2023-07-20 12:06:08 ET
Summary
- In FY24, Clorox Company's organic sales growth is expected to benefit from volume growth helped by easy comps, new innovations, and increased advertising.
- Margins are expected to recover to pre-pandemic levels due to carryover impact of pricing, moderating inflation, investments in digital infrastructure, and cost-saving initiatives.
- The company's stock is trading slightly lower than its historical average, providing a good reason to upgrade the rating to buy, given the prospects of volume and margin recovery in fiscal 2024.
Investment Thesis
The Clorox Company's ( CLX ) organic sales growth should benefit from the carryover impact of price increases implemented till December last year. I expect volume to also start recovering in fiscal 2024 due to easing comparisons, and less impact of price increases as the company does not plan to take additional pricing, giving room for volume to recover. In the medium to long term, the company's revenue should benefit from new innovations and an increase in advertising and promotions.
Additionally, margins are also expected to recover to pre-pandemic levels, benefiting from the carryover benefit of pricing, moderating inflation, productivity improvements from investments in digital infrastructure, and cost-saving initiatives. The company is also trading slightly lower from its historical average based on FY24 forward P/E. This reasonable valuation along with volume and margin recovery prospects in fiscal 2024, provides a good reason to upgrade the rating to buy.
Revenue Analysis And Outlook
In my previous article , I discussed the concerns regarding Clorox's volume decline due normalization of demand post the pandemic peak, and tight consumer spending in an inflationary environment. I also preferred to stay on the sidelines given its higher than the historical valuation at that time. The stock has underperformed since then declining slightly versus mid-teen gain in S&P500 ( SPY ).
The company has reported its earnings for the third quarter of fiscal 2023 since then. In the third quarter of fiscal 2023, the company continued to see benefits from price increases, which helped it post revenue growth. This was partially offset by volume decline. This resulted in a 6% YoY increase in sales to $1.9 billion. Excluding a 2 percentage point headwind from foreign currency, organic growth came at 8%. This increase in organic sales growth was primarily due to a significant price increase, which provided a 19 percentage point boost to sales, more than offsetting the 11 percentage point impact from volume decline.
In the quarter, management expected a mid-teen volume decline but delivered a low double-digit volume decline as it faced a one-time benefit from lower trade promotion spending and higher sales in the Pine-Sol business due to the competition being out-of-stock.
CLX's Historical Revenue (Company Data, GS Analytics Research)
Looking forward, while there are still some headwinds from demand normalization and volume decline associated with CLX's significant price increases, I believe volume decline should bottom in Q4. Moving into the next fiscal year, the company should see benefits from the carryover impact of past pricing increases, easing volume comps, new product innovations, an increase in advertising and promotions, and a new ERP system.
Clorox took significant price increases in 2022, with its last price increase in December'22. The company increased prices for its products to protect its margins from inflationary pressures. This also supported its sales growth through a good contribution from price/mix. Moving forward, the company does not plan to take additional price increases. However, sales growth should continue to benefit from the carryover impact of price increases for a couple of quarters more as the company laps all the previous year's price increases.
To give a recap on CLX's organic growth, the company is seeing benefits from price increases, while its volume growth suffered. This is due to a couple of reasons. One, the company saw good volume growth for its cleaning products during the pandemic as people around the globe focused on the hygiene of their surroundings as well as of themselves. Now coming out of the pandemic and getting vaccinated, people are generally less cautious about getting an infection than they were during the heart of the pandemic. This is leading to the normalization of demand and affecting volume growth. The other reason for lower volume growth has been significant price increases. In an inflationary environment, where consumer spending becomes tight, high price increases for products, even essentials lead to trade downs to lower price points or to other brands and private labels. These factors have impacted the company's volume growth and some of the impact of these factors is expected to continue when the company reports Q4 results.
CLX's Historical Organic Sales Analysis (Company Data, GS Analytics Research)
However, I expect volume decline to end towards the beginning of fiscal 2024 and start recovering from the second quarter of fiscal 2024. CLX is not planning any additional pricing in the near term as it has all the price increases needed to offset current inflationary pressure. Easing volume comparisons coupled with stable pricing in the next fiscal year should give a boost to volume growth. Additionally, I also expect demand to fully normalize to pre-pandemic levels in the coming few quarters. This normal pattern of demand should also help increase sell-through and boost volume. Further, the company is also progressing well in dealing with supply chain challenges that arose from the pandemic. It has been improving its fill rates. This should also help in volume growth in the next fiscal year.
