Valuentum Exclusive Analysis for the Discerning Investor

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The consumer staples sector (XLP) hasn't done much relative to the broad market index (SPY) this year. Many might find this surprising given the pantry stuffing and perhaps changed consumer purchasing behavior. However, many names continue to be saddled with hefty net debt positions, an anchor to cash-based intrinsic value calculations, keeping them down while net cash and free-cash-flow giants continue to soar in this market. We’re still keeping a watchful eye on the sector.

By Brian Nelson, CFA

Church & Dwight

Church & Dwight (CHD) tends to fall under the radar for many seeking consumer-staples exposure, but the company is one of the best, with shares advancing a cool 35% this year. During its second quarter, report released July 31, Church & Dwight revealed sales growth north of 10% thanks to a 13.6% increase domestically. The company’s gross margin advanced 220 basis points in the period, while adjusted earnings per share soared 35%. The COVID-19 pandemic was obviously the key driver thanks to pantry loading by consumers--and management was quick to note:

Q2 was an extraordinarily strong quarter for Church & Dwight. Both our household and personal care businesses delivered higher growth as consumers and retailers focused on core essentials. We experienced strong consumption in Q2 and continue to see similar strength in July. The pandemic drove double digit consumption growth in several domestic categories, especially gummy vitamins, women’s hair removal, cleaners, and baking soda while restrictions on consumer mobility drove double-digit declines in other domestic categories, notably condoms, dry shampoo, and water flossers. Year-to-date shipments and consumption are in balance for our brands. However, retailer in-stocks lag normal levels for some brands, including gummy vitamins, baking soda, and cleaners. Online sales as a percentage of total sales continued to grow rapidly and reached 13% of sales in Q2.

For 2020, Church & Dwight is targeting sales growth of 9-10%, organic sales growth of 7%-8%, adjusted EPS growth of 13%, and cash flow from operations of $960 million--all measures raised meaningfully from the company’s last update. The only consideration that keeps us on the sidelines with respect to Church & Dwight, besides its huge run in price so far in 2020, is that it holds a rather large net debt position, to the tune of $1.43 billion. We don't like net debt positions at all. 

Clorox

Wow -- those that were in Clorox's (CLX) shares at the onset of the COVID-19 pandemic have been rewarded considerably. On a year-to-date basis, the stock is up more than 50%, and we didn’t think it was necessarily undervalued to begin with. Still, the market is pricing in the idea that consumers are going to change their spending patterns indefinitely, demanding pandemic-type levels of its products for the foreseeable future. While we expect consumers to be more aware of pandemic risk in the future and prepare/stockpile accordingly, we don’t think Clorox will enjoy the permanent step-change in demand its share price today implies.

Nonetheless, the company put up a monster quarter August 3. It reported a 22% increase in sales, which translated into a 28% leap in diluted net earnings per share during the calendar second quarter, its fiscal fourth quarter. Its gross margin increased 170 basis points in the period. The true gem in the quarter was its ‘Health and Wellness” division that witnessed sales advance 33% and pre-tax earnings soar 84%. Here’s the division’s commentary from the press release:

Segment sales were up behind double-digit growth in two of three business units. Growth was fueled by a broad-based increase in demand for disinfecting and cleaning products across the Cleaning and Professional Products portfolios related to COVID-19. The increase in pretax earnings was driven mainly by sales growth, which was partially offset by higher advertising investments and manufacturing and logistics costs.

Looking ahead to fiscal 2021 (its current fiscal year), Clorox expects somewhat of a return to “normalcy,” with the executive team planning for flat- to low single-digit increases in sales and a mid-single-digit decrease in diluted earnings per share. Most of the expected sales increase will be driven by “continued elevated global demand for cleaning and disinfecting products,” but the market may not be fully factoring in the expected earnings decline for the current fiscal year (fiscal 2021) and what fiscal 2022 might look like given a potential reset in its “Health and Wellness” division. It ended its fiscal 2020, the calendar second quarter, with a net debt position of ~$1.9 billion.

