Wednesday, May 23, 2012

A Recession Proof Small Cap

Church & Dwight $CHD  a great stock for a balanced portfolio because it is recession resistant. It trades on a good evaluation and offers the prospect of some upside from a fall in commodity input costs.

Furthermore, the company is a small player in a market dominated by large acquisitive companies like Colgate  $CL Procter & Gamble $PG and, London listed Reckitt Benckiser. In fact, Reckitt took over another British company SSL whose Durex condom brand competes with Church and Dwight’s Trojan.

Church and Dwight competes successfully with the likes of Procter & Gamble because it aggressively defends its niche markets from competition. As such, it is able to defend its positions and generate growth in a way that Procter & Gamble's management has failed to do. Furthermore, Church & Dwight offers value brands which already compete on price. A company like Procter & Gamble tends to be reticent to cut prices because consumers tends to want them to stick.

A classic example of this, would be with  the company's Arm & Hammer toothpaste with Colgate's. Arm & Hammer is the value brand and moreover, Church & Dwight's management are nimble enough to leverage the brand by releasing products such as electrical toothbrushes.

The company is little discussed but has an excellent track record of generating earnings through the cycle. I think they can generate at least double digit returns for a stock investor from here and, are a genuine takeover target.

 Church & Dwight Brands

The company’s brands can be categorized as a diversified collection of personal and homecare goods. Much of it’s brands are value propositions which offer upside in a stagnant economy, as consumers trade down to cheaper options. In terms of profits and sales, 80% of them come from the eight leading ‘power’ brands…
  • Arm & Hammer (toothpaste, baking soda, detergent, cat litter)
  • Trojan Condoms and Vibrators
  • OxiClean Laundry Additive
  • Spinbrush Battery Powered Toothbrush
  • First Response Pregnancy Kit
  • Nair Hair Removal
  • Orajel Pain Relief
  • Xtra Extreme Value Laundry Detergent
The list reads like a roll call of US value brands commonly found in the home. However, Church & Dwight is far smaller than its major competitors and, its business model is tailored towards grabbing leadership in niche markets.  This means that it can protect its market share without resorting to margin erosion via price cuts.

What makes this company really special is the quality of its execution.

Church & Dwight Earnings

The management has demonstrated a tremendous ability to grow earnings and revenues over the years, even in the face of rising commodity costs and, the great recession.  This can easily be summarized below

Gross Profit7618779721,1011,1571,215
Adjusted EPS ($)
EPS Growth (%) 18.316.321.613.812

At the final results in February, management guided towards 3-4% revenue growth in 2012 with EPS growth of 14-15% .

All of which paints a picture of a recession proof company. However, 2011 has proved challenging. End demand was lower than initially expected and, rising commodity costs put pressure on margin expansion. No matter, the outlook for 2012 presents upside potential as the US economy generates employment gains and, commodity costs may abate with slowing emerging market growth.

It is also worth noting that gross margins jumped in 2009 with the fall in commodity prices and, Church & Dwight has managed to hold onto them despite rising costs. Similarly, with such a well run business, working capital management is excellent and, the company always generates large amounts of free cash flow.

Church & Dwight Target Price

The stock currently trades at a price of $49.59 with a market cap of $7.09bn. There is $251m in cash on the balance sheet with $249m in outstanding debt. Free cash flow has grown from $200m to $365m from 2007-2011 with a compound annual growth rate of 16%.

Obviously, on a current PE ratio of 22.4, it looks expensive but investors should focus on free cash flow. Church and Dwight trades on a current free cash flow yield of 5.1% and, that is attractive for a recession resistant company which is growing earnings in the teens. In addition, management states that they expect to generate $1.1bn in free cash flow over the next three years. This represents over 15% of the current market cap. Having increased the dividend by 41% at the last earnings, I think we should take them seriously!

 For a relatively secure double digit growth over the next couple of years, this stock could trade on an evaluation closer to $55. There is upside potential from reducing commodity costs and, a potential value outer from an acquisition bid for the company.  A $55 target represents 11% upside with plenty of room to grow, should a slowing Chinese economy reduce commodity input costs. Similarly, a strong return to US consumer spending will see upside to revenue growth at all the leading consumer goods companies.

Church & Dwight is a nice recession resistant stock which is good for balancing any portfolio.  

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