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Morningstar | Church & Dwight Chalks Up Margin Degradation in 4Q; Shares Far From a Bargain

For the second quarter in a row, Church & Dwight boasted positive price and favorable mix (to the tune of 1.6% in combination), which led to organic sales gains of 4.3%. However, this did little to quell concerns surrounding profitability--gross margins sank 250 basis points to 44.1%, as inflationary headwinds, tariff pressures, and higher compensation offset the benefits from productivity savings--as shares fell at a high-single-digit clip. Even after accounting for the decline, though, we continue to view the stock as heated, trading at a more than 30% premium to our valuation.

Results for the year (high-single-digit organic sales growth and $2.27 in EPS) and the firm’s fiscal 2019 guidance (low-single-digit organic sales growth and EPS of $2.43-$2.47) generally align with our outlook, and as such, we don’t anticipate altering our $44.50 fair value estimate, beyond a low-single-digit increase to account for the time value of money. Trading at a mid-20s forward price/earnings multiple (versus the high-teens implied by our forecast), we’d suggest investors remain on the sidelines. For investors looking to build a position in the household and personal-care arena, we’d suggest wide-moat Colgate, which trades around a 10% discount to our valuation.

While price-driven top-line improvement persisted in the quarter, we’re reluctant to view this performance as sustainable, particularly in light of the intense competitive landscape in which it plays. Firms across the consumer products industry are seeking to raise prices to offset higher raw material and logistics costs. And we posit volume erosion may ensue for no-moat Church & Dwight if consumers opt to trade down or out within the categories in which it plays. The firm goes to bat daily against peers that maintain significantly more resources and ultimately are more entrenched in retailer supply chains, a challenging position given its lack of a competitive edge.

Despite management’s claims to the contrary, we surmise that promotional intensity could remain inflated, as other branded operators, low-priced private-label fare, and small, niche operators all strive for additional share gains. And we think that in an attempt to steady its competitive position, Church & Dwight will need to spend behind its brands to withstand competitive angst. Our forecast calls for spending behind marketing, research, and development to hold at around $650 million annually, or about 14% of sales.

We will be attending the Consumer Analyst Group of New York conference in a few weeks and hope management takes the opportunity to delve further into its priorities for cash, including its appetite for deals. Beyond acting as a consolidator, we expect Church & Dwight will opt to return a portion of its free cash flow, which approximated 17% of sales in fiscal 2018, to shareholders through both dividends and share repurchases. We’ve held the firm to be a standard steward of shareholder capital in the past, and we don’t expect it will veer from this bent. Our forecast calls for it raise its dividend at a high-single-digit growth annually on average over the next decade (maintaining a 40% payout ratio) while also repurchasing around 2%-3% of shares outstanding each year.