We're big fans of the household products industry. Firms in the household products industry sell some of the most recognized branded consumer packaged goods in the world and often hold a significant market share position in a variety of product categories. Though the industry is characterized by stiff competition from retailers' private-label brands, constituents tend to boast meaningful competitive advantages due to their brand strength/reputation and generate high returns on invested capital. Household products companies remain tied to the vicissitudes of consumer spending, but we tend to like the structure of the group. Colgate-Palmolive (NYSE:CL) is one such constituent in this favorably-structured industry and boasts one of the more attractive dividend profiles. Let's take a look at the firm through the numbers.
For those that don't know us, at Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers coupled with a technical and momentum overlay is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies (from value through momentum), thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Said differently, more interest --> more buying --> greater likelihood of price-to-fair value convergence.
If a company is undervalued both on a DCF and on a relative valuation basis (and is timely), it scores highly on our scale. Colgate-Palmolive posts a VBI score of 3 on our scale, which is based in part on our 'fairly valued' DCF assessment of the firm and its unattractive relative valuation versus peers. We compare Colgate-Palmolive to peers Clorox (NYSE:CLX), Johnson & Johnson (NYSE:JNJ), and Procter & Gamble (NYSE:PG) for relative value considerations. The primary valuation consideration we use is a DCF-based fair value estimate process.
Colgate-Palmolive's Investment Considerations
Colgate-Palmolive's Investment Highlights
- Colgate-Palmolive earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 52.8% during the past three years.
- Colgate is a leader in oral care and personal care with the leading toothpaste, manual toothbrush, and liquid hand soap brands throughout many parts of the world. Its portfolio includes Colgate Total, Colgate Plax, and Palmolive.
- Colgate-Palmolive has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 18% in coming years. Total debt-to-EBITDA was 1.2 last year, while debt-to-book capitalization stood at 70.5%.
- Colgate's growth metrics have been staggering in recent history. Net sales have advanced at a CAGR of 5%+ since 1991, the firm's gross margin has increased from 37.9% in 1984 to the high-50% today, while operating profit has increased at a 9%+ CAGR since the early 1990s. We expect solid performance to continue.
- The firm sports a very nice dividend yield of 2.2%. We expect the firm to pay out about 48% of next year's earnings to shareholders as dividends. Colgate has raised its dividend for more than 49 consecutive years. The firm's Valuentum Dividend Cushion score sits at 1.7.
Colgate-Palmolive's Business Quality
Colgate-Palmolive's Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC - with its weighted average cost of capital - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Colgate-Palmolive's 3-year historical return on invested capital (without goodwill) is 52.8%, which is above the estimate of its cost of capital of 9.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Colgate-Palmolive's Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Colgate-Palmolive's free cash flow margin has averaged about 15.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Colgate-Palmolive, cash flow from operations is about flat from levels registered two years ago, while capital expenditures expanded about 3% over the same time period.
Colgate-Palmolive's Valuation Analysis
Our discounted cash flow model indicates that Colgate-Palmolive's shares are worth between $38.00-$64.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. If shares are trading between this range, which they are, we consider a company to be fair valued. The estimated fair value of $51 per share represents a price-to-earnings (P/E) ratio of about 19.8 times last year's earnings and an implied EV/EBITDA multiple of about 12.1 times last year's EBITDA. Even though this fair value estimate is below the firm's share price, we use a margin of safety and a fair value range in determining whether shares are truly undervalued or overvalued. Our model reflects a compound annual revenue growth rate of 4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 3.7%. Our model reflects a 5-year projected average operating margin of 26.3%, which is above Colgate-Palmolive's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3% for the next 15 years and 3% in perpetuity. For Colgate-Palmolive, we use a 9.4% weighted average cost of capital to discount future free cash flows.
Colgate-Palmolive's Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $51 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Colgate-Palmolive. We think the firm is attractive below $38 per share (the green line), but quite expensive above $64 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Colgate-Palmolive's Future Path of Fair Value
We estimate Colgate-Palmolive's fair value at this point in time to be about $51 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Colgate-Palmolive's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $64 per share in Year 3 represents our existing fair value per share of $51 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Disclosure: JNJ is included in the portfolio of our Dividend Growth Newsletter. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.