The company scores well on all financial metrics, from return on capital, to operating margins, free cash flows, and dividend policy. Yet at 2 times revenue and a 16 PE, the company doesn’t show up on many guru lists. It is clearly not a classic distressed/value situation, nor cheap on any relative basis. But for an absolute return very likely to be positive over the long haul, it is worth looking at. I started buying it in the high $50s for myself and clients.
Why, besides the obvious?
The last year has tempered my enthusiasm somewhat for traditional hard asset plays, even though I am still long a smaller position in Burlington Northern. The economy has a bit to do with it, but the greater risk in my view to any “strategic asset plays” (including rail, energy, or mineral investments) is the risk of government interference or regulation. This is one reason why I have increased my investments in some global “soft asset” companies that sell sub $5 items, namely Cadbury PLC and Colgate. I could be wrong, but I see little risk of government interference in toothpaste and soap markets. These products are not on the forefront of the “rage against the machine” brewing all over the world either…which could imperil profitability in industries deemed to serve the public interest and characterized by public impressions of monopolistic behavior.
If I compare the product portfolio of Colgate to other household item purveyors, I am impressed with the focus of the company. Compare the product lines with a company like Unilever or Clorox, or even P&G, and you will see what I mean. Over 40% of the company’s sales come from oral care, primarily toothpaste. This is a category very hard for new entrants to crack, including store brands. If you buy a tube of toothpaste every few months, are you going to risk your palate’s displeasure for 50 cents? I’ve been brushing with Colgate my whole life and don’t plan to change. Categories like hand soap are a bit easier for new competitors, but Colgate sticks with value pricing in brands like Softsoap. Another household staple, dish soap, lends itself to strong brands because of the need for both decoration on the sink and perceived quality. If I can get a bottle of Ajax for 99 cents, why switch? The premium dog food business (Hill’s) doesn’t do much for me, but is contained to about 15% of the company’s sales.
One area investors may have overlooked when comparing CL’s earnings quality to other branded staples concerns is taxes. Colgate has been paying over 30% tax rates for years on both domestic and international business, and should not be subject to upward revisions in tax rates based on tax avoidance schemes typical in many prominent multinational companies. Although there is pending tax litigation on Colgate’s Brazilian operations, the amounts in dispute are not material to long term investors. When I compare global staples companies, I like the fact that Colgate is already paying its fair share of taxes. This provides less earnings downside than many other companies, potentially including PG (no position) and KO (long).
If I’m going to pay a 15-16 PE for a stock with other potential bargains available, the price premium over other issues needs to be justified. In this case, growth opportunities abound in foreign markets.
One thing some American investors dismiss about “emerging market plays” are that in economies growing out of poverty, the consumers are upgrading their environments with inexpensive lifestyle improvements. Obvious broad macro “plays” like iron ore, water treatment, fertilizer, and energy are not top of mind for individual consumers of daily-use items. An upgraded lifestyle also means things like clean teeth and sanitized dishes. This is where Colgate’s focus on inexpensive lifestyle upgrades that we take for granted will help them grow over an extended period. Further, in growth economic regions like Latin America and Asia, consumers are far less leveraged than in the developed world. I consider that these consumers will likely have excellent runway to adopt some of these low-cost lifestyle upgrades over the years. Already, CL maintains a vast majority of its revenue outside the U.S.
A conservative balance sheet (under $4 billion in low-cost debt and a manageable pension liability) means that excess cash (nearing $2 billion per year) can be returned to shareholders, which CL has a history of doing in dividends and share repurchases. Although Colgate has incentive stock options outstanding totaling 5% of diluted shares, dilution to shareholders will not be excessive at current prices since the average exercise price is $57.
Finally, the events of the past year have convinced me (even though the market disagrees with me at the moment) that consistent earning, non-cyclical companies do in fact deserve the premium multiple usually placed on the shares. Although price volatility has been dismissed as unimportant by a wide range of investors, I believe the underlying reasons for much price volatility in cyclical issues are much more obvious now that the supposedly “unthinkable” has happened. If a company is itself leveraged, and sells products to leveraged consumers, what is going to happen to equity investors in a downturn? They are lucky to only be diluted slightly or to have dividend cuts. Onerous bond refinancings crippling cash flows, forced asset dispositions at unfavorable prices, or insolvency are terrible risks for equity investors. Why bother with this business downside when you don’t have to? Even comparatively steady, moderately leveraged, dividend achieving industrials like Dover, 3M or Emerson have seen orders collapse in some product lines. If and when demand returns for these companies, are their product lines still intact and competitive?
To be sure, there is risk with any investment. I suppose Colgate toothpaste could turn up poisoned in some geography and send the shares down 50% in one day. Anything’s possible, but I figure my chances for catastrophe are less here than most investment options. They’ve survived 200 years already.
Registered Investment Adviser
President, Liberty Steward Capital,