- Clorox continues to underperform the broader market and the staples sector.
- We look at our 10-year zero total return call from earlier and revise our estimates.
- Has the stock actually become more expensive despite falling?
- I do much more than just articles at Conservative Income Portfolio: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
It is human nature to get excited when the story seems just right in the stock market. But almost always tends to create exceptionally bad entry points. We have seen quite a lot of such poor setups over the last year and it is fascinating to see such clear disregard for valuations. Today, we take a look at our earlier call on The Clorox Company (NYSE:CLX) to deliver negative total returns over 10 years and tell you where it stands today.
The Earlier Case
In 2020 when absolutely everything was going right for Clorox, we simply ran the numbers and told you that this was unlikely to work out well. Specifically we said,
The key driver is the ending valuation. The current 23 represents an epic bubble of sorts and will revert over time. If we even assume a move to 12X, we are priced for almost zero returns over a decade.
For those griping about the 12X EV to EBITDA, remember that we were at that valuation in 2014 when interest rates were pegged to zero.
Clorox has lagged the broader market by 62% since that article.
Source: Setting Up For A Decade Of Negative Returns
While it is easy to dismiss the broader market outperformance thanks to bubble valuations, Clorox has also been beaten comprehensively by the staples (XLP) sector.
Curious investors would want to know though just how improved are the total returns prospects from this point.
The Optimism Built Into Our Earlier Model
One thing that we want to point out first is that our earlier model was flat out optimistic. It modeled 3% growth into perpetuity off a very high base, something we reminded readers was not even remotely feasible. We had also completely ignored competitive pressures or margins issues, which we felt were highly likely. So when that model pointed to abysmal returns, investors should have taken it seriously. We now look at where our total return profile stands today, assuming Clorox can deliver growth from here on.
We have assumed here that Clorox' margin pressures peak about here and the EPS delivers a robust 4% increase for next year. Further out we have gone at a 5% annual growth clip. Keep in mind that over 11 years from 2009 to 2019, total EPS growth for Clorox was 71.70% (a timeframe that included tax cuts) so a 5% annual growth rate is close to the norm.
Just as previously, we have assumed all earnings are paid out as dividends. This keeps the model simple because if we assume that earnings that not paid out as dividends are used for buybacks, we have to model an assumption for the share price at each time point. Using our model assumptions and an ending valuation of 12x EV to EBITDA we come with a total 30.15% return over 10 years.
Source: Author's Estimates & Calculations
How do the wall street analysts differ from these numbers?
Well for one, they are modeling incredible earnings growth over next 5 years.
Source: Seeking Alpha
But that is the curse of the wall street analyst that has a "hockey stick" at the end every time. We saw this over the last 12 months despite a very clear end to the pandemic level use of products and creeping margin pressures, estimates were fairly unrealistic. Reality has set in on the front-end but further out numbers remain quite optimistic.
Source: Seeking Alpha
What Do Other Models Say?
Investors tend to look at the dividend yield on Clorox for clues on valuation and we agree that a fat yield tends to provide a floor at times. But perhaps one can also consider that in 2012-2013, with Treasury yields as low as 1.65%, Clorox had a dividend yield of 3.5%.
The current dividend yield does not remotely provide a hard floor on the stock. We also expect the 10 year Treasury rates to breach 2.0% and that could give Clorox a tougher risk-free rate. Clorox also has a high payout ratio now, with the dividend consuming 83% of the earnings. So don't expect rapid boost to the dividends.
Finally, price to sales ratio is beginning to look less of a headwind. But let's keep in mind here also that a drop to 2.4X sales implies another 20% share price drop.
The good news here is that we see very little chance of negative total 10 year returns from this point for Clorox. The stock price drop has fixed that issue. The bad news is that earnings drop has prevented the valuation from even approaching an attractive level. If you want to buy at this point with the logic that this will outperform the 10 year treasury bond over 10 years, then go ahead. The odds are heavily in your favor (unlike in July 2020). But Clorox is still one of the most expensive stocks in the consumer staples sector. It gets a D for value from Seeking Alpha's composite valuation metric and most of its other metrics are abysmal as well.
Source: Seeking Alpha
One other thing to notice there is that value factor grade has fallen from D+ 6 months back. That has happened as earnings estimates have deteriorated even more than the stock price.
We are steadily looking to add consumer staples stocks in this expensive market so we are always looking for opportunities. But one thing that has kept us underinvested is that inflationary pressures have turned out to be far higher than what we envisioned. We had a very bullish stance on inflation as we came into 2021, but it has surpassed our highest estimates. This is a big challenge to the sector and until pressures dissipate/peak, we are nibbling here, rather than feasting. Investors interested in quality staples can consider Unilever (UL) which has better return prospects at this point in our opinion.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
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This article was written by
Trapping Value is a team of analysts with over 40 years of combined experience generating options income while also focusing on capital preservation. They run the investing group Conservative Income Portfolio in partnership with Preferred Stock Trader. The investing group features two income-generating portfolios and a bond ladder.
Trapping Value provides Covered Calls, and Preferred Stock Trader covers Fixed Income. The Covered Calls Portfolio is designed to provide lower volatility income investing with a focus on capital preservation. The fixed income portfolio focuses on buying securities with high income potential and heavy undervaluation relative to comparatives. Learn more.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.