Church & Dwight Still Has Upside Potential

f you have any doubt about how difficult the US mass consumer market is right now, you need only look at the third quarter results from Church & Dwight (NYSE: CHD  ) . Its organic sales growth was only up 1.6% amid increasing pricing competition. However, its management team continues to deliver in challenging times. The full-year earnings per share target of $2.79 was reaffirmed. Can it continue to outperform despite a difficult environment?

Church & Dwight's management delivers mixed results
The bad news in Church & Dwight's latest results was the reduction in its full-year organic sales growth estimate to 1.5%-2%. Church & Dwight started the year by forecasting 3%-4% sales growth, and just last quarter the forecast was at 2%. Furthermore, six of the 14 categories that the company sells into experienced lower category sales in the quarter.  In addition, rival household goods company Clorox (NYSE: CLX  ) only delivered 2% sales growth in its first quarter and predicted 2%-3% sales growth for its full year.

Meanwhile, industry end markets remain tough. Church & Dwight may already be feeling the early effects of Procter & Gamble's (NYSE: PG  ) decision to launch a cheaper version of its market leading Tide laundry detergent in 2014.

Indeed, when questioned about the reduction of organic sales growth on the conference call, management cited laundry detergent as being "the key call."  Procter and Gamble's move is intended to take aim at Church & Dwight's value-based Arm & Hammer and XTRA laundry detergents. Consequently, it's understandable if Church & Dwight took pre-emptive measures to strengthen market share before Procter & Gamble launches in 2014.

And now the good news
First, Church & Dwight's Avid (gummy vitamins) acquisition continues to outperform expectations with 20%-plus growth generated in the quarter. Management forecasts "double-digit growth for the foreseeable future." 

Second, Church & Dwight's specialty products saw a return to form with an organic sales increase of 3.7%. Going back to the previous quarter, there had been some weakness attributed to cold weather reducing demand for electrolyte replacement products for cows. However, with a more normal weather pattern in the third quarter this product's sales rebounded.

Third, thanks to ongoing productivity improvement,s Church & Dwight's gross margin continues to grow. In fact, the company's gross margin is now forecast to grow by around 75 basis points for the full year. This is an increase on last quarter's forecast of a 50 to 75 basis point improvement, which in turn was an improvement on the 25 to 50 basis point increase forecast two quarters back. Essentially, Church & Dwight has been progressively generating better margins as the year has gone by. An impressive performance when you consider that the company has been increasing its discounting in response to pricing competition.

What will 2014 look like?
A pessimist will look at the company and argue that the contributions from Avid's gummy vitamins mask weakness in organic sales growth. Moreover, increasing competition from Procter & Gamble in the value end of laundry detergents will pressure Church & Dwight further in 2014. Furthermore, when Clorox came out and announced that its first-half sales will be at the "lower end of our full year range due to competitive activity,"  the conclusion he would draw is that Church & Dwight faces significant headwinds going forward.

On a brighter note, there are plenty of reasons for optimism. The company is promising its "biggest amount of new product launches we've ever had," and the idea is that 2014 will turn into a year where the industry focuses on product innovation rather than pricing competition.

Much of this will depend on overall US GDP growth in 2014 because it's fair to say that US growth was expected to be higher than it turned out in 2013. The upshot of this is that many household products companies were forced into discounting in order to retain market share in 2013. With growth expectations somewhat more muted going into 2014, there may well be some easing of pricing pressures if growth turns out better than expected during the year.

Furthermore, the increased competition from a value version of Tide may spur more interest in the value category and paradoxically lead to increased sales for Church & Dwight's value brands.

Where next for Church & Dwight?
All told, your decision to purchase or hold the stock will partly depend on your level of confidence in Church & Dwight's management continuing to execute well in 2014. Fortunately, history would be on your side should you decide to do this. The company's management has an excellent record of generating market share growth with its leading brands. Moreover, the stock is attractive on a relative value basis.

CHD EV to EBITDA (TTM) data by YCharts

Analysts only expect Church & Dwight's rivals to achieve single-digit earnings growth, while it has analysts penciling in double-digit EPS growth for 2014. Overall, the stock looks slightly undervalued.

Church & Dwight Demonstrates That Managements Matter

Investors in household-goods company Church & Dwight (NYSE: CHD  ) have watched the stock almost double over the last five years. It's tempting for them to think that the outperformance of the stock is solely due to the nature of the company's products. Indeed, 40% of its sales come from the kind of value brands that the consumer has been trading down toward. However, events over the last year have demonstrated that the company's excellent management team is an even larger part of its success.

