Clorox's CLX
fiscal first-quarter results, which included modest sales growth and
margin improvement, supported our thinking that spending to invest
behind its brands (both in terms of advertising and product
innovation--about 11% of consolidated sales) as well as investments to
improve its cost structure are appropriate for the long-term health of
the business. However, we are maintaining our cautiously optimistic
outlook, given that Clorox competes in categories with high levels of
private-label penetration and derives the bulk of its revenue from
mature, developed markets. While we aren't forecasting robust growth
from this household- and personal-care firm anytime soon, we still think
Clorox will generate outsize returns and excess cash for shareholders
over the longer term (with the strong brand equity inherent in its
portfolio that results in leading share in several of the categories in
which it competes). Management confirmed its full-year fiscal 2013
guidance for 2%-4% sales growth, 25-50 basis points of EBIT margin
improvement, and earnings of $4.20-$4.35 per share (which slightly
exceeds our $4.36 forecast). While we intend to update our discounted
cash flow model for Clorox’s recent results, we don’t anticipate a
material change to our $68 fair value estimate, which remains in place.
Despite this, we view shares as slightly overvalued at 17 times the
midpoint of the company's earnings per share guidance (compared with an
average of 15 times for Morningstar's household- and personal-care
coverage universe).
First-quarter sales, adjusting for foreign
currency movements and acquisitions, ticked up 1.8% year over year, as
lower volume (down 1%) was offset by higher prices (up nearly 3%).
Volume weakness in the household business (due to lower shipments of
charcoal products and cat litter, two categories where the firm recently
raised prices) was offset by continued momentum in the cleaning
segment, which included the highest level of volume growth for bleach in
more than two years. Because the consumer spending environment has yet
to meaningfully pick up steam, we intend to continue monitoring the
impact that Clorox's higher prices have on the firm's volume over the
coming quarters. If volume remains depressed, we wouldn't be surprised
to see the firm roll back prices in a few of the categories where
commodity cost pressures have retreated. Clorox's cost-saving
initiatives combined with the higher prices it's charging at the shelf
offset modest raw material inflation, increased supply chain costs, and
unfavorable product mix, as gross margins expanded 90 basis points to
42.9% (excluding restructuring charges in the year-ago period). However,
consolidated operating margins increased just 20 basis points, as
Clorox ramped up its spending behind brand marketing support--in line
with our thinking--to ensure that its products stand out in this
intensely competitive operating environment.
Thesis by Morningstar Equity Analysts, 06/05/12
With
14% of total sales derived from bleach, 13% from trash bags, and
another 11% from charcoal, Clorox is a consumer-packaged firm in a tough
spot. Leading brands, including its namesake bleach, Glad, and
Kingsford, haven't entirely insulated the firm as its categories have
continued down the road of commodification over the years. Input cost
inflation has compressed margins along the way, and while we still
accord Clorox a narrow economic moat for its brand equities and
economies of scale, the company's returns on invested capital have
eroded.
For most household product firms, the name of the game is
differentiated products in growing categories or growing markets. Clorox
is doing a decent job considering the cards it has to play, but
activist investor Carl Icahn trained his sights on the firm last year
because he viewed the stock as underperforming. Icahn's attempt to flush
out a buyer for the firm fell flat, as we expected it would. While it
would be possible to unlock value in Clorox by breaking up the firm and
selling off its brands, we don't believe there is a sound strategic
argument to buying the firm outright or merging it with another company.
Private-label penetration is high in many of the company's categories,
sales are derived predominantly in developed markets, and 44% of total
revenues are concentrated with only five domestic retailers. All these
factors made the firm relatively susceptible to economic shocks during
the last several years, and arguably a less attractive partner.
While the board wasn't interested in Icahn's offer, and no other
buyers came forward, it should be noted that for all of its challenges,
Clorox is a fairly well-run firm. Management has shed noncore assets,
including its Armor All brand, and has made acquisitions to diversify
its product base. During the last several years, Clorox acquired Burt's
Bees, and in keeping with its strategic aim of building an
infection-control business, which we view as complementary to its core
foothold in bleach, the company completed tuck-in acquisitions of
Caltech, Aplicare, and Healthlink. The timing for Burt's Bees was poor;
at 2008 prices, management had to write down $258 million in goodwill
last year when the optimistic projections underpinning the purchase
price failed to materialize. However, we don't disagree with the aim of
product diversification or the focus on the natural or organic niche.
The issue is more about growth, and as Clorox has come to realize with
its Green Works brand, consumers are willing pay for natural or organic
products, but not necessarily the premium that was once expected.