Colgate-Palmolive

Colgate-Palmolive (CL) reported solid second-quarter results July 31 that showed organic sales increase 5.5%, as it noted its base business earnings per share advanced 3%. The company’s GAAP gross margin increased 120 basis points, and it did a nice job retaining its global market share in toothpaste, which now stands at ~40%. The company is also the top dog in manual toothbrushes with ~31%. Here’s what management had to say about trends in its business:

While net sales growth was significantly impacted by foreign exchange, the 5.5% organic sales growth reflected a good balance of positive volume and higher pricing on a worldwide basis and was led by strong growth in North America and Hill’s…We continue to see elevated demand across our geographies in certain categories such as liquid hand soap, dish liquid, bar soap and cleaners. In other categories, we are starting to see the impact of consumers working down their pantry inventories, particularly in Europe.

Unlike many of its consumer staples peers, Colgate-Palmolive opted not to offer 2020 financial guidance, perhaps suggesting greater levels of uncertainty in its business than others' in the consumer-staples group. The firm expects a “mid-single-digit negative impact on net sales for the year from foreign exchange,” and maybe this is why it is not showcasing the type of visibility one might expect from a consumer-staples giant. Colgate-Palmolive’s net debt position stood at nearly $6.4 billion at the end of the second quarter.

Kellogg

As expected, pantry loading during the COVID-19 pandemic drove material demand during Kellogg’s (K) second quarter, results released July 30. I know that I’ve been loading up on lots of cereals and frozen foods as my family hunkers down at home. Organic net sales advanced 9.2% during the second quarter, while adjusted operating profit surged 26.7%, after adjusting for currency impacts. Currency-neutral adjusted diluted EPS jumped 27.3% in the quarter.

As with Colgate-Palmolive, the company is facing some headwinds with respect to currency, but it had the following to say about core demand:

Amidst the COVID-19 crisis, demand for packaged foods for at-home consumption remained elevated for longer than anticipated. This drove higher sales of the Company's products in retail channels, more than offsetting a related decline in foods sold in away-from-home channels. On an organic basis, which excludes the impact of divestiture and currency, the Company's net sales increased by over 9%.

Year-to-date, cash flow from operations increased significantly, to $971 million, and it matched the strong cash-flow generation with a reduction in capital spending, a strong combination with respect to driving free cash flow expansion, which came in at $753 million during the first half of the year. The company ended the second quarter with a net debt position of ~$7.2 billion, however.

Unlike Colgate-Palmolive, the firm pushed forward with giving guidance for the current year. Organic net sales growth is expected to be up 5%, while adjusted earnings per share will be roughly flat due to the prior July 2019 divestiture of its cookies, fruit snacks, pie crust, and ice cream cones businesses. It is targeting free cash flow of $1 billion during 2020.

Procter & Gamble

P&G (PG) is a name that we have included in the newsletter portfolios in the past. We had removed it because we didn’t like that it was hastily divesting some of its name brands, but the company has done quite well regardless. Shares are up roughly 7% year-to-date, and while it is not huge outperformance, it is outperformance, nonetheless.

During the calendar second quarter (its fiscal fourth quarter), report released July 30, the company reported 6% organic sales growth and a core EPS increase of 5%. Organic volume was strongest in its “Fabric & Home Care” division (home cleaning and dish washing products), which grew 8% in the quarter, but organic volumes actually declined in its “Grooming” and “Health Care” operations.

Looking ahead, P&G “expects fiscal 2021 all-in sales growth in the range of 1-3%...(including) an estimated one percent negative impact from foreign exchange.” It expects organic sales growth in the range of 2-4% and GAAP diluted net earnings per share expansion in the range of 6-10%. On a core basis, this growth rate is expected at 3-7%. It ended its fiscal 2020, the second calendar quarter, with ~$18.5 billion in net debt.

Concluding Thoughts

By far, the best quarterly reports from the group came from Church & Dwight and Clorox, but in both cases we expect a return to more normalized conditions in the coming years, which could see both organic sales and earnings declines from current levels. While we expect some changed consumer buying patterns as a result of COVID-19, we don’t expect the current pace of pantry loading to continue indefinitely. We have dabbled in the space in the past and we love the free cash flow generation of the group, but their net debt positions aren’t that great. The consumer staples sector hasn’t done that well during 2020 either, and it even has underperformed since the publishing of the first edition of Value Trap where we noted their comparatively stretched valuations due to their respective high P/E ratios and net debt positions.

Household Products: CHD, CL, CLX, ENR, HELE, KMB, JNJ, PG

Related: XLP

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Brian Nelson owns shares in SPY and SCHG. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.