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).

Valuation

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.

Great Colgate Palmolive Analysis

After reporting a solid first quarter and indicating that it has instituted pricing actions that will enable it to continue to gain market share and hold margins, CL stock has rallied substantially and now trades near all-time highs.  Which begs the question - has the stock topped out?

Management has raised the dividend to $0.58 per quarter, or $2.32 over the next year and has continued a frantic pace of stock buybacks while managing to pay cash for Unilever's Sanex business.  This will provide CL with an even stronger European market position.

This breakdown estimates the value of CL stock at $95 based on historical valuation.

I think it is about right based on my own internal DCF models. My own view is that the company is likely to earn near $5 per share this year.  It will depend on how the 2nd half goes (though lower commodity costs should help margins) and of course, how much stock the company is able to buy back.




There is no doubt that the company will be able to continue to grow earnings and take advantage of its market position to maintain margins (the company vows to improve them).


The stock remains a core holding for me, with the expectation that it will provide a nice dividend income sufficient to function as a small pension in retirement.  Nothing is more satisfying than watching the growth in each quarterly dividend payment and knowing that even as I am accumulating shares, the number of diluted shares outstanding continues to contract sharply, ensuring that each share represents a growing share of the future earnings of an incredible business.

CL - Colgate-Palmolive Update

In my last post about Colgate-Palmolive, I discussed whether it was time to sell, as the stock has enjoyed a nice run. It has held its position, even as the markets have melted down, mostly because at the same time the stock market has melted down, the dollar has fallen, which is leading to expectations that the company's results will continue to be strong.

Over at the AntiBrokers, they have analyzed the chart for CL, and have concluded that the stock's current run is not done, and if it can break out of the 60-65 range, we should expect further bullishness.

Until I find an investment I like more, I will continue to hold

CL - Colgate-Palmolive

How to play the falling dollar? Everyone from Warren Buffett to Joe Kernan thinks that the dollar is headed lower against othe currencies. Treasury Secretary John Snow wants "currency flexibility" by which he means a weaker dollar - as a matter of government policy. They cite many reasons to justify their position: trade deficits, a slowing economy, easy money, and a negative savings rate. In seeming confirmation of their view, the dollar has definately taken lumps lately.

I will leave the economics of the dollar to another post, but suffice it to say, I believe that easy money from the Fed has very probably devalued the dollar, so further weakness would not be surprsing.

What to do? How do I protect myself from the ravages of a weaker dollar and lower purchasing power? Buy foreign currencies? Purchase commodities? Foreign equities?

While I do invest in international equity through my 401(k) I do not generally pick international stocks myself, even though I speak two languages, and many international stock reports are available in English. I don't invest directly, because the reporting and accounting rules for foreign companies are different than those in the US, and I have no expertise in those systems. I may consider studying them in the future, but I would probably choose to invest in other US assets before investing directly in foreign stocks. The only exceptions are those companies that also list their shares on US exchanges (ADRs), and therefore make filings with the SEC.

Similarly, I realize that the commodities and currency markets are outside of my expertise. So, what do I do? Invest in US equities with lots of overseas exposure!

Here's the thing - a weaker dollar is far from a certainty, only a possibility. As an investor, I want to be prepared whatever happens, and by investing in good US businesses with extensive foreign sales, I am. If the dollar strengthens, I make money, if the dollar falls, I make lots of money.

For the same reason, I like consumer staples. Here, the international operations help again - if the global economy continues booming, or even simply keeps growing, rising incomes in Asia mean growing sales, while, if the economy stalls, well, Westerners will keep buying basic necessities. Either way, I make money.

All I need is the right company, and in Colgate-Palmolive I found it. In my mind, this is about the most perfect business anywhere. Not only does it offer upside potential with downside protection, it also demostrates the following characteristics.

• A simple, understandable, profitable business, with a wide moat. This is a business that manufactures and distributes a host of household, personal care, and pet care products. The business has strong and rising margins (over 50%, excluding the temporary effects of their restructuring program). These products and margins are protected by the strong moat of their brands, including the eponymous Colgate and Palmolive brands, Irish Spring, Ajax, Softsoap, and Science Diet. People are remarkably loyal to brands. My girlfriend swears by Colgate Total, and the price differential that you would have to offer her to switch is huge. I'm not sure you could get her to switch if you gave your brand away.
  

• Honest, effective, shareholder-friendly management. What do these numbers mean to you? 591, 585, 578, 567, 551, 536, 534, 527, 516? They are the number of common shares outstanding from 1997 to 2005. The company has just committed to repurchase 30 million more shares over the next two years. What about these numbers? 0.53, 0.55, 0.59, 0.63, 0.675, 0.72, 0.90, 0.96, 1.11? That is the cash dividend per share over the same period. Management takes every excess dollar and returns it to shareholders. It keeps equity compensation to a minimum, and has consistently reduced the amount of convertible preference stock. As far as honestey is concerned, the company regularly gets top billing from Institutional Shareholder Services, for the independence of the board. Finally, in the best measure of management effectiveness, return on equity is over 100% (because of all the capital regularly returned to shareholders), and return on assets is in the double digits. Management does not uses shareholder's money to fund its pet projects, only the profitable ones.

• Good growth potential. Household products may not seem like a growth category, but on a worldwide basis, they are. As incomes rise, people chose to invest in more preventive medicine (good dentistry being one of the most important indicators of health, since it influences diet and other health issues), invest in larger homes (that require more cleaning) with modern appliances and the like. The company's ability to continue to grow revenue at a high single digit basis, or better, is likely.
  

• A good price. When I purchased the stock in October of 2004, the stock was near a 52-week low, and trading at about 20x trailing earnings that were hampered by older factories with higher costs (due to lower efficiency). Still, the stock was attractive, the dividend yield had risen to 2.5%, earnings were clearly at a nadir, and opportunities to improve margins abounded. Shortly thereafter, in fact, the company announced a new restructuring program (first in 10 years), and, after a charge in the 4th quarter, began a process of modernization of facilities. That program is in its second year (it is a four year program), and so far, results have been exemplary. Still, the stock has experienced both increased earnings and multiple expansion, and at 24x earnings, no longer looks cheap.

In short, I own shares in a well run company, with good growth prospects, excellent management, and good downside protection. Revenue is likely to grow 6-8% per year, margins should expand, pushing overall earnings to 7=10% per year, and share repurchases should increase EPS at 8-12% per year, with dividends increasing at a comparable rate.

Downside risk is small, the stock rallied in the middle of last week's commodity and market meltdown (lower commodity prices mean lower costs and better margins) though the higher multiple invites more price volatility.

Still, the question remains, does it fit in my portfolio at $60+? My goal is to grow at 20% per year, and while the stock has achieved this over the last 19 months, I don't expect it be able to maintain this rate going forward. On the other hand, it helps to prevent losses (guaranteeing a positive portfolio return, and from my first post, recall that losses kill compounded returns).

Your thoughts?