CL - Colgate-Palmolive: The Uptrend Should Continue

2023-12-20 17:10:53 ET

Summary

• Colgate-Palmolive should see a volume recovery in the coming quarters.
• Margin prospects also look good with moderating inflation.
• Valuation is lower than historical averages and the stock also offers a decent dividend yield.

Investment Thesis

I last covered Colgate-Palmolive Company ( CL ) in September when I upgraded my rating to a buy citing improving fundamentals and the stock has given mid-single digit returns since then. Looking forward, the company's growth prospects remain encouraging. The revenue growth is expected to benefit from volume recovery helped by easing comps, increased promotional activities and advertising, new product innovations, and carry forward the impact of past pricing increases.

On the margin front, the company should benefit from moderating inflation, price increases, and improving the mix in the Red Collar business. Hence, I believe the company offers decent earnings growth prospects. The valuation also remains favorable as it is trading below historical averages. As a result, I continue to have a buy rating on the stock.

Revenue Analysis and Outlook

Colgate's revenues have seen strong growth in recent quarters driven by price increases which the company implemented to offset inflationary pressures. In the third quarter of 2023, the company's revenue growth momentum continued to reflect the benefits of price increases, and its revenue increased by 10.5% YoY to $4.9 billion. Excluding a 0.5 percentage point benefit from foreign exchange and a 1 percentage point benefit from the acquisition of the Red Collar pet food business, revenue increased by 9% YoY on an organic basis. This organic growth reflects a 9.5 percentage point benefit from price/mix and a 0.5 percentage point of volume decline.

Looking forward, I believe the company's volumes should return to growth in the coming quarters. The company's volume has suffered over the past two years due to consumer trade-downs in an inflationary environment. However, the good news is that volume decline is becoming less worse due to easing comparisons and should return to Y/Y growth in the coming quarters. The company implemented significant price increases till the first half of 2023. However, with moderating inflation, it plans to become much more selective in terms of price increases moving forward which should help the volume recovery.

In addition, the company is also planning on increasing promotional and discounting activities across its end markets to help offset the impact of consumer trade downs in an inflationary environment. In the first half of 2023, the company went conservative on its promotional offers in order to improve the mix for margin growth in an inflationary market. This led to volume loss to peers, who kept promotional activities elevated throughout the first half. However, now that inflation is moving in the right direction, the company started increasing its promotional activities toward the end of the third quarter. This increase in promotional offers should narrow the promotional gap with peers and help in volume recovery, supporting volume growth in the coming quarters.

Further, the company has been aggressively increasing advertising spend over the last few quarters. In Q3 2023, advertising spending was up 23% YoY on an absolute dollar amount basis whereas advertising spending as a percentage of sales was up by 130 bps YoY to 12.2%. The company plans to keep advertising investments elevated in the coming year as well which should help sales.

In addition, the company is also focusing on product innovation to drive its long-term growth and market share gains. Management sees a good growth opportunity in Hill's Pet Nutrition in the prescription diet category. According to management, only about 5% of pet owners are using a prescription product, whereas potentially up to 80% could be using it. So as the company continues to innovate and launch products in this growing market, it could be a good growth driver in the coming years.

Moreover, over the last two years, the company has been able to support the topline growth momentum with the help of price increases. Looking forward, while I am not expecting significant price increases (like we have seen in the past few quarters), the carry forward impact of past price increases should result in good Y/Y pricing benefits at least till the first half of next year. Further, the company still expects to take incremental pricing in a few markets where inflation is still a pain point (e.g., Africa/Eurasia and Hill's Pet Nutrition.) This incremental pricing and carry forward benefit of past price increases should benefit the company's sales in the coming quarters. I expect investors to positively react to a balanced contribution from volume and price increases driving organic revenue growth in the coming quarters.

Overall, I remain optimistic about the company's revenue growth prospects ahead and the company should be able to deliver on its long-term revenue growth algorithm of 3% to 5% annual organic growth in the coming years.

Margin Analysis and Outlook

In the third quarter of 2023, the company was able to more than offset inflationary raw material costs (a 460 bps YoY headwind), and lower-margin private label volume associated with Red Collar's additional facility (a 50 bps YoY headwind) through price increases and cost-saving initiatives, which were a 360 bps YoY and 290 bps YoY benefit respectively. As a result, the adjusted gross margin increased by 140 bps YoY to 58.2%. The adjusted operating margin increased by 30 bps YoY to 21% due to gross margin expansion which was partially offset by elevated advertising spend.

Looking forward, I believe the company should be able to continue delivering margin growth. Inflationary raw material and packaging costs, which were a major headwind for the company's margin over the last couple of years, have now been consistently moderating on a sequential basis. In Q1 2023, inflationary raw material and packaging costs were a 770 bps YoY headwind. This declined to 540 bps YoY in Q2 2023 and to 460 bps YoY in Q3 2023. I expect these headwinds to further moderate next year as Y/Y inflation comps become favorable. Margins should also be supported by price increases in the remaining few markets where inflationary headwinds are yet to ease (such as agricultural costs at Hill's and specialty chemicals). Furthermore, logistics costs are also trending in a favorable direction, which should also decrease inflationary pressure on margins.

In addition, the company has also celebrated the one-year anniversary of its acquisition of the Red Collar pet food business and should see Y/Y benefit in the coming quarters as it has changed the mix of the business meaningfully in the last year. As I stated in my previous article , this business had some private label production before the acquisition, which was a low-margin business. However, since the acquisition, the company has been gradually decreasing this low-margin volume mix and expects private label volume to wind up exiting 2023. This should help the margins in the coming year. Hence, I remain optimistic about the company's margin growth prospects ahead.

Valuation and Conclusion

Colgate is currently trading at a 22.66x FY24 consensus EPS estimate of $3.45 which is lower than its 5-year historic average P/E of 24.62x. I believe the company offers good revenue growth prospects benefiting from recovering volume growth, increased focus on promotion and advertising, new product innovations, and a carry forward impact of past price increases. Moreover, with inflation moderating, margins should also improve. In addition, the company also offers a decent dividend yield of 2.46%. A good dividend yield combined with lower than historical valuation and good growth prospects makes Colgate a good buy.

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