Instead, natural and organic products are becoming more mainstream, in
which case Clorox should be fairly well-positioned given its scale and
distribution network.
In the meantime, Clorox is doing a respectable job managing input
cost inflation, which drove down gross margins by 160 basis points in
2011, and controlling costs, which boosted margins by 170 basis points
during the same period. The firm is adept at navigating price increases
to balance the inevitable volume declines, and has worked hard to expand
into adjacent product categories to reduce its dependence on product
lines, like trash bags and food containers, where consumers are likely
more inclined to shop on price. This type of expansion can still smartly
leverage a strong brand equity like Clorox or Glad, while also
providing higher margins. Clorox's hard work hasn't been paying off as
it had in the past, but the company is holding steady with its market
shares. Pricing the firm has pushed through also appears to be sticking,
which speaks to management's skills at gauging appropriate price points
and the firm's strong brands. With commodity costs likely to ease in
coming quarters Clorox should be able to regain some lost margin. If
management invests back in the business on higher ROIC projects, which
we fully expect it to do, the firm's narrow moat should remain intact.
We
are maintaining our fair value estimate of Clorox shares at $68, which
implies a forward fiscal-year adjusted price/earnings of 16.8 times,
enterprise value/EBITDA of 10.1 times, and a free cash flow yield of
5.3%. We expect soft consumer spending in developed markets to continue
weighing on top-line results, so we forecast annual revenue growth of
3%-4% during the next five years (excluding the impact of acquisitions).
Input cost inflation has been difficult to overcome, but we expect to
see some modest margin expansion during our forecast period.
Clorox does a solid job of managing overhead expenses, and as it
slowly reduces its dependence on sales of trash bags and charcoal,
margins should show steady improvement. We forecast operating margins in
excess of 19% by fiscal 2014, up about 150 basis points to the fiscal
2011 adjusted operating margin. Management expects to build margins 25
to 50 basis points a year so we see this estimate as fairly reasonable.
Through 2016, we expect return on invested capital to average 22%, well
in excess of our 9.0% cost of capital estimate, supporting our opinion
that Clorox maintains a narrow economic moat. Even with a choppy revenue
line and margin line, we place a low degree of uncertainty around our
fair value estimate for the shares as we think projections of the
company's cash flows fall within a fairly narrow range.
Clorox
is influenced by the commodity-driven nature of its business. Volatile
input costs, as well as the commodification of several of its categories
(such as bleach and trash bags), can have a significant impact on
profitability. The company also faces stiff competition from branded and
private-label manufacturers in many of its product lines. In addition,
with 44% of its sales resulting from its top five customers (26% from
Wal-Mart alone), Clorox maintains significant exposure to consolidation
among retailers.
Management & Stewardship
From
our perspective, Clorox is a well-run organization, with returns on
invested capital (including goodwill) that have been more than
double our cost of capital estimate in each of the last 10 years. Donald
Knauss, 60, assumed the CEO and chairman positions at Clorox in October
2006. Since taking over at the firm he has overseen the company's
acquisition of Burt's Bees and push into consumer and professional
health and wellness categories. Knauss coolly kept Carl Icahn at bay as
the investor attempted to sell Clorox off to a bidder that never
materialized. While overtures failed, with Knauss looking as steady and
sure as ever, the effort drew attention to the firm's lagging stock
price. Improved fundamentals, solid cash flows and healthy dividends and
buybacks all point to management running Clorox for the long term and
not the quarter, but the solid results are failing to boost the shares.
At some point shareholders may lose patience. In the meantime we accord a
standard stewardship grade to Clorox.
It's worth noting that in fiscal 2011, in the midst of Icahn's run at
the company, Clorox made numerous positive changes to its compensation
program, including reducing the change in control severance payments and
eliminating tax gross-ups for "golden parachute" tax liabilities.
Compensation at Clorox is reasonable and, despite some fairly
long-tenured board members, corporate governance at the firm is sound.
Overview
We
are not concerned by Clorox's nearly $2.6 billion of debt on its
balance sheet, given the substantial cash flows it generates. During the
next five years, we forecast debt/capital to fade to below 0.75 (from
1.03 in fiscal 2011) and operating income to cover interest expense
between 7 and 8 times. We assign Clorox an issuer credit rating of A-.
Profile:
For
nearly 100 years, Clorox has operated in the household product
industry, expanding its portfolio to include such leading brands as
Clorox, Glad, Hidden Valley, and Kingsford. The firm distributes its
products through mass merchants, grocery stores, and other retail
outlets. With its acquisition of Burt's Bees in 2007, Clorox gained
entry into the fast-growing natural personal-care category.
International sales amount to 20% of the firm's consolidated total.
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