When the going gets tough...

The recent second-quarter results saw the company delivering good numbers in spite of an ongoing tough consumer market. Indeed, there are three reasons to suggest that conditions are going to remain difficult.

 

Firstly, full-year organic sales growth is now forecast to be just 2% from an earlier estimate of 3%-4%. One-third of the shortfall is due to weaker-than-expected sales within specialty products. The remaining two-thirds is due to plans to increase discounting in the face of price competition. When pressed on the categories facing pricing pressures, the management replied that cat litter and laundry were the main culprits.

Secondly, plans are being made to increase marketing spending in the third quarter in order to support some of its key brands. Again, this is a sign of a more difficult marketplace. Indeed, management outlined that in the conference call:

"In fact, of the 14 categories that Church & Dwight operates in, five incurred lower category dollar sales in the second quarter versus the prior year and five more had category growth of less than 2% versus the prior year."

Thirdly, key rival Procter & Gamble (NYSE: PG  )  recently discussed plans to release a cheaper version of its Tide laundry detergent in 2014. Although the launch is set for next year, Church & Dwight is likely to act in advance to try to protect market share for its XTRA brand. In addition, Germany's Henkel will also be pressured into protecting its Purex detergent brand.

 

....the tough get going

The good news is that its management team has long been acquainted with dealing with difficult conditions, and its excellent execution is a key reason why the company continues to do well. There are three near-term pathways to growth, and all of them are thanks to management's actions.

 

Firstly, full-year gross margins are now expected to increase by 50 basis points to 75 basis points instead of the 25-to-50 basis-point increase previously forecast. The key to this upgrade was better-than-expected cost savings with the integration of its gummy-vitamin manufacturer Avid.

Secondly, sales growth at Avid is "tracking ahead of expectations," and is expected to be a significant contributor to sales growth in the second half. Thirdly, on the conference call, Church & Dwight argued that it had a "great pipeline" of new products to be released next year.

 

What about its peer group?

Essentially, the mass-consumer market remains difficult, but Church & Dwight has already demonstrated that it can outperform the market and its peer group in such an environment.  

 

Procter & Gamble data by YCharts

 

Moreover, the company has a good opportunity to continue its outperformance. Its relatively small size gives it a significant amount of flexibility in responding to changing market conditions. Furthermore, unlike much larger peers Procter & Gamble or Kimberly-Clark (NYSE: KMB  ) , it does not rely on premium brands for its profitability.

 

In previous economic cycles, such companies would have preferred to retain pricing during the downturn in order to benefit when the recovery came. However, this recovery has been so tepid (particularly for the mass market) that many large consumer goods companies are forced into discounting to retain market share.

 

A good example of this is with Procter & Gamble with the previously mentioned plans to release a cheaper version of Tide (rather than just cutting Tide prices), but also with its plans to downsize its Pampers diapers. Similarly, its key rival Kimberly-Clark is also used downsizing with its Kleenex brand. While such measures are innovative ways to try to keep pricing for premium brands, they are also emblematic of a weak consumer market.

Church & Dwight set to carry on outperforming

This sort of macro environment favors Church & Dwight's mix of value and power brands. In addition, its management has demonstrated that it can make earnings-enhancing acquisitions, and generate productivity improvements, even in a weak economy. Furthermore, at some point, a much larger rival may look to buy the company in order to generate some much-needed growth.

 

On a less positive note, Procter & Gamble appears to be stepping up the competitive pressure, and Church & Dwight's valuation of over 23 times current earnings suggests the stock is close to fair value. Consequently, long-term investors can look for the stock to 'do its earnings growth' in future years. Given that this implies double-digit returns, the stock remains attractive, particularly if its management can continue to wring every bit of growth it can from unhelpful market conditions

Walgreen Disappoints But is it a Buying Opportunity?

Investors in Walgreen (NYSE: WAG) have had a pretty good time of it over the last year with a near 50% gain as I write however, the recent results were somewhat disappointing. The market did what it does with an earnings miss and promptly marked the stock down. By now most interested parties will be aware of the situation so I decided to take a more in-depth look at what happened.

In summary, I think that this report contained some of the themes that have been repeatedly seen in the mass consumer market in recent years and this gives cause for optimism.

A tough mass consumer market?

