Consumer goods company Church & Dwight Co. Inc. (CHD), most known for its Arm & Hammer baking soda products, closed out its fiscal year 2018 with earnings on Tuesday morning. Despite revenues that met analysts' expectations and missing earnings per share by just a penny, the market hammered the stock with a decline that closed trading at -7.5% (in a positive trading session). However, when you peel back the data, the actual performance of the company doesn't justify such a price drop. So, what happened? This sharp move lower is a solid lesson in how valuation impacts the market's reaction to catalyst events such as earnings. We dive into the quarter and reveal how investors should be feeling about Church & Dwight following its decline.
The company's earnings release included quarterly revenues of $1.07 billion, which were in line with analysts' estimates. Earnings per share were $0.57, short of expectations but only by one cent.
(Source: Church & Dwight Co. Inc.)
Was the stock punished that much just for a penny miss on earnings? Not likely. The downward momentum from the market likely had something to do with a 2019 outlook of between $2.43 and $2.47 per share. The high end of guidance is just short of consensus expectations (short by $0.01). The dividend was increased 5% to an annual payout of $0.91 per share. This raise falls quite short of the company's average five-year growth rate of 9.3% (and well short of last year's raise of 14.5%).
Was The Quarter Really That Bad?
The answer is somewhat relative, but our conclusion is that there is a ton of "good" in Church & Dwight's results. When you walk through each "key" area of the company's performance, you start to put together a string of positive observations.
In a sector where many of the "household" name companies are struggling to grow, Church & Dwight is having success. Not only is the company's positive sales growth impressive (both quarter and full year), but the figures are driven by strong organic sales growth of +4.3%. These results well exceeded the company's organic growth forecast of 3.0% for the fiscal year. The business saw growth in all segments during the fourth quarter.
- Domestic Consumer Sales: +4.0%
- Consumer International Sales: +5.0%
- Specialty Products: +1.5%
Regarding profitability, the company was vulnerable to a number of margin pressures that have hit the sector as a whole. US tariffs and inflation of input costs caused contraction of gross margins by 250 basis points. While this is significant, the company is expecting to address these headwinds with price increases that began to be implemented late in the year. Management is forecasting margin expansion in 2019.
Church & Dwight remains a cash flow generator. The company saw a full-year boost of 12% to operating cash flow, thanks to revenue growth combined with lower working capital.
Despite its smaller size as just a $16 billion company by market cap, Church & Dwight is able to turn more than $0.16 of every revenue dollar into free cash flow. This is right up there with the titans of the sector.
While the dividend was smaller than usual at 5%, this doesn't indicate weakness in the business. Management is building cash (cash balance rose from $188 million to $316 million from the prior quarter) to maintain financial flexibility for a company that is known to be active in acquisitions. The company is nearing Dividend Champion status with a growth streak now at 23 years and a dividend that still only consumes 27% of cash flow. The dividend is in great shape.
So, Why Did The Stock Drop 7.5%?
The price drop in Church & Dwight stock ultimately boils down to when valuations become high enough that the market "raises the bar" too high for its own good. Prior to today, shares were trading at approximately $65 per share. With full-year earnings at $2.27, this resulted in an earnings multiple of 28.6X.
The valuation at this point is disconnected from the normal/historical trading range of the stock. Church & Dwight has traded at a 10-year median P/E of 22.73X. From this multiple to where shares closed on February 4th, there is a gap of almost 26%.
Over the past 10 years, Church & Dwight has grown revenues at a CAGR of 5.45% and earnings per share at a CAGR of 16.78% (partially driven by acquisition growth). Now you have shares trading at a large premium - to a multiple that resulted from higher growth than is expected moving forward. This disconnect has a lot to do with why shares sold off. Church & Dwight remains a very high-quality business and is generating organic growth that many peers can only dream of accomplishing. However, when a stock is priced to impossible expectations, investors shouldn't be surprised when a correction occurs. It was bound to happen.
Are Shares A Buy Now?
The large haircut that the stock took certainly improves the valuation of Church & Dwight, but investors buying this dip may end up disappointed. Even at $60 per share, the valuation remains high at 26.4X. If investors bought now, the stock would take until hitting 2019's forecast of $2.47 to even bring the valuation within striking distance of "normal" at what would then be 24.3X 2019 earnings. To build a position that will provide satisfactory capital appreciation in the short and long term, we would like to see shares fall to a range of 23X earnings, or $52 per share.
The large price drop that Church & Dwight experienced Tuesday can confuse investors on the surface. A slight earnings miss by a penny, strong cash and sales growth combine to form what was a solid quarter. However, when valuations demand unrealistic performance, even a blue-chip stock can come crashing back down to earth.
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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.