Clorox: Good Company But Shares Aren't Cheap; Dividend Is Overrated

| About: The Clorox (CLX)

Clorox (NYSE:CLX) gets a lot of attention for being classified as a Dividend Aristocrat, or a firm that has raised its dividend in each of the past 25+ years. Though a track record of such consistency is remarkable, investors know that the past is only as valuable as it informs the future. That's why we perform a rigorous discounted cash-flow methodology where we forecast the key valuation drivers of a company long into the future to derive its intrinsic worth. Let's examine how we do this for Clorox.

But first, a little background. At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, and an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This three-pillar 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, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). We like to think in simple terms: more interest in shares due to more methodologies being interested in them --> more buying -- > increased likelihood of price to fair value convergence. We still calculate fair values and assess relative strength, but it comes down to embracing the face that buying or selling drives equity prices higher or lower. Here is the graphical depiction of our three pillar system.

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Clorox posts a Valuentum Buying Index score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. We compare Clorox to peers Colgate-Palmolive (NYSE:CL), Johnson & Johnson (NYSE:JNJ), and Procter & Gamble (NYSE:PG) for relative value purposes (a relative value assessment is the second component of our process). We place a greater emphasis on discounted cash-flows because they are innate and unique to the firm we are valuing. Relative valuation has its limitations.

Our Report on Clorox

Clorox's Investment Considerations

Clorox's Investment Highlights

  • Clorox 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 39.6% during the past three years.
  • Clorox markets some blockbuster brand names, including its namesake bleach/cleaning products, Pine-Sol cleaners, Fresh Step cat litter, Glad bags, Kingsford charcoal, and KC Masterpiece sauces. Nearly 90 percent of the company's brands hold the #1 or #2 market share positions in their categories.
  • Clorox has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 11.3% in coming years. Total debt-to-EBITDA was 2.5 times last year.
  • The company has some noteworthy annual financial goals: organic sales growth of 3%-5%, EBIT margin improvement of 25-50 basis points, and free cash flow of 10%-12% of sales.
  • Clorox is a Dividend Aristocrat with a healthy dividend growth track record. Though we have no qualms with its dividend at this time, we do note that it is not as strong as that of its peers (see dividend analysis here). Its Valuentum Dividend Cushion score is 1.

Clorox's Business Quality

Clorox'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 (NASDAQ:ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Clorox's 3-year historical return on invested capital (without goodwill) is 39.6%, which is above the estimate of its cost of capital of 9%. 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.

Clorox'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. Clorox's free cash flow margin has averaged about 7.6% 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 At Clorox, cash flow from operations decreased about 25% from levels registered two years ago, while capital expenditures fell about 5% over the same time period.

Clorox's Valuation Analysis

The estimated fair value of $75 per share represents a price-to-earnings (P/E) ratio of about 18.3 times last year's earnings and an implied EV/EBITDA multiple of about 11.5 times last year's EBITDA. Before reading about our specific assumptions, please click here for an important background on how we think about forecasting in our discounted cash-flow model more broadly. Our model reflects a compound annual revenue growth rate of 3.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 0.1%. Our model reflects a 5-year projected average operating margin of 17.8%, which is below Clorox's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Clorox, we use a 9% weighted average cost of capital to discount future free cash flows.

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 $75 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 Clorox. We think the firm is attractive below $56 per share (the green line), but quite expensive above $94 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.

Future Path of Fair Value

We estimate Clorox's fair value at this point in time to be about $75 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 Clorox'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 $91 per share in Year 3 represents our existing fair value per share of $75 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 and PG are included in the Dividend Growth portfolio. 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.

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