Is Colgate Really Considered 'Expensive'?

 |  About: Colgate-Palmolive Co. (CL)
by: Jason Meissner


Colgate is currently trading at its highest P/E in 10 years.

Long-term growth rates suggest this should be much lower than it is.

After a DCF model, I find it is almost within pretty light assumptions.

The Colgate-Palmolive Company (NYSE:CL) is the second-largest household product company in the world. It features products in oral care, personal care, home products as well as pet nutrition. 46% of revenues in FY2013 came from oral care, which includes toothpaste, toothbrushes and mouth rinse. CL owns brands such as Irish Spring, Speed Stick, Soft Soap, and Palmolive.

As of year-end, 50% of all sales came from high-growth regions, such as Africa, Asia and Latin America. Asia had the highest organic growth rate of 10.5%, and a rate of 9% after exchange impact. Latin America had the second-highest growth rate of 9.5%, but it didn't contribute to net income after a foreign exchange impact of -9.5%. A large percentage of this number was contributed to by a significant devaluation of the Venezuelan bolivar. Margins also increased due to cheaper input prices, reduced packaging and better supplier agreements.

I started following CL around late February, and at the time, it was trading for about $64. I thought it was "too expensive" when comparing to its competitors, like most people also believed, so I decided to wait until the price went down. Well so far, it hasn't. It recently has made me really intrigued to find out why.

Doing a background check

CL is currently priced at a P/E TTM of 29.7. This is much higher compared to the industry average of 22.5 (or for any large stable company with slow growth, for that matter). When I looked into it more, I found that CL has never traded below the S&P at a year-end TTM over the last 10 years, but came very close back in 2009.

As for margins, CL has some of the best in the industry. Actually, they ARE the best in the households industry, except for its most recent profit margin for the quarter and pretax margin (for the last quarter, annualized).

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The margins are pretty impressive, and they will only get slightly better. During the Q1 2014 earnings call, management said to expect an increase in gross margin every quarter. There was no growth during the first quarter, though.

When looking at some of the return numbers, we will also see they are some of the best in the industry. It is the best in the industry for return on assets. The largest contributor to this would be its profit margin. Its asset turnover is only in the 67th percentile, suggesting it isn't quite using its assets as efficiently (remember, ROA=profit margin*asset turnover). It is also worth noting that intangible assets and goodwill make up about 27% of total assets. When looking at ROE, we can just take ROA*financial leverage, which happens to put CL as the highest ROE in the industry. CL is leveraged! Its debt/equity is almost twice as high as the industry average.

Time to look at and see what the DCF says...

Okay, I get it. A company has great margins and returns, but to have a 10-year net income CAGR of only 5.7% and be trading close to a 30 P/E, there has to be something missing. I decided to build a DCF model to really see what's going on. Let me walk you through it and some of the major assumptions.

EBIT Growth - EBIT is affected by net income, COGS margin as a % of revenue as well as SG&A expenses as a % of revenue. Below, you will see my revenue growth assumptions. I have the gross margin shrinking very slightly over 5 years, which I believe is very attainable. Operating costs remain the same.

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Depreciation comes from my depreciation schedule. Those implications are given to us in the 10-K form. Also, in the 10-K, we find that management expects amortization to remain constant at 29.

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In that picture, you can also see the projected Capital Expenditures. Those numbers come from the 10-year capital expenditure growth rate of 7.5%.

Working capital remains fairly flat, because I kept the cash conversion cycle fairly consistent each year. Inventory is projected from days inventory outstanding (using the average of the current and prior year). The same case applies to receivables and payables.

Interest expense also remains fairly consistent, as it has in the past. For net borrowings, I looked at the 10-year historical growth rate of LTD and applied that 5% number to my debt sweep to estimate future LTD after paying off current portions.

The final numbers

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As you can see, the model suggests CL is currently trading just above estimates. I believe I gave some pretty "light" assumptions to EBIT. EBIT margin is at its lowest in 4 years by about 2%, and the gross margin increase of .1%/year should be very attainable. I also believe keeping SG&A constant is fair, and I believe after a while it will likely decrease. WACC was taken from the firm's unlevered beta and applied to the CAPM model. Cost of debt averaged 2.2%, with an effective tax rate of 32%.

Why I think it's still a solid holding

If you're a dividend grower, I think this company will do an excellent job at keeping you happy over the long term. The 10-year CAGR for dividends paid to shareholders is 12.3%, with an average 48.1% payout ratio. While growth may be slow, EPS has continued growing, as the company has been spending billions buying back shares at a 2.1% rate over those same 10 years. If you would have invested in CL at the end of 2006 or early 2007, when it was at a P/E of 27, you would have seen your shares gain 107.28%.

Personally, I would wait a little bit to get in on CL. Even though it's slightly out of the range and that's not too worrying, I don't think the price will move much for the next year or so.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.