Colgate-Palmolive: A Masterclass In Long-Term Value Creation

Apr. 20, 2022 12:02 PM ETColgate-Palmolive Company (CL)2 Comments6 Likes
Vladimir Dimitrov, CFA profile picture
Vladimir Dimitrov, CFA
3.81K Followers

Summary

  • In spite of certain short-term headwinds, Colgate-Palmolive remains one of the highest quality Home & Personal Care businesses.
  • Rising commodity prices created only a temporary headwind for Colgate's valuation.
  • The company retains the crown in terms of a high return on capital, best-in-class brands, and outstanding capital allocation.

Set of Colgate toothpaste with toothbrush

Gilles_Paire/iStock Editorial via Getty Images

Colgate-Palmolive (NYSE:CL) is one of those high quality businesses that rarely come at a discount and almost always trade at a premium. Since I first covered the company, back in November of 2018, it has delivered a total return of roughly 40%.

Chart
Data by YCharts

This made CL one of the best performing large cap Personal & Home Care businesses, with only Procter & Gamble coming in ahead of it. Of course, we should not forget that P&G also benefited heavily from its strong exposure to the U.S. market, while CL experienced significant headwind with its Emerging Market exposure that suffered due to the strong U.S. dollar.

Nevertheless, CL remains among the highest quality businesses in the Home & Personal Care space.

Personal & Home Care - margins vs valuation

prepared by the author, using data from Seeking Alpha

Although I did occasionally change my rating on the company to Neutral, as for example I did during the top in November of 2020, long-term investors do not necessarily need to try to time the market. What matters the most in such cases is Colgate's strategy and the company's capital allocation policy.

Some Headwinds Ahead

Colgate's decision to expand more aggressively into the high margin skin care space was a good fit to the company's long-term strategy. However, as I have warned previously, there are risks involved when pursuing exceptionally large deals, such as the $1.7bn acquisition of Laboratoires Filorga.

Already, it appears that CL might have overpaid for the skincare business, just two years following the deal.

In the fourth quarter of 2021, we took a non-cash, aftertax impairment charge of $518 million to adjust the carrying values of goodwill and a trade name intangible asset related to the Filorga skin health business. Any of these risks could adversely impact our business, results of operations, cash flows and financial condition.

Source: Colgate-Palmolive 10-K SEC Filing

As expected, pandemic related tailwinds for working capital have also dissipated over the course of last year.

Colgate Change in Net Working Capital

prepared by the author, using data from 10-K SEC Filings

Additionally, capital expenditure is also rebounding from its multi-decade low levels recorded in recent years.

Colgate Capex to Depreciation Expense

prepared by the author, using data from 10-K SEC Filings

While all these matters are significant and require shareholders' attention, none of them is reason enough why one should avoid CL at current levels.

The Main Valuation Driver

Over the long-term, changes in gross profitability are the key driver of Colgate's valuation.

Colgate margins versus valuation

prepared by the author, using data from 10-K SEC Filings

That is why, periods such as 2009, 2010 and 2018 (see below) offered a great buying opportunity for long-term investors as the corresponding Price-to-Sales multiple during these years was below the trend line we saw in the graph above.

Chart
Data by YCharts

Having said that, CL could hardly experience a significant upward multiple repricing in the coming years, however, that does not necessarily mean that it is not a superior long-term investment given its high return on capital.

Gross profitability also suffered heavily during the most recent quarters as pandemic tailwinds subside and supply chain issues persist.

Colgate change in gross margin

prepared by the author, using data from Colgate-Palmolive Quarterly Earnings Conference Calls

By breaking down the net impact on gross margin to its three key drivers, we could see that commodity price inflation has been the chief culprit behind the falling profitability.

Colgate pricing, productivity and raw materials impact

prepared by the author, using data from Colgate-Palmolive Quarterly Earnings Conference Calls

Almost all major raw materials that CL products rely on have increased significantly during the past year or so.

