Saturday, February 25, 2012

CL 10-K Released

One of my favorite days of the year is the date of the release of the Colgate-Palmolive (CL) form 10-K, otherwise known as the Annual Report.  In it, we get to drill into the numbers, and look at the gruesome details of the company's performance.  While much of this information is provided by CL in the earnings announcement in January, the full report is always my basis for evaluating the company, as it is only in the annual report that we can fully understand the changes to the capital account (i.e. how many shares the company handed out in compensation).


Let's do the important part first - I think the intrinsic value of CL lies between $95 and $105, with a best guess of around $101.

It is always important to compare the actual results to those of your projections for the company in a DCF.  With some self-congratulation, I was surprisingly accurate, having nailed Net Income (before minority interest) within $4m on a line item of $2554m, about 2/10th of 1% error.  This was achieved with some underestimation of total revenue offset by overestimation of the gross margin the company would achieve.  Several of the operating estimates were quite close, even though they were significantly different from FY2010 results.

As I slightly underestimated depreciation and overestimated capex, actual owner earnings were higher than I anticpated (before minority interest).  Using a discount rate of 8%, which seems fair for such a solid and apparently predictable earnings stream and a terminal growth rate of 2%, We arrive at a PV of $48bn, very close to the current market value of $45bn.  Using a truly fully diluted measure of shares outstanding (which assumes all unvested restricted stock awards and options will be exercised), we have a value of about $95 per share.  One would be tempted at this point to argue that the shares are fully valued, indeed, that they could potentially be somewhat overvalued.

The key variable in my mind is gross margin.  Management has communicated a 65% gross margin target, although, due to price actions in 2011 and commodity costs, margins actually fell in 2011.  The above valuation assumes that margins return to their previous norm of 59%, and growth ticks on at about 6% per year, excluding currency fluctuations.

Were management able to restore margins to 59% and to further expand them, at 0.5% per year over the next decade, falling slightly short of their target, present value would be about $55.5bn, or $110 per share on a truly fully diluted basis (505mn shares outstanding).  These are, to my way of thinking, the main anchor points.  That is, intrinsic value of CL lies between $95 and $105.  So a 3 to 13% gain seems possible, with a nice 2.7% div yield.  One should expect a dividend hike to around 62c per quarter and a price around $101.

Thoughts on management effectiveness

If the Ian Cook era at CL has a theme, it is leverage.  While previous managements have been systematic repurchasers of stock, this management has become downright aggressive.  At first, I thought this was a reaction to a tax code change that required the company to convert the convertible preference stock used to fund the Employee Stock Ownership Plan.  This conversion created 21mn common shares overnight (they had always been there, but were only slowly converted over the previous two decades).  I thus assumed that the step up in repurchases was aimed at keeping the number of shares outstanding relatively stable.  In fact, Cook has continued to repurchase shares at a rate of about 20mn per year (up from 14mn or so under Reuben Mark) and has initiated a significant repurchase program of 50mn shares, which he has indicated he wishes to complete within 2-3 years.

This is no bad thing, provided that he is able to repurchase shares at a discount to intrinsic value.  It appears that CL is doing so, but that discount might be rather small.  What is more likely, however, is that the company has a very high ROE (return on shareholders equity) target.  The single best way to manage the amount of equity is not, sadly, to manage the business, but rather to manage the capital account.  Dividends are a key aspect of CL's investment value for investors, but these are also hard to cut (especially since the company prides itself on paying uninterrupted dividends since 1895 and on raising dividends every year for a half century).  Buybacks offer far more flexibility.

Consider this table (it is my favorite and another reason I always read the annual report).  In it, we see the 10 year development of many key statistics for the company.

The first observation is that Sales On Assets has been pretty stable over time. This means that to grow the business 6% per year, we have to expect assets to grow at about the same rate, thus we can expect that CapEx will continue to exceed depreciation, or there will be some big acquisitions, or the company will stop growing.  Cook has stated that his "funding the growth" initiative is designed to free up the capital to grow from operatoinal efficiencies.

What we also notice is after a very weak point in 2004 (when the company announced a major four year restructuring) there was a steady lift in shareholders equity, book value per share and most important improvement in ROA and ROE.

