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Morningstar | Higher Costs, Foreign Exchange Taint Colgate's Full-Year Profit Outlook, but Wide Moat Unwavering

The main headline coming out of Colgate’s second-quarter results was the pronounced profit impact from inflationary pressures and unfavorable foreign currency (primarily the strengthening dollar, given 80% of sales are derived beyond its home turf), which in combination constrained gross margins by 320 basis points. However, the firm has been working to extract excess costs, benefiting gross margins 170 basis points in the quarter. When netted against a few ancillary items, adjusted gross margins sank 140 basis points to 59.3% (only the second time in the past eight quarters this metric fell below 60%). We anticipate that management will prudently maintain an eye on driving efficiencies, 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. But we don’t think the entirety will bolster profits. Rather, we think Colgate will direct a portion toward investing behind its brands (new products and marketing support). Further, management noted its intent to selectively raise prices, and while concern about the competitive landscape and the potential contraction in volumes that could ensue is valid, we posit that Colgate is proactively taking steps to ensure its wide moat proves unwavering.

Management now foresees mid-single-digit adjusted EPS growth in 2018, down from low double digits prior, and we will likely trim our $76 fair value estimate by a few dollars to reflect this near-term margin pressure. However, we don’t expect material changes to 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. Shares trade at a modest discount to our valuation, but we’d suggest investors looking to clean up in the household and personal care space should also consider wide-moat Procter & Gamble.

Similar to peers, tepid top-line performance persisted, with Colgate chalking up just 0.5% in organic sales gains in the second quarter (entirely due to volume gains). This shortfall was particularly of note in Latin America (around one quarter of sales, down 1.5% on an organic basis), where sales were negatively affected by the Brazilian truck strike, a factor that has been called out as a challenge by a number of operators. As such, we don’t think this headwind will prove lasting, and still forecast mid-single-digit annual sales growth for the region over our explicit forecast.

Further, we contend that management is taking steps to position the business to withstand the intense competitive landscape and boast accelerating sales longer term. In line with our expectations that Colgate will direct around 12% of sales (or more than $2 billion annually) to research, development, and marketing, the firm continues to emphasize 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) isn’t tarnished, which we view as prudent. In addition, we’re encouraged that Colgate remains staunch in its reluctance to chase short-term promotional volumes, which we see as supportive of the inherent brand equity in its mix. From our vantage point, it is these factors that have enabled Colgate’s global toothpaste market share to hold around the mid-40s for the better part of the last decade, and we don’t expect its share position will be permanently eroded.