Colgate-Palmolive (NYSE:CL) has been on my watch list for many years. Nonetheless, I have not written on it since late 2015. For that reason, I was happy to include it as one of the options on my recent poll regarding what company should next face my five FCF tests. With the results in, Colgate-Palmolive came top of the pile and so I have got to work pitching the consumer goods giant against my tests (incidentally, the fresh poll is now open).
Although far from exhaustive, my five FCF tests give me a good indication of a company's competitive advantages, FCF health and efficiency, as well as the debt and dividend position. Fair value based on FCF alone is also calculated to give a little taste of whether it offers value today. I should stress that these tests merely mark the first step in what may develop into a more thorough analysis of the business in the future.
Since I opened the poll, Colgate-Palmolive has released its FY2016 results. Investors were a little unimpressed by what they saw as rather lackluster organic sales growth. This was, however, less to do with FY2016 results which were, in fact, quite respectable at 4% but the Q4 2016 results specifically. Indeed, Q4's 1.5% growth relied almost exclusively on Latin American growth:
Investors were, therefore, a little jittery as Colgate-Palmolive appeared to be entering 2017 with the growth wind taken out of its sales. Nonetheless, taking a look at it from a cash flow perspective suggests that it has more than enough firepower to rebuild momentum whilst also reward shareholders. As you will see, Colgate-Palmolive's performance against my FCF tests was very impressive. Indeed, it only failed one of my five tests.
First, let's take a more general look at the business. Colgate-Palmolive is, obviously, most famous for its eponymous Colgate and Palmolive brands. Yet it has a wide variety of additional leading names including Sanex, Ajax and its Hill's Pet Nutrition brand.
Whilst most of its business is focused on the oral, personal and home care industry, it also has an attractive position in the pet nutrition industry through its Hill's brand, which contributes a notable amount:
The power of its brands means that it has also managed to build strong market positions across the globe meaning that although its home North American market is important, it is actually a fairly modest overall contributor to total revenue and operating profit (some of the Pet Nutrition segment is generated in North America, of course, but the company has not provided a geographic breakdown of this yet for 2016):
Colgate-Palmolive is, therefore, a highly attractive consumer goods company with a small, well-managed brand portfolio which has come to have great commercial clout across the globe. An opening overview of Colgate-Palmolive's business:
1: Positive FCF
We open with a pretty basic test. All we are looking for here is, simply, that Colgate-Palmolive has generated positive FCF consistently over the last decade. As you'd perhaps expect from an established brand-led consumer goods company, Colgate-Palmolive does very well indeed on this front. Since 2009, it has been stable around the mid-$2 billion mark:
This has been largely driven by strong operating cash flow performances, partially offset in recent years by a fairly sizeable lift in CapEx:
Colgate-Palmolive, therefore, gets off to a strong start with a comfortable PASS.
2: CROIC: Cash Return on Invested Capital
Next, we turn to more challenging tests. In this case, CROIC or cash return on invested capital. CROIC is calculated by dividing its FCF by the sum of its invested capital (that is, total debt and shareholders' equity) to give us a good idea of how efficiently it generates its cash flow.
What I am looking for here is a CROIC which has averaged above 10% over the last decade. In other words, I am looking for Colgate-Palmolive to have generated at least $10 in FCF from each $100 capital invested in its business. This represents a very strong rate of return providing a company with large amounts of cash to fund its growth and shareholder returns.
So how does Colgate-Palmolive do? Staggeringly well, to be honest:
Over the last 10 years, Colgate-Palmolive has averaged a CROIC of 35.5%. Even more impressive is that CROIC has been expanding consistently since 2013. We must, however, acknowledge that a large part of that recent CROIC growth has been due to shrinking equity levels, which, in recent years, have even turned negative.
Something to worry about? Not really as the main drag on shareholders' equity levels have been the "cumulative foreign currency translation adjustments" accounted for under the "Accumulated Other Comprehensive Income/Loss" section of the balance sheet, which has seen nominal losses through translation to its reported USD currency expand significantly as the USD has continued to strengthen (we do not yet have a breakdown of FY2016 figures):
As these are not realized losses, they are not something to be too concerned about. Yet they do noticeably exaggerate CROIC figures by depressing shareholders' equity levels.
Despite this, however, even if we were to assume far higher levels of shareholders' equity, Colgate-Palmolive's CROIC remains comfortably ahead of my 10% target (indeed, its historic 30%+ easily surpasses the target).
Colgate-Palmolive, therefore, gets another PASS here.
3: FCF to Debt
Next, we focus down a little more on the matter of Colgate-Palmolive's debt. Although incorporated in CROIC calculations, debt is an important element to consider separately. Colgate-Palmolive, like so many consumer goods companies, has been building up debt levels significantly in recent years. This has been especially true since the turn of the decade:
2016 saw a welcome pause in this growth (indeed, a modest shrinkage). Nonetheless, it is clear that Colgate-Palmolive has been increasingly building leverage. Yet here, I am less interested in the level of leverage as the ability of Colgate-Palmolive to service this debt from an FCF perspective.
