The Clorox Company (CLX) – Headwinds will prove to be less “transitory” than management believes.

When I began covering CLX several months ago, the stock had reached an all-time high of $166.33. Last Friday and nearly 6 months after, shares closed down -8.70% at a price of $151.86. I believe shares will continue to slide another 5-8% before returning to a fair value.

During my initial analysis, I thought shares were pretty fairly valued and that there was an overwhelming emphasis on what I thought may just be transitory headwinds in two of the company’s main products. Management has consistently noted that declines in volume were mainly isolated to trash bags and charcoal, but the data is suggesting that the problems are also elsewhere. After the Q1 earnings report and taking a further look, I realized some of my assumptions were generous and that Clorox’s market shares were being eroded faster than I expected. Here’s my report on The Clorox Company (CLX).

Click here to download my model and a few key resources I leveraged while updating my brief CLX report.

Click here to view the report that was highly influential to my outlook for the CPG industry as a whole.

Key Points

– CLX is a solid business with a tremendously strong brand portfolio. CLX has proven to grow earnings through recessionary periods, produce consistent and slowly growing FCFs, and has increased its dividend for 42 years straight (the past two increases being greater than 10% each).

– Management has done a decent job of focusing on innovation, cutting costs, and allocating capital effectively, but the recent strategy does not focus on the challenges the business is facing in the coming years and provides weak guidance in the face of numerous headwinds.

– There are fundamental challenges to the business models in the CPG space. These include, but are not limited to: shifting consumer preferences, reduced pricing power, and the continued rise of private-label/in-house brands that will continue to chip at CLX’s market share(s).

– Using a DCF with an EV/EBITDA exit-multiple of 15.00x and discount rate of 7.50%, I value shares at $142.62, representing that shares are currently overvalued by 6.48% . While consumer staples typically offer a safe yield during an economic downturn, I would recommend selling or avoiding shares of CLX for the time being.

Summary of CLX’s Business & Competitive Advantages

Clorox is a multinational manufacturer and marketer of consumer and professional products headquartered in Oakland, CA. CLX sells its products primarily through mass retailers, grocery outlets, warehouse clubs, dollar stores, home hardware centers, 3rd-party and owned e-commerce channels, military stores and distributors. CLX operates through 4 business units: Cleaning, Household, Lifestyle, and International.

Cleaning (34% FY19 Rev.): Laundry, home care, and professional products sold in the US.

Household (30%): Charcoal, bags, wraps & containers, cat litter, digestive health products.

Lifestyle (20%): Food products, water-filtration systems and filters, natural personal care products and dietary supplements.

International (16%): All products sold outside of the US.

Source: CLX 1Q20 Investor Presentation

One of CLX’s strongest suits is its brand portfolio. Here’s a look at those brands (which I’m sure many you will recognize and several you may be surprised to see):

Source: 1Q20 Investor Presentation
Source: Personal Work

CLX’s brand portfolio is tremendously strong, but I question if it will remain resilient given the rise of private-label and in-house brands (more on this later). CLX notes in both their 4Q19 and 1Q20 Investor Presentation that nearly 80% of global sales are from #1 or #2 share brands. CEO Benno Dorer has consistently noted that the brand portfolio is the key strength and competitive advantage of the company.

Source: 1Q20 Investor Presentation

CLX’s products are used by millions each day — in both good and bad economies. Clorox-branded products are in about two-thirds of US households, so I’m willing to bet you’ve used one of their products. It’s no surprise that the company has grown earnings through past recessions. Many investors tend to consider companies like Clorox as “recession-proof.” While no company is fully protected from recessionary woes, Clorox is a safer bet for investors looking to attain a secure dividend yield and consistent business. After all, the company has increased the dividend for 42 consecutive years and currently sports one of the highest yield among peers at 2.79%.

Source: Seeking Alpha

While the company is struggling with eroding market share, an advantage that Clorox and its peers have in the CPG space is that there is a low threat of new significant entrants due to diverse product mixes and the highly competitive nature of the market. However, the threats posed by new entrants into the market are the least of Clorox’s worries.

IGNITESounds cool, but don’t buy the hype.

The company recently announced its new strategy, IGNITE, which details how the company intends to focus on maximizing economic profit with a commitment to what they call “Good Growth.” CLX has chosen to focus on the following strategic choices to accelerate that growth: Fuel Growth, Innovate Experiences, Reimagine Work and Evolve Portfolio. The strategy also outlines the company’s ESG goals, which include:

  • 50% Reduction in virgin packaging
  • Science-based greenhouse gas emission targets across operations & value chain
  • 100% Recyclable, reusable or composting packaging packaging by 2025
  • 100% Renewable electricity in US & Canada by 2021

In terms of measurable affects on the business, the company is seeking to increase their cost savings target to +175bps (+25bp increase) by leveraging digital, integrated design, and sustainability. CLX is also aiming for total sales growth of +2% to 4% annually while improving EBIT margin by +25-50 bps and generating FCFs of 11-13% of sales. I believe the goals are reasonable for the future, especially considering the company expects FY20 sales down low single digits to up 1% (Organic sales growth between 1-3%) and Diluted EPS down 1-4% in the range of $6.05 to $6.25.

