Summary
- In this article, I give a full view of Church & Dwight, a leading producer of consumer-packaged goods.
- The core of this article is to highlight the way Church & Dwight has achieved great compounding results through its business model.
- I end with some considerations about shareholder return and current valuation.
Introduction
Consumer staples companies are being screened by many investors who seek reliable and predictable companies with stable growth and that have a policy of returning cash to shareholders via dividends and share repurchases. Since I am building a personal dividend growth portfolio, I spend some time looking around and researching possible companies to add.
In this article, I would like to share the research I have done on Church & Dwight Co. ( CHD ), one of the leading U.S. producers of sodium bicarbonate (baking soda) and that has been expanding its brand portfolio over the past 20 years through key acquisitions.
An overview of the company
Many American investors should know the most famous brand owned by Church & Dwight: Arm & Hammer. However, as we will see, non-American investors might still not be very familiar with this company as it has started to develop its international activities only of late.
The company was founded back in 1846 and it has an interesting history . The two founders were Austin Church and John Dwight who decided to prepare bicarbonate of soda for commercial distribution. They packaged this product by hand into paper bags in their first factory which was none other than Dwight's kitchen. From this milestone, the company developed a broad range of products using baking soda to clean, deodorize, leaven and buffer.
Nowadays, about 43% of the company's domestic consumer products are sold under the very well-known Arm & Hammer brand that can be seen not only on baking soda, but also on liquid and powder laundry detergent, cat litter and dental care products.
"Power Brands"
Since 2001, Church & Dwight has begun to focus on key acquisitions of brands that are usually number 1 or 2 in their market. This has brought the company to the point it now owns, among many brands, 14 so called "power brands" that represent approximately 80% of its total revenues ($5.2 billion in 2021). As shown in the graph below, the company is very clear in stating that it will not stop at 14 power brands, but that it has made it a key point of its business model to add new leading brands. Thanks to these acquisitions, Church & Dwight has managed to multiply its 2001 revenue by 5x.
To get a quick grasp of what each of these power brand does, we can look at this other infographic, which clarifies, for those who are not familiar with these brands, what they are mostly focused on.
Church & Dwight's portfolio is also well balanced between premium and value brands, with the former accounting for 60% of the portfolio and the latter for the remaining 40%. Overall, the company sells more than 80 brands.
The criteria that lead to an acquisition are quite clear:
- Brands with #1 or #2 market share
- Brands with higher growth and higher margin
- Asset light brands
- Brands that can leverage Church & Dwight structure of manufacturing, logistics and purchasing
- Brands that can deliver sustainable competitive advantage
We have to acknowledge that, so far, the company has been executing quite well according to these pillars and it has delivered an outstanding twenty years of growth. This is why the company clearly states in its Annual Report that:
We possess a competency in targeting, acquiring, and integrating brands and businesses. In a world where seven out of 10 acquisitions do not create value, we have a superior track record in making accretive acquisitions.
An example of this was the last acquisition of Therabreath , completed on December 24, 2021. Therabreath is brand of oral care products it is has the second largest market share among alcohol-free mouthwash producers. Church & Dwight paid $580 million, for a company whose annual net sales for 2021 were approximately $100 million. This is a price/sales multiple of 5.8 which is not very expensive and proves a part of Church & Dwight's ability in signing good deals. Now, Therabreath's EBITDA was $27 million, which equals to a 31% margin. Moreover, as the acquisition press report stated, the forecasted synergies brought by the integration of this brand into Church & Dwight's distribution network, manufacturing footprint, and operating expertise are forecasted to achieve an estimated $6 million in run rate operating synergies by 2023.
Business Segments
Church & Dwight is divided into three business segments: Consumer Domestic, Consumer International and the Specialty Products Division ("SPD"). This last one is a division that focuses on specialty inorganic chemicals, animal nutrition, and specialty cleaners. In 2021, household products constituted approximately 53% of the Consumer Domestic sales and approximately 41% of the consolidated net sales; personal care products constituted approximately 47% of the Consumer Domestic sales and approximately 35% of the consolidated net sales.
Overall, in 2021, the Consumer Domestic, Consumer International and SPD segments represented approximately 76%, 18% and 6%, respectively, of the company's consolidated net sales, as shown below.
The company has begun to expand internationally only over the past few years (foreign sales are accounted for only from 2017) and this should make investors aware that there is indeed quite a bit of room for the company to grow organically, asides from M&As. True, the company operates in a highly competitive industry where it already has a control over several international markets. However, as the company wrote in its 2021 Annual Report, while the U.S. grew 2%, the international division grew by 6%. The international sales breakdown is as follows:
- Europe 33%
- Canada 26%
- Australia 8%
- Mexico 8%
Globally, Church & Dwight has subsidiary operations in seven countries (Canada, Mexico, U.K., France, Germany, China and Australia) and sell into over 130 other countries.
