Monday, September 17, 2012

Church & Dwight Research Analysis

So it turns out that Church & Dwight $CHD are human after all. After quarter after quarter of beating estimates and causing analysts to raise forecasts, the company disappointed. Q2 EPS was slightly ahead of market estimates but revenues were a bit light. In addition, the EPS guidance for Q3 was lower than market estimates at 58c vs. 61c. So is it time to give up on Church & Dwight?

Product Mix in Personal Care

In a sense it was merely more of the same. In the last quarter, management noted that the product mix of revenues in the personal care division was being skewed toward lower-margin goods. This trend continued in this quarter and was the main cause of the disappointment. However, management pointed out that July had begun well for the personal care division and that consumption had outpaced shipments in the last quarter. This is usually an indication of stronger growth to come. In addition, full-year EPS guidance was maintained.

The main problem seems to be Orajel oral care products, which are traditionally higher margin. Action has been taken and management sounds confident of a resolution to the underlying issues. New products are being launched and I would expect Orajel to make a comeback.

Competitive Markets Remain Competitive

Once you have taken in the full impact of the pearl of wisdom in the subheading, it will then be time to look into more detail as to what happened in this quarter.

Frankly, this sort of thing is inevitable in the fast moving consumer goods (FMCG) category. Competition is fierce and the macro environment is not particularly strong for the mass market. Church & Dwight is a relatively small player in the marketplace that outperforms via a relentless focus on growing and defending its brands within niche markets of FMCG. It offers a significant amount of its revenue in ‘value brands,’ which benefit from consumers trading down.

I always like to compare it with its much larger rival, Procter & Gamble $PG. PG owns some classic brands and its long-term strategy is different. It is usually understood to favor retaining pricing during a downturn -- at the expense of some volume loss -- in order to benefit from not devaluing its brands, so when the recovery takes place it will see earnings leverage. It’s a beautiful idea in theory and it usually works in practice, but this time it really is different.

This recovery is a lot slower and more shallow than normal. As such, consumer behavior is changing. US consumers are trading down and they are shopping more at discount stores. Companies that try to take pricing are suffering volume losses. Even an extremely well run and innovative company like Colgate-Palmolive $CL saw volumes decline in North America when it took pricing on certain product lines.

The result is a highly competitive market where promotions and discounting are tactically used in order to generate market share gains and favorable sales mixes. The old strategic ways aren’t working anymore for a company like PG and so it is reacting and stepping up pressure with categories such as laundry detergent.  Church & Dwight felt the pressure in this category in the last quarter and I note that Clorox $CLX also declined on these results in an otherwise strong day for the market. Clorox has had administrative issues to deal with in the past and now looks set to face stronger competition from PG.

Great Companies or Great Investments?

You should always look for both and for the last few years the household and personal care sector has offered both, but investors are entitled to ask how much longer the market will give high teens to low 20s PE multiples for companies growing earnings in single digits.

Church & Dwight has usually commanded a premium over Clorox, PG et al because its cash flow conversion is very strong and its management has a track record of doing what it takes to get growth. The new products in personal care due to be released in the second half, as well as the commentary on current trading, suggests it can do it again.

It’s hard to argue that Church is not fairly valued right now, which means that it is likely to "do its earnings" going forward. No matter, the recent pull back could create a decent buying opportunity because companies with this kind of track record should not be taken lightly and the economy continues to move in Church & Dwight’s favor. Well worth watching closely particularly as the ultimate value creator could be that the company ends up being taken over by one of its much larger competitors.

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