Our rating on Colgate-Palmolive Co. (NYSE: CL) is BUY. Colgate has credit ratings in the low AAs and unlike the fixed coupon on a Treasury note, CL’s dividend should continue to increase.
While the U.S. still seems to be a long way from the often discussed ‘new normal’ after the pandemic has subsided, we believe that consumers will continue to focus on health, safety, cleanliness, and pets. We expect Colgate to be a beneficiary as it delivers innovative products.
A major theme in our coverage of Consumer Staples companies is the need to drive sales. Colgate is doing just that — launching one of its biggest initiatives in the last 20 years with improvements to the Colgate Total brand and increased advertising spending. The new Total toothpaste has improvements to neutralize bad breath, fight bacteria, and be gentler on sensitive teeth. The company is also expanding its offering of products with natural ingredients and promoting new pet foods for younger pets and for older pets with kidney problems. Organic sales were improving even before the pandemic, increasing 4% in 2019 with growth in every division. For 2019, Organic volume was up 2%, with positive performance in every region.
We are raising our target price to $94 from $90.
Colgate is scheduled to report 3Q20 earnings before the market opens on January 29. The average analyst estimate is $0.76 per share. Our estimate is also $0.76. The range is $0.73-$0.79. The standard deviation is a very narrow 1.8 cents. There has been no change in consensus over the last four weeks.
The Bloomberg consensus is for revenue of $4.13 billion. Our estimate is $4.06 billion. The average analyst estimate is for operating income of $467 million. Our estimate is $465 million.
On December 2, 2020, Panagiotis Tsourapas, Group President of Latin America, Asia Pacific & Africa-Eurasia spoke at an investor conference. He said that the company is seeing strong sales with its innovative products, with the relaunch of Colgate Total, with premium products such as Optic Renewal and newer areas such as face cleansing, baby care in Brazil and eCommerce in China.
Looking forward to 2021, Mr. Tsourapas expects to see elevated sales of hand soap, and dishwashing liquid, but probably not at the COVID-affected levels we saw in 2020. He expects that people will continue to be diligent in washing their hands when they return to away-from-home activities, but there may be some offset because people won’t be doing as many dishes at home. He sees steady growth prospects in Oral Care, which wasn’t significantly impacted by COVID and from the Hill’s Pet business which should benefit from an increase in pet adoptions.
Mr. Tsourapas was confident that there are additional opportunities to reduce costs, improve productivity and continue to raise gross margin. Three areas for potential improvements are technology for accounting and financial reporting, machinery for producing packaging and less expensive formulations of packaging materials.
EARNINGS & GROWTH ANALYSIS
Our 2020 EPS estimate is $3.05. Colgate reinstated financial guidance with its 3Q results. The company expects sales to grow in the mid-single digits and organic sales to grow at the top of the mid-single-digit range. It also expects the gross margin to expand. Advertising is expected to rise for the year with an even bigger increase in 4Q. The adjusted tax rate is expected to be 23.5%-24%. Adjusted earnings are expected to be up 6%-7%. This puts adjusted earnings in a range of $3.00- $3.03. The current consensus is $3.05.
We are maintaining our 2021 estimate at $3.30 per share. We expect consumers to maintain a focus on health, cleaning and pets. We believe that the company’s focus on efficiency during the pandemic along with its emphasis on more innovative products will help operating income. One potential question will be whether the company can top strong 2020 sales of cleaning supplies.
We won’t formally provide a 2022 estimate until after CL reports 4Q20 results, but we expect EPS to be in the neighborhood of $3.50.
We expect to see effective innovation, both to drive sales and to improve efficiency. We also believe that CL has some innovative products that it can market more aggressively. Colgate has been earning high returns on capital investments and we expect it to be successful in improving production and efficiency. Emerging markets are under some pressure from a strong dollar, but we expect this to normalize over time. CL should be successful in offering education and creating demand for its products, though it will need to innovate to retain share at attractive margins. The company has a pipeline of innovative products that it may not have promoted aggressively enough; we expect promotion to improve in the near term.
FINANCIAL STRENGTH & DIVIDEND
Colgate said in the 10-Q for the second quarter, and again in the third quarter, that its strong cash generation and financial position would continue to provide it with broad access to global credit and capital markets.
Moody’s rates CL’s debt Aa3, with a stable outlook, and Standard & Poor’s rates the debt AA- with a stable outlook. The company has top-tier A-1/P-1 short-term ratings, which provide ready access to the commercial paper market and allow a company to have a more efficient capital structure. CL has been issuing commercial paper throughout the crisis. The average daily balance of borrowing in the CP market was $1.1 billion for the first nine months of 2020 and $1.7 billion in the prior-year period. Colgate said in the 10-Q for the third quarter that it had access to $4.5 billion in unused lines of credit.
The company generated about $3 billion of cash from operations in 2016, 2017, 2018 and 2019. Free cash flow has also been solid, with capex running at $550 and $590 million in 2017 and 2016, respectively, and declining to $436 million in 2018 and $335 million in 2019. Free cash flow was $2.8 billion in 2019, up from $2.6 billion in 2018. In the first three quarters of 2020, the company generated $2.76 billion in cash from operations, up from $2.16 billion in the prior-year period. Free cash flow was $2.5 billion.
Adjusted EBITDA topped $4 billion in both 2018 and 2019. Non-GAAP EBITDA was more than 20-times interest expense in 2018 and 2019. This is very strong coverage which explains the high credit ratings.