Frankly the last few years have been difficult for the mass consumer market. It has been dogged with the levels of unemployment and sluggish spending that it wasn’t structured to deal with. As a consequence many of the old strategies aren’t working.  For example the challenges facing a company like Procter & Gamble (NYSE: PG) have been emblematic. It is known to have classic brands with which it can try and hold pricing (at the expense of volumes) during the downturn and then benefit from profit expansion when the upturn comes and volumes come back.

Unfortunately that upturn hasn’t happened yet –at least in the mass market- and the whole sector has been locked in a circular game of raising marketing and promotional activity, seeing volumes rise, then trying to take pricing, only to then see volumes and footfall decline as customers walk away to competitors. Then the cycle is repeated again with the company hoping that ‘next time round’ it’ll get lucky.

It turns out that the way to play this type of market has been to buy companies with good brands who are under-performing but about to make these changes. Procter & Gamble has been a good example of this. It has had to fight hard to stabilize its core North American market, but its emerging market performance hasn't been great recently. No matter, the market has rewarded it for sorting out its pricing strategy.

Procter & Gamble's 25% stock price rise over the last year is a testimony to what can be achieved when companies start to leverage the underlying strength of their brands. For example it recently stated that two thirds of its business in the U.S. (defined by sales) had held or increased sales in the last quarter. This compares very favorably with a figure of only 15% for the June quarter last year.

And Walgreen another?

All of which leads me into Walgreen’s Q3 report. Earnings missed estimates and the disappointment is centered on comparable same store sales only being up .4% and comparable store traffic down 3.9%. It appears to be a familiar story of Walgreen cutting back on promotions and discounts only to see customers walk away to competitors like CVS Caremark (NYSE: CVS) or even a big box retailer like Costco Wholesale (NASDAQ: COST).

With regards to Costco its performance in the last quarter, as discussed here, stands in contrast to much of the sector. Costco’s traffic remained stable, but its frequency  was up 4-5%. In other words its customers are making more trips, on average, to the store in the quarter.  This is a good indication that it is doing a good job engendering customer loyalty and understanding the purchasing needs of its members. This is easier said than done, especially in a quarter categorized by issues such as unseasonable weather, delayed tax refunds, rising gasoline prices, the sequester and payroll tax increases. Costco may have done well thanks to its gasoline sales driving customers as well as its relentless focus on pricing.

Unfortunately Walgreen did not fare so well and frankly this wasn’t the time to cutback on pricing and promotions. With that said Walgreen has recognized the problem and a renewed focus on promotions and pricing was initiated in mid May. Essentially it is trying to drive traffic and same store sales growth. This is likely to impact margins, but Walgreen is quite candid that it is more focused on gross profit than margins. Which means that it is willing to discount and promote (which reduces margins) in order to drive revenue and profit growth.

Elsewhere its script comparables were up 7.1% in a market where physician visits were reported to be down 2.7% in May. Therefore I don’t think it’s fair to conclude that the weak sales are a consequence of ongoing weakness due to the Express Scripts debacle. Walgreen is winning customers back.

CVS reported results at the start of May and its front store business comparables were only up 1.4% with front store traffic ‘down slightly’ although it claimed to have gained market share. CVS claimed its market share compared to other drug retailers was up 1.2% and 0.1% against multi-outlet retailers. The former number suggests CVS has taken market share from Walgreen.

As ever, investors will focus on the CVS vs. Walgreen debate but frankly I see no reason why you can't hold both! If you like the long term trends of increasing generics sales (which tend to slow revenue growth but increase margins), expanding private label sales (higher margin) and the demand pull from an aging demographic than both are set to grow over the long term. These trends have resulted in substantive increases in free cash flow for these businesses over the last few years.

WAG Free Cash Flow TTM data by YCharts

And despite good stock price performance, both companies look like good values.

WAG Price to Cash Flow TTM data by YCharts

The bottom line

In conclusion, I think there are reasons to be positive. Its retail traffic and sales problems appear to be issues related to pushing its balanced rewards card and losing focus of promotions and discounts. The good news is that recent history suggests that these issues can be rectified in due course within the retail sector. If customers aren’t ‘loyal’ to Walgreen then they are not likely to be loyal to CVS, Wal-Mart, Costco or whoever.  Moreover the balanced reward card gives Walgreen more data with which it can better manage its sales initiatives. It can also use reward cards to drive promotions and pricing.

Long-term growth looks assured and history suggests that customers are price sensitive. In other words when Walgreen makes the necessary pricing and promotional adjustments it should see traffic and front store sales growth come back. The valuation remains attractive and I think it's a decent opportunity to pick some up.