EUR 850.00 For Business Accounts Only

Morningstar | Decaying Sales and Profits at Colgate Not Indicative of an Eroding Edge; Shares Getting Attractive

Much angst followed Colgate’s tepid third-quarter results--as shares slumped 6%--which included a 0.5% organic sales decline, a 120-basis-point erosion in adjusted gross margins to 59.2%, and a 190-basis-point downtick in adjusted operating margins to 23.4%. However, we attribute this performance to a few ancillary macro factors, as opposed to signaling cracks in its wide moat.

For one, the bulk of the sales shortfall stemmed from two markets, Brazil and China. In Brazil, volume pressure ensued as it opted to raise prices to offset higher costs, actions that have yet to be matched by its peer set. This drove a 3.5% downdraft in Latin America organic sales (more than 20% of sales, as volumes sank 6%). However, we perceive the firm’s decision as prudent, as it shows an unwillingness to chase short-term volumes and share to protect its intangible asset long term. Further, rhetoric from other industry operators suggests the intent to elevate prices; as such, we don’t expect these pressures will persist.

In China, sales were tempered as Colgate faced retailer inventory reductions as it shifts its mix to more premium offerings (from the mid-tier), a segment realizing outsize growth. As such, despite the near-term hit (contributing to a 4% pullback in Asia Pacific organic sales, 18% of its total sales), we think this positions Colgate to better win with local consumers.

Despite recent challenges, we haven’t wavered on our stance that its solid relationships with retailers and professionals combined with the resources Colgate funnels to support its products at the shelf (research, development, and marketing have accounted for 11% of sales or $1.8 billion) should enable it to withstand these headwinds and boost sales and profits longer term. We’ll likely shave a low-single-digit percent off of our $72 fair value estimate to reflect the near-term shortfall, but think investors should keep Colgate on their radar, as it trades at more than a 10% discount to our valuation.

From a profitability perspective, rising commodity and transportation costs are taking a toll; however, relative to peers, the impact is currently being inflated, given the strengthening dollar, as 80% of Colgate’s sales are derived beyond its home turf. We’re encouraged that the firm has been proactively working to extract excess costs, targeting $500 million-$575 million in savings by the end of 2019, which equates to around 5% of cost of goods sold and operating expenses excluding depreciation and amortization. And we see little to suggest that the firm will artificially boost profits by pulling back brand spend. Rather, we surmise Colgate will direct around 12% of sales (or more than $2 billion annually) to research, development, and marketing, as it has repeatedly referenced the importance of bringing consumer-valued innovation to market (even that which comes with a higher price tag) as a means to ensure the brand equity in the business (as well as its entrenched retail relationships) aren’t tainted. In this vein, we don’t expect to alter our long-term forecast of 4% average annual sales growth, 60% average gross margins, and operating margins expanding to the high 20s by the end of the next decade from the mid-20s over the past few years.