Total debt of $7.2 billion looks high at 92% of capital, but that is because the company had a $1 billion charge in 2015 related to Venezuelan operations. This reduced shareholders equity and raised debt-to-capital. The company’s interest coverage is a more relevant indicator and that is very strong. Leverage, with total debt at less than 2-times trailing-12-month EBITDA in FY19, FY18, FY17, and FY16 is similarly supportive of high credit ratings.
CL paid a 2018 dividend of $1.66 for 2018 and $1.71 in 2019. Dividends in 2020 totaled $1.75, reflecting one payment of $0.43 and three payments of $0.44. The dividend payout ratio has risen from about 37% in 2009 to 57% of our 2020 adjusted earnings estimate. We think the current level is reasonable for a mature company. We will initiate a 2022 dividend estimate after the company reports results for 4Q20. Our 2022 dividend estimate will probably be in the neighborhood of $1.84.
The company has a share repurchase program, but plans to moderate repurchase activity for 18-24 months after the Filorga deal in order to pay down debt more quickly. That should limit repurchases into 2021. CL repurchased $1.2 billion of its stock in 2018 and $1.2 billion in 2019. There was no repurchase activity in 2Q. The company repurchased $370 million of its stock in 3Q. It has a remaining authorization of $2.7 billion.
MANAGEMENT & RISKS
In the near term, negotiating the COVID-19 crisis is a risk.Colgate has held up well because it sells health, cleaning, and pet products. It could still be hurt if a surge in virus transmission disrupts supply chains or staffing. The company may also face tough volume comparisons against the ‘pantry loading’ that occurred in early 2020 as shoppers stockpiled important products. The company could lose share to lower-tier products if its customers are hurt by high unemployment. The company may also see some currency pressure, particularly if the U.S. is perceived as a safe haven relative to emerging markets.
Noel Wallace became CEO on April 2, 2019 as part of the company’s succession planning process. He became chairman of the board on April 1, 2020. He joined the company in 1987, rising to president and CCO in 2018. Henning Jakobsen became CFO in May 2014; he retired in November 2020. On October 30, the company announced that Stanley Sutula would replace Mr. Jakobsen on November 9. Mr. Sutula was previously CFO at Pitney Bowes. Prior to that, he spent28 years at IBM, rising to the position of Controller.
We met with him regularly when he was CEO of Saks. Before Saks, he had been president of Clairol and head of the beauty business at Bristol-Myers Squibb. He led Saks through a major, successful, turnaround after the Great Recession. He strengthened the balance sheet, improved the store base, upgraded online capabilities, and improved store productivity. We regard him as a skilled and pragmatic executive who has been shareholder-friendly.
The biggest risk to CL is a lack of sales growth. The company seems to be well aware of this weakness, as some form of the word ‘growth’ appeared on the cover of nine consecutive annual reports through 2019. 2019 sales were up slightly from 2018.
Toothpaste and cleaning supplies are mature categories in developed markets. The company won’t be able to grow as more people recognize the value of brushing – that’s already happened. To do that, CL will need to raise sales of its most innovative products, including premium toothpastes, products for sensitive teeth, more products with natural ingredients and high-end pet food. The company is working to do this with innovation. They have also managed to increase market share in businesses, like Tom’s of Maine Toothpaste that they have acquired. We were very pleased to see that the company acquired Hello Products, a premium brand of natural toothpastes and rinses that is popular with younger shoppers and compliments Tom’s business.
The company’s commodity hedges are primarily associated with its Hill’s pet food business. Colgate sells its products in 200 countries. CL manages its currency exposure through cost containment, sourcing strategies, price increases as well as by hedging certain costs. CL primarily uses forward contracts to manage portions of its foreign exchange exposure. One issue is that CL is a market leader. When it raises prices in response to inflationary pressures, competitors may temporarily delay their price increases and try to grab some of CL’s share.
Colgate’s 2019 balance sheet includes pension and retiree liabilities of $1.7 billion. This isn’t huge, but is worth noting. The liabilities were $1.6 billion in 2019. The company contributed $113 million to the plans in 2019 and $67 million in 2018. The annual report said that the company did not plan to make voluntary contributions to its U.S. plans in 2020. Colgate’s customer base is diversified. Walmart did represent about 11% of sales in both 2018 and 2019. In addition to other consumer products companies, such as Procter & Gamble, Colgate competes with private label brands at Walmart, Target, Kroger, Walgreen’s and Costco.
PricewaterhouseCoopers has been the company’s auditor since 2002.
About 75% percent of 2019’s $13.2 billion in Oral, Personal and Home Care sales came from outside North America. Sales are split almost evenly between developed markets (52%) and emerging markets (48%). Based on product category, 46% of sales are from Oral Care, 20% Personal Care, 18% home care, and 16% pet nutrition.
The company reports on a calendar-year basis.
At 27-times trailing earnings, the shares are also near the top of their three-year P/E range. The shares have outperformed the market as organic sales have grown for eight consecutive quarters in an environment that has favored high-quality stocks.
Our dividend discount model allows us to analyze the longer-term profitability of the business, financial strength, profitability, and ability to generate dividends. We are using a cost of equity of just under 7%. We continue to model a transition to a stable growth rate of 3%. Based on our 2021 estimate and our preliminary estimate for 2022, this analysis points to a fair value of approximately $94 per share. We are raising our target price to $94 from $90.
On January, BUY-rated CL traded at $84.06, down $0.27.