higher effective tax rate associated with business realignment charges recorded during the first six months.  We expect our effective income tax rate for the full year 2007 to be 36.0%, excluding the impact of tax benefits associated with business realignment charges during the year.
 
Net Income and Net Income Per Share
 
Net Income in the first six months 2007 was reduced by $103.4 million, or $0.44 per share-diluted, and was reduced by $3.0 million, or $0.01 per share-diluted, in the first six months of 2006 as a result of net charges associated with our business realignment initiatives. After considering the impact of business realignment charges in each period, earnings per share-diluted for the first six months of 2007 was lower by $0.06 per share-diluted as compared with the first six months of 2006.
 
Liquidity and Capital Resources
 
Historically, our major source of financing has been cash generated from operations. Domestic seasonal working capital needs, which typically peak during the summer months, generally have been met by issuing commercial paper. Commercial paper may also be issued from time to time to finance ongoing business transactions such as the refinancing of obligations associated with certain lease arrangements, the repayment of long-term debt and for other general corporate purposes. During the first six months of 2007, cash and cash equivalents decreased by $58.3 million.
 
Cash provided from operations, short-term borrowings, cash provided from stock options exercises and cash on hand at the beginning of the period was sufficient to fund the repayment of long-term debt of $188.8 million, the repurchase of Common Stock for $197.0 million, business acquisitions of $77.0 million, dividend payments of $120.8 million and capital additions and capitalized software expenditures of $83.2 million.
 
Cash used by changes in other assets and liabilities was $153.8 million for the first six months of 2007 compared with cash used of $92.3 million for the same period of 2006. The increase in the amount of cash used by

-24-


 
other assets and liabilities from 2006 to 2007 primarily reflected the effect of hedging transactions, the impact of the exercise of stock options, and increased payments for interest and employee benefits.
 
During the second quarter of 2007, we acquired a 51% controlling interest in Godrej Hershey Foods and Beverages Company in India for $58.7 million. During the second quarter of 2007, we also acquired a 44% equity interest under an agreement with Lotte Confectionery Co., LTD in China for $18.3 million.  Under each of the acquisition agreements, our Company and the other parties are currently obligated to make additional investments. We expect to invest a total of approximately $23.8 million later this year in these businesses.  The additional investments will not change our ownership interests.
 
A receivable of approximately $16.5 million was included in prepaid expenses and other current assets as of July 1, 2007 and $14.0 million as of December 31, 2006 related to the recovery of damages from a product recall and temporary plant closure in Canada.  The increase resulted from currency exchange rate fluctuations and additional costs.  The product recall during the fourth quarter of 2006 was caused by a contaminated ingredient purchased from an outside supplier with whom we have filed a claim for damages and are currently in litigation.
 
Interest paid was $62.5 million during the first six months of 2007 versus $ 51.7 million for the comparable period of 2006.  The increase in interest paid reflects additional borrowings and the higher interest rate environment.  Income taxes paid were $105.9 million during the first six months of 2007 versus $154.2 million for the comparable period of 2006.  The decrease in taxes paid in 2007 was primarily related to a lower federal extension payment for 2006 income taxes and the impact of lower annualized taxable income in 2007.
 
The ratio of current assets to current liabilities decreased slightly to 0.9:1.0 as of July 1, 2007 from 1.0:1.0 as of December 31, 2006. The capitalization ratio (total short-term and long-term debt as a percent of stockholders' equity, short-term and long-term debt) increased to 79% as of July 1, 2007 from 75% as of December 31, 2006.
 
Generally, our short-term borrowings are in the form of commercial paper or bank loans with an original maturity of three months or less. In December 2006, we entered into a five-year credit agreement establishing an unsecured revolving credit facility to borrow up to $1.1 billion with the option to increase borrowings by an additional $400 million with the consent of the lenders. We may use these funds for general corporate purposes, including commercial paper backstop and business acquisitions.
 
Outlook
 
The outlook section contains a number of forward-looking statements, all of which are based on current expectations.  Actual results may differ materially.  Refer to the Safe Harbor Statement below as well as Risk Factors and other information contained in our 2006 Annual Report on Form 10-K for information concerning the key risks to achieving future performance goals.
 
We have revised our operating performance expectations for the full year 2007 as a result of slower than expected improvement in U.S. retail sales trends and continued significant increases in dairy input costs.  Our latest expectations with regard to key operating performance measures are presented below.
 
We expect sales growth for the full year 2007 in the low single-digit range.  As we increase investment spending in consumer and customer programs, which include trade and consumer promotions, advertising and sales force staffing increases in the U.S., we expect sequential improvement in retail takeaway and market share.  Sales are also expected to increase as a result of the acquisition of the Godrej Hershey Foods and Beverages Company and the fall product launch in China.
 
We expect that our 2007 business realignment initiatives designed to execute a comprehensive, three-year supply chain transformation plan will result in total pre-tax charges and non-recurring project implementation costs of $525 million to $575 million.  Total charges include project management and start-up costs of approximately $50 million.  In 2007, we expect to record charges of approximately $270 million to $300 million, or $.75 to $.84 per share-diluted.  As a result of the program, we estimate that our gross margin should improve significantly, with on-going savings of approximately $170 million to $190 million generated by 2010.  A portion of the savings will be invested in our strategic growth initiatives, in such areas as core brand growth, new product innovation, selling and go-to-market capabilities and disciplined global expansion.  The amount and timing of this investment will be contingent upon market conditions and the pace of our innovation and global expansion.

