Clorox Should Struggle To Repeat Its Pristine Past Performance

| About: The Clorox (CLX)


Clorox has demonstrated itself to be a solid company with a strong shareholder return policy.

Over the past decade investors saw double-digit annualized gains from an investment in the security.

This article demonstrates the difficulty of repeating this past success.

As far as income producing securities go, a company like Clorox (NYSE:CLX) would probably be on your radar. First you have the strong stable of brand names: ranging from Clorox and Glad to Kingsford, Brita, Burt's Bee's and Pine-Sol. Roughly 80% of the company's portfolio is number one or two in its industry.

Next you have the idea that the company has been quite shareholder friendly over the years. Clorox has not only paid but also increased its dividend every year since 1977. Had you purchased shares any time sine then, each and every subsequent year you would have received a raise. And these increases were not inconsequential: over the past decade the average compound increase has been about 10.5%. Moreover, since 2004 the company has retired about 40% of its common shares outstanding.

With those concepts in mind, it might be useful to review the business and investment growth over the past decade (2005 through 2015):

Although the shareholder returns might be impressive, the top-line growth for Clorox hasn't been especially spectacular. The company sold roughly $4.4 billion worth of stuff in 2005 as compared to $5.7 billion by 2015, or a 2.6% annual increase.

Next up you have the profitability of the firm, which is even more lackluster. Had you owned the entire business you would have seen total profits go from about $520 million to $610 million, or a compound yearly increase of about 1.6%. Sales were growing a bit faster, but the quality of those sales (as measured by the net profit margin) had declined a bit.

Of course this is only half the story for the investor. The business performance of Clorox, while positive, wasn't exactly inspiring - you don't text home about 2% annual growth.

Clorox really picked up the slack with the investing components to come. In 2004 Clorox had over 200 million common shares outstanding. By the end of 2015 this number was closer to 130 million. As such, earnings-per-share increase by a much faster rate than company-wide earnings.

From there you also had an uptick in the valuation that investors were willing to pay. At the end of 2005, shares were trading hands around 20 times earnings. By the end of the 2015 this number was closer to 28 times earnings, based on trailing profits. This allowed the share price to grow by over 8% annually as compared to just 2% business growth.

Finally you have the dividend component, which grew at over 10% per annum. You would have started with a dividend yield near 2% in 2005 and ended with a yield-on-cost above 5%. With dividends included (but not reinvested) your total annualized gain would have been about 10% per year. As a point of reference, this is the sort of thing that would turn a $10,000 starting investment into $26,000 a decade later.

In short, Clorox the business didn't do anything that spectacular, but an investment would have worked out well due to the company's share repurchase program and dividend policy to go along with the price investors were willing to pay.

This is the sort of thing that an investor relations website likes to display:

Clorox as an investment has performed quite well in the last few decades. Yet the exact thing that the company touts - outperformance - could very well be the same reason that you would be dissuaded from potentially investing today. Let's set up a hypothetical example to see if we can get a better feel for what I mean.

Here's a look at the same historical information presented above, to go along with a hypothetical scenario to get more insight into today's value proposition:

The theme of this table could be described as "prudent, but reasonable." That is, I wanted to strike a balance between expecting spectacular performance and using a bit of caution. In my view, it's better for things to work out if the business performs marginally than needing exceptional results to do all right.

On the top line I assumed 3% annual growth for the next decade - faster than the past decade and representing a future sales number of about $7.6 billion. Keep in mind that the table presented above is merely a base line, a means by which to think about the process. Your own assumptions can be (and really ought to be) different, so you can make the adjustments accordingly.

Over the past decade Clorox's net profit margin has been in the 5% to 12% range. During the past few years this number has been pretty close to 10%. I assumed an 11% future profit margin, indicating that earnings growth could be slightly faster than revenue growth.

You'd anticipate that the company would continue with its share repurchase program. However, today there are two additional roadblocks that did not exist to the same degree a decade ago. First, you have fewer "organic" funds (derived from profits) that can be allocated toward the repurchase program. The dividend payment now takes up a much larger portion of earnings. Granted debt could be used, but in thinking about a long-term prudent course of action you'd like to see this driven sustainably.

To compound this idea of fewer potential funds going toward share repurchases, the company would be retiring shares at a much higher valuation today. Thus the "buyback buck" doesn't go as far. Combined, these two factors could materially decrease the effectiveness of the company's repurchase programs.

It you put it together, you might expect earnings-per-share growth that is roughly inline with the EPS growth of the past decade. Next you have to come up with an expected valuation for shares. Once more these are all assumptions, but it nonetheless provides a place to begin thinking about the security.

Over the past decade shares of Clorox have traded with an average earnings multiple of about 20. This seems more or less reasonable for a large, slow growing business with a solid economic moat. For a lot of securities this would mean an upward revision in valuation. With Clorox this provides disappointing results. Should Clorox grow earnings-per-share by 4.6% per annum and trade at 20 times earnings, this equates to just 1.2% annual share price growth over the next decade.

Much like the share repurchase program, the higher dividend payout ratio leaves less room for substantial dividend increases in the future. You might anticipate the dividend to more or less grow in line with earnings as a result. If you add in the dividend component, your total expected return might be 3.5% or thereabouts. As a point of reference, that sort of return would turn a $10,000 starting investment into $14,000 after 10 years.

In short, Clorox has proven itself to be a solid and formidable company. The capital returned to shareholders has been steady and the investment returns have been quite solid. Yet these facts alone do not simultaneously indicate that the security must be a good investment today.

A lot of what propelled Clorox to be a solid investment in the past is the same thing that could inhibit future gains. The business performed marginally, but the share repurchase program, increasing dividend and uptick in valuation provided investors with double-digit gains. Moving forward you might suspect that the business can once more chug along, but the other factors don't have the same propensity as they once did.

A much higher payout ratio and valuation means that dividend growth and future share repurchases are apt to be diminished. Moreover, compression in the valuation by itself can restrain an investor from capturing business performance over time. Naturally anything is possible, but at present it seems that the road to repeatability for a Clorox investor is an uphill battle.

Disclosure: I/we 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.