Source: 1Q20 Investor Presentation

Furthermore, the strategy seems largely iterative of the 2020 strategy, which focused on e-commerce and brand-management initiatives. The 2020 strategy sought to increase net sales by 3-5%, expand EBIT margin by 25-50 bps and generate FCF of 10-12% annually. Comparing the IGNITE strategy to the 2020 strategy, it appears all the company has adjusted are sales growth expectations and cost savings targets.

I personally believe that the company will need to focus on cost savings and targeted M&A in particular in order to revamp growth. With a long track record of successful M&A, management seems well prepared to do so, but I think this will ultimately take longer to add value considering the headwinds in current markets and distribution channels.

Financial Strength

Here’s a snapshot of a few key ratios for CLX:

Source: Personal Work

One of the first things that stood out to me about CLX was its high debt levels. Compared to peers, CLX tends to use larger amounts of debt to finance operations and reinvest in the business. At first worrisome, you can obviously tell from the 11.37x interest coverage that CLX can sufficiently cover its financial obligations. I’m not worried about the high levels of debt for this reason, but I think it’s important to keep an eye out for how the company chooses to use this debt.

When it comes to uses of cash flows, the company has proven to be fairly efficient. With a 5-YR Average Return on Invested Capital of 30.61%, the company has proven to be an effective capital allocator. They note their effectiveness in the 1Q20 Investor Presentation (see below in Management) and show that they have one of the highest rates among peers. Strong, consistent cash flows have also allowed the company to pursue targeted M&A, evident in the RenewLife and Nutranext acquisitions (more in the Management section).

As mentioned in the IGNITE strategy, the company seeks to continue using cash flows in a disciplined manner, with two of the four priorities focused on returning value to shareholders. Consistent FCFs have allowed management to increase the dividend the past 42 years and I don’t see any impediments to this trend. The company has the one of the highest dividend yields among its peer group at 2.79%. In May 2018, the BOD approved a $2B repurchase program — in 2019 the company repurchased 2.3 million shares worth $328 million.

Source: 1Q20 Investor Presentation
Source: 1Q20 Investor Presentation

Quality Management

Benno Dorer (55) has served as CEO of the company since Nov. 2014 and Chairman of the board since Aug. 2016. He has been an elected officer since 2009 and joined the company in 2005.

During his time as CEO, Dorer has consistently emphasized the strength of the brand portfolio and focused on continuing to strengthen it, whether that be through innovation or targeted M&A. Recent acquisitions include Nutranext (2018; $700 mm) and RenewLife (2016; $295 mm). Nutranext is a health and wellness company that manufactures and markets dietary supplements in retail and e-commerce channels. Products include multivitamins under the Rainbow Light brand (No. 2 brand in the natural channel), specialty minerals under the Natural Vitality Brand (No. 1 anti-stress and sleep brand in the natural channel), and supplements for hair, skin and nails under the NeoCell brand. (Clorox Press Release dated March 12, 2018). RenewLife, a leader in digestive health, has led to significant growth in CLX’s e-commerce channel, which now represents about 8% of company sales.

Management has diligently focused on being an industry leader in cost savings in order to improve profitability and the holy grail of metrics in the CPG space — Gross Margin. The company has seen some success in expanding GM. In 2013, GM sat at 43.2%. GM expanded to 45.1% in 4Q19 (representing a 2.5% increase YOY) as a result of cost savings, but came in overall at 43.9% for FY19. Nonetheless, the cost savings initiative associated with the 2020 Strategy helped generate the company +$100 mm in cost savings during FY18. I expect the company to keep a strong focus on costs over the coming years and anticipate their use of sustainability ideas to help generate those savings (see packaging above in the IGNITE section).

In addition, management has done a solid job of employing capital effectively, which is why I feel shareholders have been handsomely rewarded over the past few years.

Source: 1Q20 Investor Presentation

“Transitory” Headwinds – Not so fast, CLX.

As measured retailed trends have eroded over the past year, management is conscious of decelerating market share gains in several key product categories, most notably in the Glad trash-bag business and Kingsford Charcoal, but has consistently reiterated that the issues seem transitory. Management points to a challenging pricing environment as the key issue, but I believe there’s more to the erosion than several isolated price gap challenges in a few key products.

“Transitory” underscores the challenges that lie ahead for CLX. For a company that stresses innovation, there are several key categories where innovation has lagged and allowed competition to catch up. Consider the bleach business, where the company is seeking 25% compaction in order to aide consumers with handling (i.e. pouring bleach). When CLX moved forward with a similar compaction in 2013, the company lost 300 bps of market share as consumers opted for non-compacted private-label brands as price-value perception changed. According to Goldman Sachs Global Investment Research (GIR), “Bleach, multiple areas of its liquid household cleaner business, cleaning wipes, and litter are all suffering measurable market share losses at retail.” Goldman’s covering analysts note that the issue may not be as much due to pricing as it may be with innovation.