-25-


 
Excluding the impact of business realignment charges, we now expect our gross margin to be down over 100 basis points for the full year 2007.  We expect significantly higher input costs in 2007 compared with 2006, particularly as a result of a significant increase in dairy input costs.  The dairy markets are not as developed as many of the other commodities markets and, therefore, it is not possible to hedge our costs by taking forward positions to extend coverage for longer periods of time. We expect a moderation in the gross margin decline in the second half of the year as a result of productivity improvements and more normalized product obsolescence costs compared with the prior year.
 
Excluding the impact of business realignment charges, we now expect EBIT margin to decline approximately 200 basis points for the full year 2007.  This decline will result from the decision to maintain our increased levels of brand investment, despite the increase in expected dairy costs.  In addition to the lower gross margin, increased investment spending for trade promotions, advertising and improved selling capabilities is expected to contribute to the decline in EBIT, EBIT margin and earnings per share-diluted in 2007.
 
Excluding the impact of business realignment charges, earnings per share-diluted is now expected to decline in the mid-single digits range for the full year 2007.
 
In this section, we have provided diluted earnings per share measures excluding certain items. These non-GAAP financial measures are used in evaluating results of operations for internal purposes. These non-GAAP measures are not intended to replace the presentation of financial results in accordance with GAAP. Rather, we believe exclusion of such items provides additional information to investors to facilitate the comparison of past and present operations.  Below is a reconciliation of GAAP and non-GAAP items to our earnings per share outlook:
 
 
2006
 
2007
 
Reported / Expected EPS-Diluted
$2.34
 
$1.41 - $1.50
 
Total Realignment Charges
$0.03
 
$0.75 - $0.84
 
EPS-Diluted from Operations*
$2.37
     
Expected EPS-Diluted from Operations*
   
$2.25
 
         
*From operations, excluding business realignment and one-time costs.
 
 
Subsequent Events
 
In July 2007, our Company and Barry Callebaut AG, the world’s largest manufacturer of high-quality cocoa, industrial chocolate and confectionery products, entered into a long-term global strategic supply and innovation agreement under which Barry Callebaut will supply Hershey with chocolate and chocolate products. The alliance will enable us to work together to accelerate long-term growth in the global chocolate market. Under the agreement, Barry Callebaut will construct and operate a facility to provide chocolate and chocolate products for our new plant in Monterrey, Mexico, and will also lease a portion of our Robinson, Illinois, plant and operate chocolate-making equipment at that facility.
 
Also in July 2007, our Company and Starbucks Coffee Company entered into a development and distribution agreement that will help transform the premium chocolate segment. The companies will create and market a new Starbucks-branded premium chocolate platform in the United States starting in the fall of 2007. In addition to innovative flavors, this platform will offer new forms and packaging and will be available in a broad range of retail channels such as food, drug and mass merchandise outlets across the United States.

 
Safe Harbor Statement
 
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,” among others.
 
-26-

 
Our results could differ materially because of the following factors, which include, but are not limited to:

·
Our ability to implement and generate expected ongoing annual savings from the initiatives to transform our supply chain and advance our value-enhancing strategy;
 
·
Changes in raw material and other costs and selling price increases;
 
·
Our ability to execute our supply chain transformation within the anticipated timeframe in accordance with our cost estimates;
 
·
The impact of future developments related to the product recall and temporary plant closure in Canada during the fourth quarter of 2006, including our ability to recover costs we incurred for the recall and plant closure from responsible third-parties;
 
·
Pension cost factors, such as actuarial assumptions, market performance and employee retirement decisions;
 
·
Changes in our stock price, and resulting impacts on our expenses for incentive compensation, stock options and certain employee benefits;
 
·
Market demand for our new and existing products;
 
·
Changes in our business environment, including actions of competitors and changes in consumer preferences;
 
·
Changes in governmental laws and regulations, including taxes;
 
·
Risks and uncertainties related to our international operations; and
 
·
Such other matters as discussed in our Annual Report on Form 10-K for 2006.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk
 
The potential net loss in fair value of foreign exchange forward contracts of ten percent resulting from a hypothetical near-term adverse change in market rates was $.2 million as of July 1, 2007 and December 31, 2006.  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 $3.7 million as of December 31, 2006, to $20.7 million as of July 1, 2007.  Market risk represents 10% of the estimated average fair value of net commodity positions at four dates prior to the end of each period.
 
Item 4.  Controls and Procedures
 
Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 (the "Exchange Act") is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to management, including the Company's Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
 
As of the end of the period covered by this quarterly report, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as required by Rule 13a-15 under the Exchange Act.  This evaluation was carried out under the supervision and with the participation of the Company's management, including our Chief Executive Officer and Chief Financial Officer.  Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective.  There has been no change during the most recent fiscal quarter in our internal control over financial reporting identified in connection with the evaluation that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

-27-


 
PART II - OTHER INFORMATION
 
Items 1, 1A, 3 and 5 have been omitted as not applicable.
 
Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds
 
Issuer Purchases of Equity Securities

Period
(a) Total Number
of Shares
 Purchased
 
(b) Average
Price Paid
per Share
 
(c) Total Number
of Shares
Purchased as
Part of Publicly
Announced Plans
or Programs
 
(d) Approximate
Dollar Value of
Shares that May
Yet Be Purchased
Under the Plans
 or Programs
 
             
(in thousands of dollars)
 
                 
April 2 through
April 29, 2007
— 
 
$       — 
 
— 
 
$150,000
 
                 
April 30 through
May 27, 2007
— 
 
$        — 
 
— 
 
$150,000
 
                 
May 28 through
July 1, 2007
   839,019 
 
$    52.65 
 
           — 
 
$150,000