The "Evergreen business model"
Church & Dwight boasts about its business model that over the long-term is able to deliver superior returns. Thanks to this model, which we will consider in a moment, the company isn't shy when it states that in the past decade it was able to deliver an annual total shareholder return (TSR) of approximately 18.0%, beating the 14.3% TSR of the S&P 500 stock index during the same period.
The main points of this business model are shown in the image below.
As we can see, the company is run with the aim of creating a 3% annual organic sales growth. In order to achieve this result, the model aims at growing domestic sales by 2%, international sales by 6% and SPD sales by 5%. This is combined with a 25 basis point of gross margin expansion and a 25 basis point reduction of SG&A costs. This results in a 50 basis point annual operating margin improvement. Thanks to gross margin expansion the company can fuel its organic growth enabling it to increase investments in marketing, R&D, and technology.
Regarding SG&A, the company shows that it is 13.6% of sales and 10.7% excluding amortization. This overhead rate is one of the lowest in the CPG space. Moreover, Church & Dwight has one the highest revenue per employee of any major CPG company ($1 million per employee), a measure of productivity that is often overlooked.
Another sign of good cost management was that the company reduced its marketing spending, mainly in household products, as supply shortages impacted its ability to meet customer demand. Marketing expenses as a percentage of net sales decreased 100 bps to 11.1% in 2021 as compared to 2020 due to 70 bps of leverage on higher net sales and 30 bps on lower expenses. I think this was a smart move as the company understood it didn't need to drive more demand towards its products. It also made me consider that, at times of high demand, advertising spending is probably among the first costs to come down, hurting advertising companies. It is during difficult times that many companies need to spend more on advertising in order to sell.
The result of all these steps is that the company targets to grow its EPS by an annual 8%. Over the past decade, the company has actually achieved an average sales growth of 4.3% and an EPS average growth of 10.6%, beating its own targets, as shown in the Global Consumer Conference Presentation.
Along with consumer brands, we have to consider that the Specialty Products business should grow 5% annually taking advantage of big tailwinds. In fact, animal and food production will see great demand as the global population is expected to rise from 7.7 billion today to 9.7 billion in 2050. While demand for protein will increase, there is also a trend to move away from the use of antibiotics, hormones, and chemicals in animal nutrition. Church & Dwight owns a portfolio of natural supplements, prebiotics, and custom probiotics for dairy cows, poultry, cattle, and swine that seem well-positioned for this global growth.
Furthermore, the company has been able to diversify its portfolio in order to offset cyclicality. In fact, in 2015, dairy represented 99% of its animal productivity business, which is cyclical. The focus on the non-dairy business which now weighs 24% has created a better balance.
One last fact about how the company is managed is how it handles its bonuses. These are tied directly to four equally weighted drivers of TSR:
- Net sales growth
- Gross margin expansion
- EPS growth
- Operating cash flow
Its equity compensation consists predominantly of stock options that are valuable only when the value of the stock rises and this means that internal shareholders will not put downward pressure on the stock. Moreover, Church & Dwight's senior management team is required to maintain a significant investment in the stock to be closely aligned with the stockholders.
Financials
If we look at Seeking Alpha graphs of the income statement, we see the trends every investor wants to see: a steady growth of revenue that goes along with an equally steady gross profit growth that fosters operating income and net income growth. EPS is trending upward, while outstanding shares are reduced.
We already talked about the company's $5.2 billion in revenue.
Now, let's see what happens from the top line to the bottom line. Church & Dwight has a gross operating margin above 40%. In 2020 it achieved 45.2%, while last year the margin came down a bit to 43.6%.
As the company published its Q2 results , the operating margin decreased once again to 41.2% due to the impact of higher raw material, manufacturing, and distribution costs that were not completely offset by price hikes. However, even though the company has lost 400 basis points in less than two years, we are still talking about a company with high gross margins. This is a point I really like about Church & Dwight because without margins there is little chance for a company to invest and return cash to the shareholders. The company also has enough pricing power to climb back to higher margins. In February, it announced price increases covering 80% of the global portfolio. Just recently, it passed on a second round of price increases in laundry and litter that just hit the shelves.
As we move to the cash flow statement, we see it is also increasing year after year. However, we should be aware of the fact that the free cash flow reported by Seeking Alpha is not the same the company reports because of two different ways to calculate it. In fact, Church & Dwight calculates its free cash flow only as cash from operations minus capex which in 2021 was $875 million (while Seeking Alpha has $720 million). The company does this because it wants to highlight its high free cash flow conversion rate which was 116% last year. Church & Dwight has been consistently converting over 100% of net income into free cash flow. Over the next three years, its guidance is for a generation of over $2.4 billion in free cash flow. Over the last five years, the company averaged a 7% dividend growth rate, well ahead of the peer average. It has paid a quarterly dividend for 121 consecutive years.
