Clorox: Discomforting Thoughts On The Dividend
Summary
- Clorox is a highly profitable and well-managed company. This is underscored by consistently high margins, excellent working capital management, and return on invested capital.
- Due to inflationary pressures and pandemic-related excess capacities, the company's gross margin has fallen dramatically.
- Free cash flow followed suit and is now barely able to cover the dividend.
- The company will likely need to tap the capital markets to bolster its near-term cash flow, in addition to refinancing more than $1 billion over the next 18 months at potentially unfavorable rates.
- It will take a few years for the issues to resolve, and investors will likely continue to scrutinize Clorox's premium valuation.
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The Clorox Company (NYSE:CLX), best known for its disinfecting and bleaching products, reported third-quarter 2022 results after the market close on May 2. Over the last quarters, the company’s gross margin has declined sharply from its long-term average of 44%, down to around 37% in Q1 2022 and 33% in Q2 2022. For the third quarter, management reported a slightly improved gross margin, as price increases began to take effect. However, at 36% of net sales, Clorox's gross profit remains very weak, and investors may rightly wonder if the company is in danger of losing its status as a dividend aristocrat.
In this article, I will provide my perspective, taking into account Clorox's historical performance and management's comments during the third quarter 2022 earnings call.
Are Clorox's Glory Days A Thing Of The Past?
Clorox manufactures and sells a variety of well-known brand products, including its namesake bleach and cleaning products, Poett home care products, Fresh Step cat litter, Glad bags and wraps, Kingsford grilling products, Hidden Valley dressings, dips, seasonings and sauces, Brita water-filtration systems and filters, Burt’s Bees natural personal care products, and a number of vitamins, minerals and supplements. Clorox's focus is on cleaning products, which accounted for 43% of total sales in 2021 (p. 4 2021 10-K). Nevertheless, the company's brand portfolio leaves a somewhat unfocused impression, and the individual segments could therefore be susceptible to operational inefficiencies.
However, this hypothesis can be rejected if we consider Clorox's cash conversion cycle (CCC). CCC helps evaluating the efficiency of a company's operations and management and is particularly important in the context of companies that grow significantly through acquisition, such as Clorox. Since FY2010, the company’s CCC has steadily declined, indicating that Clorox is continuously improving its working capital management (Figure 1). The company extended payment terms with its suppliers from 50 days in FY2010 to 132 days in FY2021, while maintaining good payment terms with its customers.
Figure 1: Clorox’ working capital management: inventory days (ID), days sales outstanding (DSO), days payables outstanding (DPO), and cash conversion cycle (CCC) (own work, based on the company’s 2009 to 2021 10-Ks)
The quality of Clorox’ brand portfolio is also underlined by the continuously high return on invested capital (ROIC) of 23% over the last decade. Clorox’ cash ROIC (CROIC), which considers free cashflow, normalized for working capital movements and stock-based compensation expenses, has also been very robust at 18% on average over the last decade.
Figure 2: Clorox’ cash return on invested capital (CROIC) (own work, based on the company’s 2010 to 2021 10-Ks)
Apart from recent developments, the company has done a very good job of keeping its profit margins constant over the last ten years. Clorox' gross margin ranges between 42% and 48%, and the operating margin (adjusted for impairment losses in 2011 and 2021) is generally 18%.
Figure 3: Clorox’ gross and operating margin (own work, based on the company’s 2010 to 2021 10-Ks)
The recent decline in gross margin and consequently operating profitability is due to significantly increased input costs and supply chain disruptions. In line with its competitors, the company has increased prices – first in the fall of 2021 and most recently in April 2022.
During the Q3 2022 earnings call, CEO Rendle noted that the company expects to increase prices once again in July. Gross margin improved approximately 300 basis points in the third quarter, but the company does not expect further improvement in the fourth quarter, due in part to a $30 million headwind related to the war in Ukraine. As the company continues to invest in digital transformation, selling, general and administrative expenses will also remain elevated at approximately 15% to 16% in the near term, compared to the long-term average of 14% of net sales.
On a more positive note, Clorox has been able to consolidate and narrow parts of the external manufacturer portfolio, which has been aggressively expanded to meet increased demand throughout most of 2020 and early 2021. As the company continues to wind down its excess manufacturing capacity and keeps increasing prices, operating profitability is expected to improve further.
The vast majority of supply chain-related improvements is expected to materialize in FY2023. Management does not expect consumers to significantly trade down within categories and private label brands actually increased their share less than expected. Elasticities of Clorox’ products are slightly better than initially expected. This is most likely due to the company’s trusted brands and the products’ high quality. Certainly, the pandemic has increased brand awareness and customer confidence in Clorox products.
