Report Entitled: "Arm Yourself To Get Hammered"
Spruce Point is pleased to issue a unique investment research opinion on Church & Dwight (CHD or "the Company"), an S&P 500 company, and roll-up acquirer of personal care and consumer products. Under its older leadership, management pursued a conservative strategy to leverage its core Arm & Hammer brand by diversifying and integrating acquisitions, while still prioritizing product innovation and manufacturing excellence.
With the elevation of Matt Farrell to CEO in 2016, Spruce Point believes CHD’s strategy pivoted towards greater financial engineering and aggressive accounting, among other concerns. As fundamentals deteriorate in CHD’s retail environment, and with 60% of its legacy Power Brand acquisitions struggling (see below), Spruce Point believes that recent acquisitions are will also disappoint. With CHD’s shares at a 8% premium to average analyst price targets, and debt rising, investors seeking safety in CHD’s stock face 35%–50% downside risk ($42 - $50/sh).
Below is a brief overview of the report. The full contents of the report are available on our website. We also encourage readers to follow us on Twitter @sprucepointcap and please read our disclaimer below.
Shift in Strategy and Poor M&A Result in Deteriorating Fundamentals:
Until 2016, CHD was headed by CEO Jim Craigie, an old-school Kraft executive with a focus on marketing and brand strength. His acquisition strategy was underpinned by a desire to acquire complementary products that could be easily integrated into CHD's existing supply chain. However, with former CFO Matt Farrell having taken Craigie's place, former employees tell us that management is now hyper-focused on hitting financial targets, and that it looks for deals with a mind to satisfying Street expectations. We find that many of the "Power Brands" acquired by executives past and present are struggling, with its two most recent acquisitions - Waterpik and FLAWLESS - particularly lagging, despite their high acquisition multiples.
With 23% of sales through Wal-Mart (WMT), and reliance on struggling brick-and-mortar channels such as ULTA Beauty (ULTA), Sally Beauty (SBH), Bed, Bath & Beyond (BBBY), pharmacy (ex: Walgreens (WBA), CVS, Rite Aid (RAD)), and discount stores (Dollar General (DG) and Big Lots (BIG)), we believe CHD is experiencing channel pressures, and has been slow to transition to online sales (through AMZN) and marketing to millennials. These factors, along with an increasingly promotional environment, has been pressuring margins
Fighting for shelf space in an intensely competitive market, we find CHD’s products do not generally command the best locations, and are often placed side-by-side generic house brands or at the bottom rack. While management has suggested the promotional environment has moderated, we see retailers being very promotional to move CHD’s various brands.
Evidence of Financial Challenges:
We find it concerning that CHD’s 2019 dividend grew at the slowest rate in recent history. We believe this is a signal of weakening cash flow expectations. Yet, CHD proclaimed great performance in 2018, going so far as to reward employees and management with a special 15% bonus, per its proxy. However, our forensic analysis will show how management constructs certain financial performance metrics in such a way that presents flattering results to investors, and that has resulted in management's hitting higher performance bonus targets. Certain models tie share price valuation to dividend growth rate. As a result, it makes little sense to Spruce Point why CHD’s valuation multiple is at an all-time high with the dividend growth rate slowing.
There’s more evidence of cash flow strain by looking at CHD’s cash conversion cycle (it defines as DSO + DIO – DPO). After steadily improving from 2014 to 2017, the metric worsened in 2018 from 17 to 24 days. Nonetheless, the CFO touts that it has a 3 – 4 year plan to drive working capital to zero. Based on our research, we believe it is an ambitious goal
CHD talks about its great cash conversion, yet it should take into account A/R factoring. At first in 2015, CHD admitted that cash flow should be adjusted for the factoring. As program usage intensified, management stopped calling out the impact of factoring, and kept proclaiming working capital improvements and impressive cash flow growth. In May 2019, management increased the size of the facility from $150 to $250m, but buried the detail in an 8-K and didn’t mention the increased capacity in the 10-Qs. Management also does not provide quarterly detail about its factoring, opting instead to disclose program usage annually.
