EUR 850.00 For Business Accounts Only

Morningstar | No-moat Church & Dwight's Profits Succumb to Cost Pressure; Valuation Not Compelling

We see little in Church & Dwight’s second-quarter results (4.4% organic sales growth and 140 basis points of gross margin degradation to 44.3%) to warrant a material change in our $44 fair value estimate. Results through the first half of fiscal 2018 place the firm on track to meet our full-year outlook for high-single-digit sales growth (including the benefit from the acquisition of Waterpik) and around 20 basis points of operating margin erosion to 19.5%. However, with shares trading at a more-than 25% premium to our valuation, we'd suggest investors refrain from building a position. In our view, the current stock price fails to account for the competitive and inflationary headwinds plaguing this no-moat operator. In this vein, the market price implies 5% average annual organic revenue growth over the next decade and operating margins improving to nearly 24% by fiscal 2027, which outpaces our long-term expectations calling for around 3% annual sales growth and operating margins ticking up to just north of 21% over the same horizon. For those looking to clean up in the household and personal care space, we'd point to wide-moat Procter & Gamble as a more attractive option (trading nearly 20% below our $98 fair value estimate, boasting almost a 4% dividend yield).

Within its global consumer business (more than 90% of its consolidated sales base), Church & Dwight chalked up more than 5% organic growth, driven by higher volumes (up 6.5%), as price was a 1.2% drag. We haven't wavered from our thinking that the need to continuously promote to bolster volumes and stem market share losses (which ensued in four of its top 11 brands in the quarter) fails to suggest it possesses pricing power or negotiating leverage with retailers, factors that underlie our assertion it has not developed a moat.

However, in light of the pronounced profit hit from higher commodity and transportation costs in the quarter (which ate into gross margins to the tune of 160 basis points), management suggested that it intends to selectively raise prices (an about-face from three months ago, when it repeatedly stressed its viewpoint that the pricing environment was quite challenged). Despite the merits of its plans (preserving profitability), we struggle to see how Church & Dwight will elevate its pricing without incurring a volume retreat, particularly when taking into account the intensely competitive landscape and its relative lack of resources (compared with competitively advantaged peers including P&G, Colgate, and Reckitt). Adding to these headwinds is the degree to which retailers will ultimately be receptive to its aims. Historically, these pursuits have not always been welcomed, especially for second- and third-tier brands, and Church & Dwight could also risk losing shelf space if retailers balk at its approach. In this vein, management has called out that it lost distribution of its cat litter offering through Amazon last year, supporting our stance it has failed to secure much negotiating leverage with leading brick-and-mortar and online retailers.