RBGPF - Reckitt Benckiser Group: Valuation Gap To Close On Improved Fundamentals

2023-03-28 14:24:56 ET

Summary

• I expect the Reckitt Benckiser Group business to experience stable growth in the near future based on its recent investment and execution improvement.
• Reckitt Benckiser has a strong balance sheet, which could enable it to pursue M&A opportunities.
• Reckitt Benckiser Group's current valuation is at a discount to its peers, and I expect the gap to close as the company demonstrates sustained gains in market share and continued improvements.

Summary

Now that Lysol, the flu, cost inflation, and the end of the Reckitt Benckiser Group ( RBGLY ) three-year reinvestment period have all had their effect, I anticipate more normalized, stable, and extrapolated growth for the company. There are two main points that I believe the bull case rests on. The first is the company's leadership proving to investors that they can increase revenue by increasing their market share (i.e., execution). The second is a healthy stream of free cash flow ("FCF") that can be reinvested or used to fortify the balance sheet (consensus have the business generating cumulative $5billion of FCF in the next 2 years). I also anticipate a re-rating by the market once the company demonstrates sustained gains in market share, as the stock is currently trading at a discount to its peers. A buy rating is what I'd give Reckitt Benckiser Group.

Organic growth to improve post reinvestment phase

Recent results demonstrate the efficacy of Reckitt Benckiser Group's investments, as organic growth has been strong in the ~8% (from FY20 to FY22), propelled primarily by volume expansion and, to a lesser extent, covid tailwinds. These are crucial indicators that the turnaround is producing results. Management is also confident on FY23 innovation pipeline, which gives further assurance on growth prospects. With regards to execution, management has continued to invest in strengthening the supply chain, bolstering R&D with the hiring of new scientists, and enhancing distribution operations in order to improve execution. In addition, with an eye toward outperforming the categories and generating a sizable pipeline of launches, management has also continued to invest in marketing, which I think is important to drive market share gains.

As such, I think Reckitt Benckiser Group have what it takes to keep growing in volume, especially since I anticipate innovations to pick up the pace in the near future. With the exception of Nutrition, I believe that RBGLY will emerge successfully from the challenging comps it faced throughout COVID. Overall, I anticipate a low-single-digit increase in organic top-line growth in 2023 (similar to consensus expectations). The reopening of China should also help the Core business expand through increased market share.

Margins should improve

The general idea is that the industry should see margins get impacted from high cost inflation. I can't speak for every business, but I think RBGLY stands out because I anticipate it will increase its profit margins thanks to gains in efficiency and the advantageous effects of its pricing strategy. Aside from controlling expenses, I anticipate RBGLY to maintain a healthy gross margin by shifting its focus toward the Health & Hygiene sector, where it has been investing steadily over the past few years to fuel innovation (for instance, extending the reach of Dettol and Lysol into adjacent markets, such as laundry sanitizers) and supply chain execution (for instance, increasing capacity invested by 30% for OTC products in 2022). The increased gross margin will bring in more cash flow that can be put toward R&D to fuel expansion, or simply let it flow through to the bottom line, leveraging fixed costs to boost profit margins.

Capital allocation

Reckitt Benckiser Group's less than 2x net debt to EBITDA ratio and 90% FCF conversion rate are both results of the company's strong execution capabilities and focused capital allocation policies. Using consensus estimates, RBGLY is expected to generated a cumulative $5 billion in FCF in FY23 and FY24, which can be used to pay down debt. With additional debt headroom, I would not be surprised to see more movements in the M&A department. RGBLY's diversified portfolio means it doesn't need to make huge acquisitions, I note that RGBLY has the capacity to do so as it could easily swell up its balance sheet to gather an additional firepower of around $5 billion (FY24: EBITDA of $4.2 billion at 3x net debt to EBITDA leverage). I believe the narrative of management seeking M&A to enhance growth would further excite the market as growth would further outpace peers. This would help close the valuation gap vs peers.

The new dividend policy is also excellent news for shareholders. Management is now focused on delivering annual dividend growth that are sustainable. RGBLY's ability to generate FCF and leverage ratio makes me confident in its ability to maintain this policy. In fact, I think management can go a step further to consider share buyback, which would further drive shareholder returns and also EPS growth.

Valuation

The crux of the thesis is that valuation gap vs. peers should close. Given the strong execution and guidance, I believe it is only a matter of time before this gap closes. I anticipate that the stock price and valuation multiples will be driven by the market's reappraisal of the evidence of the underlying improvements to the business made. At 17x forward P/E, the stock trades at a 25 to 30% discount to peers like L’Oreal, Clorox, Procter & Gamble, and Beiersdorf, Church & Dwight, and Colgate, which the gap has widen in the recent months to near 2018/19 levels.

Given the firm's improved fundamentals, I don't think this discount is appropriate. As Reckitt Benckiser Group continues to show promising results, I anticipate the re-rating to close the gap between its current valuation and its true value.

Conclusion

I expect Reckitt Benckiser Group to experience normalized and stable growth moving forward, and the bull case rests on the company's leadership proving their ability to increase revenue by increasing market share and generating healthy free cash flow. Organic growth should improve post-reinvestment phase, and margins to improve through gains in efficiency and the advantageous effects of pricing strategy. Importantly, I believe the valuation gap between Reckitt Benckiser Group and its peers should close as the firm shows promising results. I reiterate my buy rating.

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