By The Valuentum Team
Clorox's Investment Considerations
Clorox's Investment Highlights
• Clorox (NYSE:CLX) 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. Over 80% of the company's revenue is generated by brands that hold the #1 or #2 market share positions in their categories. The company was founded in 1913 and is headquartered in Oakland, California.
• Clorox's business quality ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively. If you like economic profit analysis, the Economic Castle rating is a good one to consider here.
• The firm has some noteworthy long-term 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. Most of this ongoing improvement will have to come from US retail, which represents 75% of revenue. Clorox has a robust innovation pipeline.
• Clorox's long-term growth algorithm targets ~80% of its sales coming from the US, where it is expecting 2%-4% annual growth to contribute 1.5-3 percentage points of overall company growth. The firm is expecting international sales growth of 5%-7% to contribute 1-1.5 percentage points of overall company growth.
• The company is targeting $300 million in sales in healthcare by fiscal 2017, up from $120 million in fiscal 2013. It plans to grow its base in surface and skin disinfection and expand organically through product and channel adjacencies. We like this area of growth.Valuentum on Consumer Staples, Jan 25
As emerging markets around the world suffer from commodity-price-led economic weakness, capital continues to find a safe-haven in US government bonds, but for those equity-oriented funds that mandate a fully-invested status, not something we're particularly advocates of, assets within US equities have favored "lower-beta" utilities and consumer staples (NYSEARCA:XLP) sectors while cyclically-dependent and credit-levered sectors such as the financials and materials have suffered thus far in 2016. The industrials and energy sectors have also encountered higher-than-normal selling pressure in the first few weeks of the New Year, as investors evaluate the global economic landscape and what a prolonged period of low energy prices may mean for the lowest quality operators.
We caution, of course, not to pay too much attention to daily or even weekly movements in equity prices, but we think it is informative to take a look at broader sector valuations to glean incremental insight regarding both opportunities and risks. There are two observations in this regard that we want to point out. First, the consumer staples sector, while certainly full of resilient business models--such as Constellation Brands (NYSE:STZ), Philip Morris (NYSE:PM), and Coca-Cola (NYSE:KO)-- aggregate valuations are starting to get stretched (19 times forward earnings versus 16.7 over the immediate 10-year period). Equity money managers may continue to increase their allocation to these "recession-resistant safe-havens," stretching their valuations further, but disappointments as in Kimberly-Clark's (NYSE:KMB) latest, for example, could send shares tumbling.
Second, the technology sector looks quite attractive from a forward price-to-earnings standpoint relative to the broad market benchmark (14.6 times versus 14.9 times for the S&P 500), but these equities, fairly or unfairly, have traditionally traded more in lock-step with new product iterations and broad emerging-market sentiment than anything else. In light of the fact that many constituents including Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT), however, have enormous net-cash-rich balance sheets, a source of value not considered in the traditional multiple analyses provided above, one can even say valuations in "Big Tech" are incredibly attractive. Said differently, if we ignore the tremendous net cash balances in the technology sector, some $150+ billion at Apple and ~$60+ billion at Microsoft alone, for example, the group is still attractively priced relative to an S&P 500 (NYSEARCA:SPY), which includes some rather heavily-leveraged (debt-heavy) entities. Near-term oriented investor "bases" and concerns regarding emerging market strength could still drive multiple "compression" across the tech sector, but we like the balance sheets of several.
Clorox's Business Quality
Clorox's Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
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 36.2%, which is above the estimate of its cost of capital of 9.1%. 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 9.8% 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. At Clorox, cash flow from operations increased about 26% from levels registered two years ago, while capital expenditures fell about 28% over the same time period.
In the first 6 months of fiscal 2016, Clorox reported net cash provided by operating activities of ~$185 million and capital expenditures of ~$68 million, resulting in free cash flow of ~$117 million, a 46% decrease from the first 6 months of fiscal 2015.
Clorox's Valuation Analysis
This is the most important section of our analysis. Below we take the mess that is our valuation assumptions and derive a squeaky-clean fair value estimate.
Our discounted cash flow model indicates that Clorox's shares are worth between $74-$110 each. Shares are currently trading at ~$128, above the upper bound of our fair value range. This indicates that we feel there is significantly more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $92 per share represents a price-to-earnings (P/E) ratio of about 21.6 times last year's earnings and an implied EV/EBITDA multiple of about 12.3 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 2.7% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.2%. Our model reflects a 5-year projected average operating margin of 19.7%, which is above Clorox's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.5% for the next 15 years and 3% in perpetuity. For Clorox, we use a 9.1% weighted average cost of capital to discount future free cash flows.
Clorox'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 $92 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.
In the graph above, we show this probable range of fair values for Clorox. We think the firm is attractive below $74 per share (the green line), but quite expensive above $110 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.
Clorox's Future Path of Fair Value
We estimate Clorox's fair value at this point in time to be about $92 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above 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 $114 per share in Year 3 represents our existing fair value per share of $92 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.
Wrapping Things Up on Clorox
Clorox holds some of the most recognizable brands in the respective industries in which it operates; it's hard not to like the company's diverse product portfolio. In the company's second quarter of fiscal 2016, earnings per share grew 18% from the previous year's second quarter, leading to an increase in the company's full-year EPS outlook for the full fiscal year. Looking forward, Clorox looks to grow revenue and improve its margins, and the majority of growth will have to come from US retail, which currently represents 75% of total revenue. Though Clorox's product portfolio certainly is impressive, shares are not enticing at the moment, at least from a valuation standpoint. Investors should be cognizant that things are getting a little stretched. Clorox currently registers a 4 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.
Additional disclosure: Several of the firms mentioned in this article are included in the Valuentum newsletter portfolios.