Colgate-Palmolive (NYSE:CL) has plunged 9% in the last two weeks and 15% off its all-time high in September. While such a decrease would not be considered dramatic for most stocks, it is quite unusual for Colgate, which has always been characterized by low volatility. Therefore, it is only natural to wonder whether the stock has become a great bargain after its recent plunge.
First of all, Colgate is facing some strong secular threats, which it has been unable to tackle so far. To be sure, its revenue has declined for three consecutive years and is poised to end up this year 11% lower than it was in 2013. The main reasons are the heating competition in the retail sector and the increasing pricing pressure exerted by large retailers, particularly as consumers have become more price-conscious in the last few years. The stalwart has been trying to tackle this secular threat with price hikes but that strategy has proved unsuccessful so far, as the decline in volumes has offset the price hikes.
This was prominent in the Q3 results of the company. More specifically, the earnings decreased 3% while the adjusted earnings per share increased only 1%. The management emphasized the improvement in the gross margin by 1.6% in Q3 over last year thanks to the ongoing restructuring program. However, that point of view is somewhat misleading. The full picture is that the management used that improvement to boost its marketing expenses and thus supported its sales, which however turned out to be lackluster. If the management had not utilized the above savings, the sales would have been even lower.
Moreover, the stock is currently trading at a trailing P/E=23.3, which is not cheap by any means. This valuation may be suitable for a stock that is growing at a consistently high pace but it is not suitable for a stock that is facing secular threats and has been posting deteriorating results in the last three years, with no light on the horizon yet. The company has resorted to aggressive distributions to its shareholders in the form of dividends and share repurchases in the last three years in order to partly offset its poor business performance. However, as the share repurchases are implemented at remarkably high prices, they do not enhance shareholder value. In addition, they have driven the book value per share from a positive $2.78 in 2011 to a negative $0.15 in the last quarter. Therefore, the management cannot maintain this aggressive strategy for much longer, particularly given that it should retain most of its earnings in order to tackle the above mentioned challenges.
Some investors may claim that the particularly rich valuation of the stock is somewhat justified thanks to the near record-low prevailing interest rates. Indeed the record-low interest rates are the major reason behind the elevated P/E ratio of Colgate and many other stalwarts, such as Coca-Cola (NYSE:KO), General Mills (NYSE:GIS) and Kellogg (NYSE:K). However, as the interest rates are likely to increase in the next few years, Colgate is likely to incur a meaningful compression of its P/E ratio. The more the Fed raises interest rates, the greater the P/E compression that the stock will incur. And while the current rich valuation may be somewhat justified by the low interest rates, it is not a sound investing strategy to bet that the interest rates will remain almost zero forever. All in all, the stock is likely to face a strong headwind from the interest rate hikes in the near and far future.
On the other hand, some investors claim that Colgate will greatly benefit from the new US government, which has promised to reduce corporate taxes. As the stalwart has one of the highest tax rates (44%), it will benefit the most from such a shift in the tax policy. However, these hopes are likely to prove short-lived. More specifically, while the tax rate may be reduced in the short term, that reduction is not likely to last for long, as the US budget deficit is appreciable and the US debt cannot keep climbing at the recent pace for many more years. Therefore, when the new US government lands to reality, it will realize that it cannot cut corporate taxes as drastically as it wishes and hence Colgate is not likely to enjoy a great tax cut.
Despite the above mentioned headwinds, one should also note that Colgate has raised its dividend for 53 consecutive years. This is certainly an exceptional record, which justifies a premium valuation to some extent. Nevertheless, as the chart below shows, the dividend payout ratio has markedly increased in the last few years, as the dividend has grown while the earnings have decreased. Consequently, although the company is likely to keep growing its dividend for the next few years, the growth rate is likely to be limited due to the absence of meaningful earnings growth.
To sum up, while the stock of Colgate has markedly corrected in the last two weeks, investors should not view the correction as an investment opportunity. Instead they should realize that the stock had rallied to unjustified levels, given its lack of growth. As long as the Fed raises the interest rates more than once in the next few months, the stock will have to incur a P/E compression. Of course this does not mean that the stock cannot rebound in the short term. It only means that it does not have an attractive valuation for great long-term returns.
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.