Since 2008, (the start of Cook's tenure) however, asset effectiveness has been on a bit of a downward trend, and while the company continues to deploy assets quite effectively (earning 19% on assets), there is still concern that the company may be finding it difficult to deploy cash as productively as before.  Part of the issue, when we dig into it, is that the company has made some significant investments in European operations, acquiring GABA and Sanex, major continental brands.  This strengthens the company's market share in Europe, certainly, but as Europe is the geographic market with by far the worst ROA growing there will hurt ROA, unless significant operational synergies or asset dispositions can be found.  (Europe was the laggard even before the acquisition massively boosted identifiable assets of the Europe operation), 

It would be more enjoyable to see further growth and investment in pet nutrition, since this segment earns massive operating profits on assets (about 50%).

The other feature we notice is that assets are being financed with debt, not with equity.  This has the benefit of lower interest rates and boosting ROE (which, as I said, is a key metric in exec compensation) bit it also leaves the company vulnerable to seizures in the credit markets.  Given the remarkably low rates available, however, it is understandable that management wants to aggressively remake the balance sheet.

All in all, CL is a company whose stock I enjoy holding, and whose dividends I enjoy receiving.  I will likely purchase more when I liquidate some winning positions, always taking a part of the gains and converting them into a permanent, rising annuity.

Please note, I can supply a copy of the DCF model I use to anyone who writes.


  1. This is really a long reading and really appreciate it and very awesome.nice article.

  2. A reader writes:

    Are you concerned with decreasing book value, and rising Price/book and eps growth slowing?

    This is an excellent question, and in many cases would be a concern, however, in the case of a franchise like Colgate, I am less concerned.

    First, the decline in book value is entirely due to management's decision to distribute more than 100% of earnings. Under Ian Cook, they have been very aggressive in repurchasing stock, and management is signalling that this will continue. But if we look at what I believe is Buffett's favorite investment - See's Candies, we see a business like Colgate. Slow unit volume growth (2% per year at See's), but with no additional capital required. In fact, the book value of See's has gone from $7m to $0 while the company has paid dividends of $1.5bn over the past 30+ years. Colgate is attempting to do something similar by using debt instead of equity financing. With low rates, it seems a reasonable strategy.

    I preface by saying that the growth forecasts used for my best case valuation projection are only about 6% per year, with a terminal growth rate of 2%. I don't expect massive growth go forward.

    Another reason I am less concerned with slowing growth in EPS is that the somewhat faster growth from 2004-2009 was due to big charges in the early years of Colgate's restructuring program.

    Where I do have concerns is asset efficiency and possible issues with capital allocation. Management has been growing the business through acquisition in Europe, and is killing ROA there. In general, a new $1 of capital employed in Colgate should generate $1.19 of revenue, on which the company obtains an operating margin of 23%. That is, each $1 deployed at Colgate generates $1.19*0.23=$0.27

    Not too shabby by any stretch. But if gross margins fall (as the have) or the amount of revenue generated for a new dollar of investment is low, then value can be destroyed. After all, Colgate's price / book reflects the incredible efficiency of its equity.

    By using more debt, the company can continue to earn high rates of return on equity, even if new investment is less efficient than previous investment (the company can lower its capital costs and hurdle rates of return), but it does add risk, as in 2008, when, companies which financed mostly short (through rollovers in the commercial paper market) found themselves unable to refinance, and caught without the cash to operate. Ugly.

    Fortunately, Colgate seems to be locking in longer term financing deals, and so is unilkely to get hit with the same liquidity problems.

    Management may also be expecting significant inflation, and looking to lock in low rates that it can repay with very inflated dollars in 10-20 years.

  3. A reader writes:

    Can u explain why a company like MSFT or Apple whose book values keep soaring where some consumer stocks like CL seem to have BV going up and down?

    The short answer is, MSFT and AAPL retain more of their earnings than Colgate does.

    This shouldn't be much of a surprise. Technology companies have to constantly innovate and invest in new products in order to continue to compete. Colgate sells products that do not need to be constantly updated and improved (though there is a great deal of marketing effort that goes into arguing that there is). It is unlikely that a competitor is going to invent a platform that nearly eliminates the need for your core product, as often happens in the IT industry.

    As a result, required CapEx at CL roughly equals depreciation, which means that CL can pay out substantially all of its earnings. It has been paying out a bit more than that of late, but BV was actually much lower just a few years ago.

    In contrast the need to have ready cash to invest and the higher risk inherent in technology investments, drives tech firms to keep more cash as a safety cushion.

    There is another reason, as well, I believe that MSFT AAPL INTC and others pay out less than 100% of earnings: lower R&D or CapEx signals that the company is out of new investment ideas. Since tomorrpw's IT earnings are entirely dependent on today's R&D, lower prosepctive R&D implies lower future earnings.