Thursday, August 2, 2012

A Recession Proof Stock

It has been a difficult earnings season for consumer staples. This type of stock has been bid up with investors attaching a premium onto certainty of end demand, whilst hoping to enjoy dividend yields surpassing US treasury yields. Unfortunately, one after the other has reported margin compression due to increased input costs and consumers exhibiting price elasticity as a consequence. For example, Kellogg appears to be structurally challenged in its core cereal business,while Procter & Gamble $PG cut its guidance due to weakness in developed markets. Clorox $CLX did ok, but there is precious little growth in the business. Furthermore, Johnson & Johnson $JNJ reported weak consumer products numbers.

Most of them are talking up the headwinds caused by higher commodity prices, but of course, many of these costs have come down this year, so arguably, they can turn into tailwinds going forward. Of course, rising commodity costs are only part of the picture. The truth is that we are seeing a long slow recovery where many consumers in the developed world are realigning their purchasing habits.
Furthermore, as every good behavioral psychologist would say, it is a lot harder to sell a surcharge then it is to sell a discount. In other words, once consumers get used to paying lower prices for an ‘equivalent’ brand, then it is very tough to get them to trade back up again.

Procter & Gamble’s Woes

Procter & Gamble knows all about such considerations, which is possibly why the company likes to defend margins and pricing during the bad times in order to profit when the recovery comes. The company doesn't want consumers getting used to lower prices.

Indeed, PG tried to raise prices this year in line with the recovery, but this time, many of them didn’t stick. The recent response has been to lower them in selected lines or else raise the size of the product. Interestingly, this is in marked contrast to the performance at two other companies.

The first is The Hershey Company $HSY who managed to increase prices and make them stick. The simple conclusion to draw would be to point out that Hershey’s products are probably viewed as an ‘affordable’ luxury whilst Kellogg’s cereal or PG’s soap powder is not. I’m sympathetic to such arguments and, if you share my opinion that we are headed for a long slow recovery, then this pricing behavior could continue.

The second company is Church & Dwight $CHD of which I have a more comprehensive write up linked here. However, I want to focus on the company’s recent results in the context of the commentary of this article.

Church & Dwight Delivers Again

What characterizes this business is that 40% of its revenues are in so-called value brands. In other words, customers will trade down into them in a slowdown. But what is so impressive here, is that the company seems to be able to get customers to stick. Indeed in the latest results, it beat on revenues significantly and, to a lesser extent, on earnings too.

Naturally, this implies some margin reduction and so this was the case. Church & Dwight saw relatively much stronger sales of (lower margin) household products as opposed to personal care products which usually come with higher margins. The news that PG is intending to cut prices across selected brands will not be welcome, but Church & Dwight have a management team well used to punching above its weight and reacting to the competition.

One consequence of the product mix is that the Q2 guidance was a bit lighter than the market had expected, but management confirmed full year guidance. They also stated that cost savings programs will gradually exceed commodity price increases as the year goes on. Since the company has many of its costs hedged for the second half; this statement can be viewed with a certain level of confidence.
Moreover five of its eight ‘power brands’ managed to increase market share in the quarter, and management plans to invest in marketing support (at approximately 13% of net sales) in order to focus on maximizing its ‘power brands’ potential.

What Next for Church & Dwight?

Frankly, this was an impressive set of results and the excellent cash flow generation cements Church & Dwight’s place in the lexicon of value based consumer staple plays. In fairness, the stock price is up with events and I would be surprised if there were more than single digit returns to be had in the next six months. However, value is value and, if commodity prices fall, than the company could see margin expansion in the future. Furthermore, I look at the market cap of $7.34bn in addition to its ‘power brands’ and consider that this company is a possible acquisition target.

Considering the lumbering growth profiles of some of the majors in the sector like PG, Unilever or Reckitt Benckiser and, the fact that cost cutting synergies are all important in such an environment, it is not hard to think that some of them might consider an acquisition. Eliminating pricing and marketing competition carries obvious benefits to margins, and Church & Dwight is probably not large enough to warrant wholesale regulatory concerns across all its brands. Moreover, as this tough pricing environment continues we may see more companies realizing that value brands and a strong focus on selected brands is the best way forward.

Just hanging on and hoping that the macro outlook will improve, is not an option anymore. Consumer behavior is changing and Church & Dwight is flexible enough in its product offering to change with it. That can’t be said for all the companies in the sector. Thus, Church and Dwight really does out from the rest.

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