Sunday, December 16, 2012

Colgate Palmolive is Relying on Emerging Market Growth

Colgate-Palmolive (NYSE: CL) did as it does and delivered a solid quarter of 5% organic growth while outlining some market share gains in key markets. This is about as good as it is going to get in the mass market these days, as the US market remains weak and emerging markets are showing signs of a slowdown. That said, Colgate is doing the right thing in launching a four year growth and efficiency program. Its new product launches have helped to drive growth and now is not the time to take the foot off the pedal. The real question, as ever, is whether the evaluation is right for the future prospects.

New Problems, New Programs

I thought there was some peculiar discussion on the conference call, with analysts trying to get at the kind of recurring time-frames for when Colgate takes charges for restructuring programs. The subject came to my mind as I sometimes write these arguments from a cafĂ© wherever I am in the world. In this case, it’s Eastern Europe, and the last few nights I have not been regaled with the melodious (higher culture) music of Liszt or Bartok, but rather a group of guys discussing discounted cash flow (DCF) analysis on some sort of financial modeling course. All of which is fine and dandy (sort of), and it’s exactly the kind of approach that analysts will take with Colgate. In other words, factor X amount of sales for a restructuring charge every Y amount of years and then nicely insert it into a DCF without actually understanding why.

However, the ‘why’ is the important bit. It is because of a bifurcation of prospects with the mass markets in the western world and large parts of emerging markets. Simply put, the US lost over 8 million jobs (payroll data) in the last recession and hasn’t even recovered 50% of them yet. Everyone knows what is happening in parts of Europe. Meanwhile, polities in places like China are doing everything they can to generate and keep employment for the masses.

The new reality has brought winners and losers. Procter & Gamble (NYSE: PG) has been doing okay recently, but it has notably underperformed companies like Church & Dwight (NYSE: CHD) on a five year view.

PG data by YCharts

The difference is that PG’s traditional strategy in a slowdown is seen as being to hold pricing at the expense of market share and then be leveraged to the upside of an economic recovery. Times have changed, and this recovery is a lot longer and shallower than usual. Not good news for PG.

As a consequence, consumer behavior is changing and adjusting to discounting as retail channels are shifting in the mass market. As such, a company with powerful value brands like Church & Dwight can be nimble enough to gain market share.

Can Colgate Generate Double Digit Growth?

Indeed, Church & Dwight is the only company in the sector that has consistently generated good growth, but Colgate-Palmolive has not been far behind. Colgate’s story is one of impressive new product launches (Colgate optic white etc) and expansion in new categories like mouthwash in the US. The restructuring plan is intended to deal with the new realities, and management affirmed its intent to generate 6-7% organic revenue with a 10-11% increase in reported EPS. Can it achieve this?

On the negative side, investors will look at the slowing economy and increasing competitive pressures in emerging markets (as everyone chases growth there) then point at the 5% organic growth in the last quarter and conclude that this is a big ‘ask.’ Moreover, the strong growth in recent years has been a result of new product & category launches that will be hard to repeat. Indeed, growth slowed in Q3 as Colgate came up against tough comparisons. According to management, it is aiming for near 1% growth in Europe, 1-2% in North America and 8-9% in emerging markets. Much depends on the latter, and given that it has huge market share in places like Brazil and Mexico, it is hard to be completely confident that it will hit these growth targets.

The positive case with Colgate is that the restructuring is timely, and focusing on efficiency gains with things like centralizing costs in Europe makes sense. In addition, a renewed focus on where to invest over the next five to ten years is also an implicit recognition that sticking to the old reality won’t work.  I’ve been skeptical on the issue of China’s mass market continuing to generate growth despite GDP growth slowing, but if you look at Yum! Brands' (NYSE: YUM) latest results, it is actually doing quite well. Growth is slowing but nowhere near as dramatically as in other parts of the economy, and generating this kind of high single digit growth looks achievable in China.

The Bottom Line

Frankly, I think the stock looks a little overvalued right now for the risks going forward. It has had a magnificent run and it remains fund managers’ favorite.  For sector weighting reasons, professional investors will pick out a ‘go to’ stock, and Colgate seems to fit the bill. The end result is that it trades on 20x earnings and an EV/EBITDA ratio of 12.2. This is hardly cheap for a company that depends a lot on macro conditions in the Far East and has been winning thanks to previous product innovation. There is no guarantee that these two factors will remain favorable for Colgate.

It is a high quality company, but I think cautious investors would do better by waiting for a significant dip before buying in here. Private investors do not have to be invested in sectors if they dont want to be. No need to chase this stock higher in my view.

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