Overall, Clorox has a highly profitable brand portfolio, which was impacted by rising input costs, delayed price increases, and excess production capacity following the pandemic. It will probably take several years for the company to regain its former operating profitability. In the long term, however, I am confident that management will be able to bring margins back to the level for which the company was known in the past - and which is probably also the reason for its premium valuation.
Is The Dividend In Danger of Being Cut?
Clorox is often touted as a sleep-well-at-night dividend stock due to its strong brand portfolio and its status of being a dividend aristocrat. The company has increased its dividend for 44 consecutive years, and the ten-year average dividend growth rate is very solid at over 7% per year. The payout ratio, as measured by normalized free cash flow, has fluctuated between 50% and 70% (Figure 4), but is expected to reach or exceed 100% in 2022.
For the nine months ended March 31 2022, the company paid out $428 million in dividends, whereas it only generated $451 million in cash from operations (unfavorably impacted by $150 million in working capital movements) and spent $172 million on capital expenditures. Clorox has always been a relatively highly leveraged company. (Figure 5). This is partly attributed to extensive share buybacks to offset dilution from share awards, but also to increase earnings per share.
Figure 4: Clorox’ dividend payout ratio in terms of normalized free cashflow (own work, based on the company’s 2010 to 2021 10-Ks)
Figure 5: Clorox’ leverage ratio in terms of normalized free cashflow (own work, based on the company’s 2010 to 2021 10-Ks)
In the short term, I doubt that the company will continue to buy back shares and instead focus only on the dividend. Given the current weak free cashflow, which may not fully cover the dividend in the coming quarters, it does not seem unlikely that Clorox will tap the capital market. Even though the company exhibits a relatively pronounced leverage, it is in a good position due to its predominantly non-cyclical business and investment grade debt.
Clorox’ long-term debt has been rated Baa1 by Moody’s. However, in February 2022, the rating agency changed Clorox’s outlook to stable from positive. It cited operating performance deterioration caused by expected volume declines after an initial pandemic surge, inflationary pressures on margins due to an unprecedented cost and supply chain environment, and a relatively long path to full recovery.
I do not doubt Clorox’ ability to increase leverage to bolster the dividend payout until profitability has recovered, and it appears unlikely that the company will lightly give up its status as a dividend aristocrat. Still, I find it discomforting to discuss such issues in the context of a stock that is touted as defensive.
A look at Clorox's upcoming maturities in Figure 6 shows that the company will need to refinance more than $1 billion over the next 18 months, likely at a comparatively unfavorable interest rate and excluding additional debt that is potentially assumed to bolster cashflow. If Clorox does indeed need to increase leverage to maintain its dividend history, it would also negatively impact its interest coverage ratio relative to normalized free cash flow (7.6x on average), which is likely to impact the company's ability to significantly increase dividends in the coming years. It can therefore be assumed that Clorox will only increase its dividend at a comparatively low rate in the future until all issues have been resolved.
Figure 6: Clorox’ upcoming debt maturities (own work, based on the company’s 2021 10-K)
Quick Investor Takeaway
In principle, Clorox is a wonderful company with a number of widely recognized and highly profitable brands. The company managed to grow free cashflow at a ten-year compound annual growth rate of almost 5%, which is quite respectable for a consumer staples company. At a share price of $140, Clorox’ dividend yield of 3.2% appears compelling. Such a return is rare for a U.S. consumer staples company, especially in the current low interest rate environment. The dividend growth rate of over 7% per year on average over the last ten years indicates that management is very committed to increasing the dividend.
However, given the current challenges, future increases should only be expected to the extent of token increases. Clorox's free cash flow has declined dramatically and will likely take time to recover, especially considering that the company's working capital management is already very good and does not leave much room for improvement. The company might even have to tap the capital market until operating profitability is fully restored. In addition, because Clorox will need to refinance more than $1 billion at potentially unfavorable interest rates over the next 18 months, the company's debt servicing ability is likely to suffer, further limiting its ability to raise dividends substantially.
Taken together, current investors are likely to lose some of their purchasing power in the near future. I doubt that the dividend will be cut, but increases should only be expected to the extent of symbolic increases. In the long term, I am confident that management will be able to restore operating profitability, but it will likely be several years before Clorox can be called a dividend growth stock again.
Thank you very much for taking the time to read my article. In case of any questions or comments, I'm very happy to read from you in the comments section below.
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