The company is also focused on supporting volume recovery in the next fiscal year by reinvesting in growth through new product launches and an increase in advertising and promotional activities. Consistent new product innovation is the heart of every consumer company. It helps them to meet changing consumer preferences and also keeps categories strong and healthy. Clorox has benefited from new product launches in the past and now plans to accelerate them to capture more demand for its product categories. One such example is a new line of cleaning products. In fiscal year '23, the company intends to introduce a new line of cleaning products. This new line is chemical and fragrance-free, and the company expects it to address the concerns of consumers who do not want to use chemicals in their homes or around their children and pets. This should reassure them that they can do all of the disinfecting required to keep their family healthy in a safe manner. This should help the company keep demand at good levels in the coming years.
The new product launches by the company are expected to be well supported by a good investment in advertising to promote and convey the right message for people to start using the product. The company targets advertising spending to be ~10% of net sales for the full year'23. Moreover, the company also plans to get back to pre-pandemic levels of promotional levels. Before the pandemic, the company had ~25% of its products that were sold through some kind of promotion. It has dropped to ~20% in recent quarters as the company focused on protecting margins. Moving forward, the company plans to gradually return to that pre-pandemic level. So, I expect promotions to increase in the fiscal 2024 which should also help the company deliver sales growth.
Lastly, the company is all set in launching the first phase of its new Enterprise Resource Planning (ERP) system. Previously the company had an ERP system that was 20 years old and not very effective in supporting sales. The new ERP system is now expected to boost sales as the company can leverage better consumer insights and better forecast demand for its products. So, as the company pivots its operations to the new ERP system, it should be able to react more quickly to changing demand patterns and support sales accordingly as needed. This should help the company in delivering sales growth in the longer run.
Given these factors, I am optimistic about the company's sales growth prospects starting FY24 and beyond.
Margin Analysis And Outlook
Over fiscal 2022, CLX's gross margin suffered significantly due to higher commodity, manufacturing, and logistics costs, as well as higher digital investments. This led to a ~800 bps drag on gross margins from pre-pandemic levels of around 44%. In order to recover its margins, the company took significant price increases to offset these inflationary headwinds and also became focused on driving cost-saving initiatives.
In the third quarter of fiscal 2023, the significant price increases (a benefit of 750 bps) over the last fiscal year and cost savings (a benefit of 150 bps) more than offset the impact of inflationary costs (a combined headwind of 350 bps from commodity, logistics, and manufacturing). This resulted in gross margin improvement, increasing 590 bps YoY to 41.8%. The increase in gross margin also reflects a 100 bps one-time benefit from lower trade promotions and slightly lower volume deleverage due to higher sales in the Pine-sol business. The adjusted EBIT margin increased 100 bps YoY to 14%.
CLX's Historical Gross Profit Margin and Adjusted EBIT Margin (Company Data, GS Analytics Research)
Looking ahead, I expect the company to keep on recovering its margins to the pre-pandemic levels. The company incurred ~330 bps commodity inflation in Q1 FY23, decreasing to 240 bps in Q2 FY23 and 230 bps in Q3 FY23, and expects inflation to further moderate in the fourth quarter. So the headwinds from high commodity and manufacturing costs should be less of a drag on margins moving forward and CLX should be able to more than offset it through the impact of carryover impact of past price increases in the next couple of quarters.
Moreover, the company is also well on track with its cost-saving initiatives. The company started taking cost-saving initiatives at the beginning of fiscal 2023 in order to recover margins. The company is aiming for a total of $75 million to $100 million in cost savings over the course of fiscal 2023 and fiscal 2024. CLX aims to save costs by reducing headcounts and decentralizing decision-making, helping to respond quickly to changing consumer behaviors, and reducing supply chain costs. Management is expecting cost savings to be $35 million in fiscal 2023, with further acceleration in the cost savings next fiscal year.
Further, the company should also benefit from productivity savings driven by the new ERP system. The company is all set to launch the first phase of its new ERP system. As discussed in the revenue analysis the company previously had a 20-year-old ERP system, making its operations inefficient. Now, with the new ERP system, the company should be able to identify unnecessary costs better, increase efficiency through the help of AI and advanced technology, and also further simplify the cost structure and supply chain network. This investment in digital infrastructure should increase productivity and help the company recover margins. So, I am optimistic about CLX's margin recovery prospects ahead.
Valuation and Conclusion
Clorox is currently trading 27.25x FY 2024 consensus EPS estimate of $5.68. The stock is trading slightly lower than its historic 5-year average forward P/E of 28.60x. The company has good growth prospects with the help of recovering volume and margins in the coming fiscal year. I expect the company's volume recovery over the next few quarters as well as margin expansion should help drive the stock upwards. The current forward valuation also provides a reasonable entry point. Hence, I am upgrading my rating to buy.
For further details see:
Clorox: Improving Growth Prospects And A Reasonable Valuation