In addition, I believe management has failed to address one of the largest issues that will impact the entire CPG space over the near, medium, and long-term: Private-label and In-house brands. Market share losses are not solely due to pricing gaps, but also due to the rise and rapid gains of private label/in-house brands. Cheaper products produced by traditional retailers are in fierce competition with Clorox’s own products. Consider Wal-Mart, who consists of 25% of CLX’s total sales, and their own Great Value brand. As CLX’s largest customer, they’re also a competitor. That’s not a good recipe for success in my opinion. In FY19, sales growth in the Cleaning segment fell to 2.4% YoY from 2.9% the year before; the Household segment experienced an accelerated decline in sales (down -4.5% YoY, FY18 -0.1%); the Lifestyle segment continues to grow, which is promising; International sales have also experienced a YoY decline in FY19 (-5.6%), but sales growth has overall been volatile in the International segment from year to year.

CLX recently announced 1Q20 EPS of $1.59, coming in above analyst expectations of $1.54 (FactSet) and reaffirmed their revised FY20 outlook as shown below. As expected, sales growth in various categories decline, with the largest decline coming from the Household segment.

  • Cleaning 1Q20 Sales -1.6% YoY
  • Household 1Q20 Sales -13.8% YoY
  • Lifestyle 1Q20 Sales +4.2% YoY
  • International 1Q20 Sales came in flat YoY
  • Net Sales 1Q20 -3.6% YoY

I believe pricing is likely to remain a challenge for CLX. Consumers did not seem to take pricing well with Glad trash bags and Kingsford Charcoal and I expect pricing to remain sticky, especially in the face of a highly competitive environment where private-label/in-house brands continue to gain market share.

There are numerous trends that investors should pay attention to over the near, medium, and long-term. These include, but are not limited to, the following:

  • Shifting consumer preference for private label/in-house brands that have better price-value perception and continue to rapidly gain market share.
  • Increased M&A Activity as a source of growth.
  • Increased use of e-commerce as a sales channel.

Valuation

Using a DCF approach with an EV/EBITDA exit multiple of 15.00x and a discount rate of 7.50%, I value shares of CLX at $142.62/sh. Several key assumptions of my analysis are included below:

  • Discount Rate: 7.50% (Preferred hurdle rate)
  • EV/EBITDA Exit Multiple of 15.00x – Chosen mainly as a reversion to the 10 YR Median of 14.20 and peer mean of 14.06. The stock currently trades at an EV/EBITDA multiple of 16.07x, a premium well above what I believe is justified for a bleak growth outlook and headwinds
  • FY Net Sales Growth of 1.2% (See model for individual segments)
  • Unlevered FCF growth of 2% for 2020, 3% PY thereafter

An alternative valuation is included in my model using the perpetuity approach which values shares at $145.65/sh., but I believe the exit-multiple approach is the more reliable valuation due to less sensitivity in changes to the multiple or discount rate. A sensitivity analysis is included below.

High-end projection (EV/EBITDA Exit x of 17.00x and a discount rate of 6% values shares at $171.11/sh.

My valuation indicates that shares of CLX are currently overvalued in the market, trading at a 6.48% premium to my assessed value of $142.62/sh.

Conclusion

This is purely anecdotal, but consider the following:

Each time I travel to the local Kroger with my roommates (all college students), I try to be mindful and pay attention to what everyone buys – from products (mainly junk food and snacks) to what brands they purchase. Maybe we’re just price conscious because we’re all broke college kids, but the majority of the time we purchase Kroger brand products. They’re cheaper and we don’t really care to pay up for value. This holds true when we buy cleaning supplies there as well. Here’s another example. Whenever I go to Target with my girlfriend, I observe the same habits. As we sat in the cleaning section the other day, she was looking for bleach to purchase. I noted that she should get the Clorox bleach because it’s probably the most dependable and best product. I was channeling “One Up on Wall Street” hard that day. She looked at me like I was an idiot, then proceeded to buy the Target brand bleach and a few other Target-branded cleaning supplies.

While this example is anecdotal, I can’t help but think that consumers in general are more susceptive to price-value and are less likely to pay up for the big brands when they can get a similar, in-house product for less.

Though I think CLX is a tremendous business with a strong brand portfolio, the fundamental challenges the business is facing are proving to be significant headwinds that are beginning to materially impact the company’s operations. A lower growth trajectory and eroding market shares all support my lower valuation and are the main reasons are for my recommendation that investors sell or pass up on Clorox right now. As the price comes down towards a more realistic level and the company begins responding to headwinds, the investment case could eventually change. However, I see fundamentals continuing to deteriorate in the near and medium-term.

-Cole.

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