Let' get to the balance sheet. Since Church & Dwight made many acquisitions, financing most of them through debt, we have to look to see if the company is overleveraged or not.
The company finished 2021 with $240 million in cash and cash equivalents and $252.8 million in short term debt and $1.6 billion in long-term debt.
At the end of June 2022, the cash position is up to $639.7 million, the short-term debt has been paid off without new debt being issued, while the long-term debt has increased to $2.1 billion. The debt/cash ratio is 3.2. However, I usually assess the company's leverage through the debt/EBITDA ratio which is 1.79. This means that it takes Church & Dwight less than two years of EBITDA to pay off its whole debt. I usually invest in companies that are under 3.0 as per this ratio.
In the Annual Report, Church & Dwight declared that approximately 75% of the outstanding debt has a fixed weighted average interest rate of 3.0% and the remaining 25% is constituted of commercial paper issued by the company that currently has a weighted average interest rate of approximately 0.30% and the term loan due 2024 with a current rate of approximately 0.80%. This makes me think the company is in a safe position even as interest rates are expected to reach 4%-5% by the end of the year.
Overall, I see a very well-managed company with very healthy financials that can withstand possible downturns or hardships. I would say that we are looking at a perfect compounder that has the business model and the financials to keep on growing on an exponential trajectory which, though driven by single-digit numbers, can deliver very good results over a long period of time.
Customer risk
Church & Dwight's largest customer is Walmart, which accounts for 24% of total net sales. It is clear that the relationship with Walmart is important and strategic. However, given the quality of Church & Dwight's products, I would see it unlikely for Walmart to stop selling them on its shelves.
Regarding other major customers, Church & Dwight informs us that no other customer accounted for 10% or more of its consolidated net sales in the three-year period from 2019 to 2021. Besides, its top three customers accounted for approximately 37% of net sales in 2021 and 36% of net sales each year in 2020 and 2019. The company expects that a significant portion of its net sales will continue to be derived from a small number of customers and that these percentages may increase if the growth of mass merchandisers continues. Ecommerce is growing too and it could be a possible hedge in case one of the main customers breaks the relationship with the company. As reported in the last earnings call, in Q2, online sales, as a percentage of total sales, was 16%.
Shareholder return
Dividend
The company has paid a dividend for 121 consecutive years and it is now in the Dividend Aristocrat list as it has paid a rising dividend for the past 26 years. Let's start from the forward free cash flow yield. Here the company has a 3.66% reading. The current dividend yield is lower at 1.23%. However, the dividend has grown over the past five years at an average close to 7%. This growth rate would be very good in times of low inflation. However, at the moment, it is not able to keep up with it. The payout ratio is around 34% and would give the possibility to the company to raise its dividend. However, given how conservatively the company is run, I would not expect the company to go over a 40% payout ratio. Keep in mind, we are looking at a company that aims at long-term compounding rather than short-term one-offs.
Buybacks
The company currently has $729.7 million in share repurchases available. Over the past ten years, the share count has been reduced from 277.5 million outstanding shares in 2012 to 242.5 million at the end of last year. This is a 1.34% average decrease that is part of the total return to the shareholders.
Dividends and buybacks, combined with capital appreciation, have led the stock to outperform the S&P500 by a great extent over the past three decades, as shown from the graph below.
Valuation
Church & Dwight is a very well-managed company that can make accretive acquisitions that push higher both top line and bottom line results. This is why it trades at a premium and it rarely dips significantly. As shown in the chart below, the company has traded almost in the 24-30 P/E range and it currently is in the middle of this range. Even its fwd EV/EBITDA is a bit high as it currently sits around 18.5, about 50% above the industry average. True, the company is clearly above average, but, still, this is a big premium to pay.
However, from a free cash flow and dividend yield point of view, the stock is a bit expensive. Since this year's growth is expected to be below 6% due to the difficult economic environment we are in, I don't expect the dividend to grow more than 4%. Since I am looking for stocks to put in my dividend growth portfolio, I believe this is not the current time to add this new position.
I ran my discounted cash flow model using the growth data from the evergreen model the company shows. At the current price, I still get that the company trades at an 18% premium. For visual reason, my model gives a sell rating when the intrinsic value is below the current price. Then it is up to me to consider external factors that may explain the result.
As said and shown, I do believe Church & Dwight deserves a premium. However, its current price is still too high for me and this is why I rate it as a hold. I believe shareholders who have gotten a stake of the company will cling to them as they are very valuable. As for me, I will patiently wait for the stock to drop below $80 before considering initiating a position.
For further details see:
Church & Dwight: A Compounder In Action