What I want to see here is that Colgate-Palmolive has an FCF to Debt ratio of 25% or more. In other words, I want to see that the company could (in theory) repay its entire debt load in four years or less using FCF alone.
Colgate-Palmolive, again, performs well here. Despite building leverage levels in recent years, its debt levels are still comfortably covered by FCF:
Its FCF to Debt ratio has been shrinking since the turn of the decade. Yet at an FCF to Debt ratio of 39% still, it easily passes my 25% target. Indeed 39% suggests that it would take just a little over two and a half years to pay off its entire debt load using FCF. A very healthy coverage indeed.
Colgate-Palmolive, therefore, picks up another strong PASS.
4: FCF Yield
Next up for testing is its dividend. Colgate-Palmolive's dividend yield has generally been solid if unspectacular. Over the last 10 years, it has averaged a yield of 2.2%. After dipping below this average in 2013, the dividend yield has begun lifting once again to slightly above that average:
Yet what I am really looking to do here is assess the strength of the dividend from an FCF perspective. As a result, I am looking for two things here:
- An FCF Yield (the yield if its entire FCF was paid as a dividend) of 3.5% or more, and;
- An FCF Payout ratio of 75% or less.
Once again, Colgate-Palmolive does extremely well against these tests. From both a historic and predicted basis, Colgate-Palmolive's dividend looks both comparatively generous and comfortably covered by FCF:
With an FCF yield around 4.4%, it sits comfortably above my 3.5% target. Similarly, with just 54% to 58% of FCF being used to service its dividend, it also falls nicely below my 75% payout threshold. Colgate-Palmolive's dividend, therefore, looks healthy right now. What is more, at a historic and forward yield of 2.4% and 2.5%, it is actually trading with a dividend ahead of its recent historic average.
Colgate-Palmolive, therefore, again picks up a solid PASS.
5: FCF Valuation
Since the start of 2016, Colgate-Palmolive has seen its share price lift over 16% before dropping back down to where it started, including a 5% fall after the release of its FY2016 results on 27 January:
Does this mean that there is value in the shares at their current price? Here, we will turn to its historic EV/FCF (enterprise value to FCF) multiple over the more familiar P/E ratio. To pass this test, Colgate-Palmolive just needs to come out with a share price below the FCF fair value calculated using this EV/FCF multiple.
To calculate this FCF fair value, we need to first ascertain Colgate-Palmolive's historical EV/FCF average. Since 2009, Colgate-Palmolive has seen its EV/FCF multiple expand significantly:
The net results is a 10-year EV/FCF average of 22.8. This seems to represent a solid FCF fair value multiple on which to work.
Now, we have to predict Colgate-Palmolive's FCF figure for the next couple of years. I explain in more detail exactly how I do this elsewhere. Using this method, however, Colgate-Palmolive emerges with predicted FCF figures of $2.54 and $2.61 billion for 2017 and 2018, respectively. Averaging these two figures (making $2.575 billion) I then feed this back into the EV/FCF calculation at an EV/FCF fair value multiple of 22.8.
What do I come out with as a result? A fair value of about $59.75 a share. At $64.50, currently, this suggests that Colgate-Palmolive, despite its recent share price weakness, is still trading about 7% above fair value. From this perspective, therefore, Colgate-Palmolive earns a FAIL on the final test.
Colgate-Palmolive is a top quality company with remarkably attractive cash flow characteristics, a healthy balance sheet and strong shareholder returns potential. Indeed, this shareholder return potential includes share buybacks which historically have been at very high levels:
Overall, it managed to pass four out of five of my FCF tests. What is more, those it passed it did so very comfortably indeed. It seems, therefore, that in line with so many of its peers, Colgate-Palmolive falls down in only one respect: valuation. This is perhaps a little surprise in light of the fact that investors have, in recent years, very highly valued the reliable, defensive, highly cash-generative businesses of which Colgate-Palmolive is a fine example.
Certainly, compared to more recent valuation levels, Colgate-Palmolive represents slightly better value at present. If we, for example, took the EV/FCF fair value as closer to the five-year average of 25.25, its FCF fair value would come out closer to $67 suggesting that when compared to its recent valuation, today's share price does indeed offer some value. What is certainly true is that Colgate-Palmolive's incredibly cash-generative and healthy business should keep it on the watch list of many an investor.
Whether or not you see today's share price as good value or not really depends on the time frame you compare it with. Yet it seems highly likely that Colgate-Palmolive's incredibly consistent cash flow performance is likely to continue to underpin its strong shareholder return in the future. I for one find that very attractive. Indeed, I may be tempted to open a small pilot position in Colgate-Palmolive at today's price. Yet, for now, would be happy to wait for the price to (hopefully) fall closer to $60 before building that up to a fuller position. Whether or not such an opportunity will present itself anytime soon is, of course, another matter.
All graphs, tables and the calculations contained within them were created by the author unless otherwise noted. All data was collected from publicly accessible company filings and reports. Creative Commons image reproduced from Flickr user mjtmail.
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.