CHD talks about great cash conversion. But in reality, it appears driven by CHD’s aggressive acquisition strategy, which assigns a significant portion of the deal value to goodwill and intangible assets (“G&I”). For recent deals identified as tax deductible for U.S. purposes, 96% of deal value has been ascribed to G&I. CHD’s strategy creates perverse incentives to overpay for deals to mark-up G&I to drive greater tax deductions. Deductibility is over 15 years
Investors like CHD because it is growing slightly faster than its bigger consumer peers. The company has talked about 4% organic growth. However, it is unusual that we could not find disclosure of its U.K. acquisition (unnamed, but explicitly referenced on UK Company House filings), which bolstered organic growth. We could not find any disclosure that this acquisition was made in CHD's SEC filings.
We believe the Street has failed to capture accounting changes which have had the effect of artificially flattering CHD’s 2018 EBITDA (see 2018 financial statement items below). Analysts simply take CHD’s recent annual results at face value, and use it as a baseline for future year EBITDA growth and margin expansion.
Source: 2018 10-K, p. 55 and p. 64
Even management does not call out the accounting benefits in its presentation of EBITDA to investors. Per the wording in its credit agreement: EBITDA must be adjusted lower by “non-cash items increasing Consolidated Net Income” and “any extraordinary, unusual, or non-recurring cash income or gains”. However, on investor presentations, management presents a calculation of Adj. EBITDA to investors that does not deduct these adjustments.
Source: CHD EBITDA from Barclays Presentation 9/3/19
Extreme Valuation Creates Unfavorable Risk / Reward
CHD is currently trading 8% above the average analyst price target of $73.88 per share. This does not appear to be a favorable risk/reward at current prices.
Recent insider sales in August near current prices:
Our normalized valuation calls for 35-50% downside on multiple compression to peer and historical averages, along with a normalization of earnings expectations based on our research
This research note and our presentation expresses our research opinions. You should assume that as of the publication date of any presentation, report or letter, Spruce Point Capital Management LLC (possibly along with or through our members, partners, affiliates, employees, and/or consultants) along with our subscribers and clients has a short position in all stocks (and are long/short combinations of puts and calls on the stock) covered herein, including without limitation Church & Dwight Co., Inc. (“CHD”), and therefore stand to realize significant gains in the event that the price of its stock declines. Following publication of any presentation, report or letter, we intend to continue transacting in the securities covered therein, and we may be long, short, or neutral at any time hereafter regardless of our initial recommendation. All expressions of opinion are subject to change without notice, and Spruce Point Capital Management does not undertake to update this report or any information contained herein. Spruce Point Capital Management, subscribers and/or consultants shall have no obligation to inform any investor or viewer of this report about their historical, current, and future trading activities.
This research note and our presentation expresses our research opinions, which we have based upon interpretation of certain facts and observations, all of which are based upon publicly available information, and all of which are set out in this research presentation. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward looking statements, expectations, pro forma analyses, estimates, and projections. You should assume these types of statements, expectations, pro forma analyses, estimates, and projections may turn out to be incorrect for reasons beyond Spruce Point Capital Management LLC’s control. This is not investment or accounting advice nor should it be construed as such. Use of Spruce Point Capital Management LLC’s research is at your own risk. You should do your own research and due diligence, with assistance from professional financial, legal and tax experts, before making any investment decision with respect to securities covered herein. All figures assumed to be in US Dollars, unless specified otherwise.
To the best of our ability and belief, as of the date hereof, all information contained herein is accurate and reliable and does not omit to state material facts necessary to make the statements herein not misleading, and all information has been obtained from public sources we believe to be accurate and reliable, and who are not insiders or connected persons of the stock covered herein or who may otherwise owe any fiduciary duty or duty of confidentiality to the issuer, or to any other person or entity that was breached by the transmission of information to Spruce Point Capital Management LLC. However, Spruce Point Capital Management LLC recognizes that there may be non-public information in the possession of CHD or other insiders of CHD that has not been publicly disclosed by CHD. Therefore, such information contained herein is presented “as is,” without warranty of any kind –whether express or implied. Spruce Point Capital Management LLC makes no other representations, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. You should assume all statements made are our opinions, unless sourced as facts where practical.
This report’s estimated fundamental value only represents a best efforts estimate of the potential fundamental valuation of a specific security, and is not expressed as, or implied as, assessments of the quality of a security, a summary of past performance, or an actionable investment strategy for an investor. This is not an offer to sell or a solicitation of an offer to Buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction. Spruce Point Capital Management LLC is not registered as an investment advisor, broker/dealer, or accounting firm.
Disclosure: I am/we are short CHD.