The Company is exposed to price volatility related to raw materials used in production, such as essential oils, resins, tropical oils, pulp, tallow, corn, poultry and soybeans.

Source: Colgate-Palmolive 10-K SEC Filing

What is also worth mentioning is that in spite of the massive commodity headwinds, Colgate-Palmolive's brands allow for significant pricing power while increases in productivity were also significant.

What Really Matters For Shareholders?

The temporary headwinds for gross margins, however, are hardly a reason for long-term oriented investors to avoid the company. Colgate-Palmolive still has the highest return on capital ratio, while also being one of the largest and truly global businesses in its peer group.

Personal & Home Care Return on Invested Capital

prepared by the author, using data from Seeking Alpha

Topline growth rate to pre-pandemic levels is also relatively high. In Developed Markets (North America and Europe) and Pet Nutrition, Colgate significantly expanded its business, while growth in Emerging Markets experienced significant FX headwinds.

Colgate 2021 vs. pre-pandemic results

prepared by the author, using data from 10-K SEC Filings

What matters the most in the graph above, however, is Colgate's ability to prioritize and grow in key additional product areas, where it could also build strong brands. In this case, Pet Nutrition offers both high customer loyalty for the most well-known brands and also an opportunity to challenge the leaders in the segment - Mars and Nestle (OTCPK:NSRGY).

pet food market share

prepared by the author, using data from ift.org

Similarly to the skin care business, where management is currently focused, the Pet Food division has exceptionally high margins even when compared to divisions of other publicly traded peers.

Pet food margins

prepared by the author, using data from annual and quarterly reports

Even before the pandemic accelerated the trend in pet ownership, the pet food segment was already enjoying a long-term demographic tailwind due to higher pet ownership among Millennials. Then the pandemic hit, resulting in a dramatic increase in ownership rates.

Pet Treats Growth

Mars Petcare State of the Pet Nation report 2020

This created the perfect environment for the high price premium and customer loyalty Hill's brand enjoys, as pet owners spend significant amounts on food for their loved ones.

Pet food spending power

Mars Petcare State of the Pet Nation report 2020

This highlights Colgate's ability to create strong brands in high return on capital areas where the company also has significant competitive advantages. Therefore, even though the skin care business has hit a roadblock, it will remain a key growth driver over the long run.

Conclusion

Colgate-Palmolive is without a doubt one of the highest quality consumer staple businesses, which also has a truly global exposure of its iconic brands. Although the company's share price performed largely in-line with the sector in recent years, the long-term potential of the business is far superior to most of its peers.

The core business generates one of the highest returns on capital in the industry, while expansion in skin care offers a long-term opportunity to a category characterized with high margins and high customer loyalty. In similar fashion, Colgate has become a dominant player the high margin pet nutrition space where its exceptionally strong Hill's brand offers a major competitive advantage.

This article was written by

Vladimir Dimitrov, CFA profile picture
3.81K Followers
Vladimir Dimitrov is a former strategy consultant with a professional focus on business and intangible assets valuation. Throughout his career he has been focused on solving complex business problems through the lens of the overall business strategy and by incorporating various valuation and financial modelling techniques.In addition to his professional experience, he has been exploring the concept of value investing and in particular finding companies with sustainable competitive advantages that also trade below their intrinsic value. He supplements his bottom-up approach to finding individual businesses with a more holistic view of the markets through factor investing techniques.Vladimir made his first investment in farmland right out of high school in 2007 and consequently started investing through mutual funds at the bottom of the market in 2009. In the years that followed he has been focused on developing his own investment strategy and philosophy. He has been managing a concentrated equity portfolio since 2016 and is a LSE Alumni and a CFA charterholder . All of Vladimir's content published on Seeking Alpha is for informational purposes only and should not be construed as investment advice. Always consult a licensed investment professional before making investment decisions.
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Disclosure: I/we have a beneficial long position in the shares of UL either through stock ownership, options, or other derivatives. 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: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

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