Clorox's Fare Continues to Win With Consumers, but Pace of Gains Unlikely to Prove Sustainable
Clorox's Fare Continues to Win With Consumers, but Pace of Gains Unlikely to Prove Sustainable
Business Strategy and Outlook| by Erin LashUpdated Mar 23, 2021
The COVID-19 outbreak has left consumers scouring the shelves for Clorox's fare, leading to a pronounced bump in near-term sales. This has been quite acute in its cleaning mix (about 40% of sales), which soared at a double-digit clip on an underlying basis in each of the past three quarters. We don't think this pace will persist, but we also don't think this sales momentum is limited to cleaning. For one, its grilling segment, which had been plagued by heightened competition and a lineup that failed to pivot toward consumer-valued pellets and lumps prior to the pandemic, seems to be winning from recent social distancing mandates. Although efforts to right the ship were already in place, we think the pandemic is creating an opportunity for the Kingsford brand to re-engage with consumers who are cooking more at home. Even if volumes decelerate as shelter-in-place initiatives are lifted and consumers gradually increase their consumption of food away-from-home, we think Clorox has laid out a solid playbook (inclusive of innovation and marketing to more effectively align with consumer trends) that should steady the grilling business over time. Combined, we continue to forecast 3% annual growth in the health and wellness and household segments (67% of sales) longer term.
Regardless of the economic backdrop, we don’t expect Clorox will ratchet back brand spend. More specifically, Clorox has long targeted to garner 3 points of annual sales growth from newly launched fare, and we think this focus will continue to contribute to its unwavering competitive position. Further, we are encouraged by management's staunch commitment to funnel additional resources to market its brands, with an aim for advertising to amount to around 11% of sales in fiscal 2021, more than 100 basis points above the prior five-year average. We view this spend as a prudent means to tether its relationships with retail partners and support its brand mix at the shelf. In this vein, we forecast that Clorox will direct north of 12% of sales (about $1.1 billion) on research, development, and marketing each year through fiscal 2030 (about 40 basis points above the level spent between fiscal 2018 and 2020).
Economic Moat| by Erin LashUpdated Mar 23, 2021
We assign Clorox a wide moat based on its brand intangible assets and cost advantages. The company’s return on invested capital has been in the 25%-35% range for each of the last 10 years, coming in at 30% (including goodwill) in fiscal 2020. We forecast ROIC to average 33% annually over the next 10 years, more than 4 times greater than our 7% cost of capital estimate and supporting our stance that the firm has amassed a sustainable competitive edge.
Even though it faces outsize competition from private-label offerings, around 80% of Clorox’s U.S. sales are from brands that are number one or two in their categories. More specifically, Clorox has carved out a significant share position in bleach (nearly 60% share), charcoal (54% share), and trash bags (30% share). It also leads in salad dressings (excluding mayonnaise), water filtration, and disinfecting wipes. Clorox has been able to maintain these leading positions, with little movement in market share over the last five years in those categories, which we think makes the company a valued partner for retailers, lending credence to its intangible asset moat source.
But Clorox doesn’t just rest on its laurels; rather it continually looks to strengthen its brands, emphasizing innovation and marketing to differentiate its fare. In this light, Clorox consistently spends about 2.2% of its revenue on R&D--more than industry peers Colgate Palmolive and Kimberly-Clark and just behind Procter & Gamble (five-year averages of 1.8%, 1.6%, and 2.8%, respectively)--while also spending to market these offerings in front of consumers (spending 9%-10% of sales annually), because even value-added new products could fail to win at the shelf if consumers aren’t aware of them. And although demand has stepped up given consumers' penchant for home and personal cleaning fare over the past year as a result of concerns surrounding COVID-19, we're encouraged that Clorox continues to lean into advertising as a means to ensure that its products stay top of mind, targeting to expend an additional 100 basis points of sales in this regard this year. Further, innovation isn’t merely targeted at the low end. Rather, features Clorox has added to trash bags include scents, leak guards, and extra strength, which has enabled Clorox to grow to greater than 50% market share in the premium trash bag category (which boasts higher margins and faster growth than the trash bag category overall).
In our view, the constant innovation and customer awareness campaigns solidify Clorox’s mix in consumers’ minds as quality, trusted brands, and we think the combination of its portfolio of leading brands and the resources it maintains to reinvest to drive traffic to brick-and-mortar outlets and e-commerce platforms entrenches its relationship with its retailer partners.
We also believe the company has a cost edge over its smaller competitors. Its adjusted operating margins (19% on average over the last five years) compare favorably with Procter & Gamble (22%), Kimberly-Clark (18%), and Colgate Palmolive (25%), which are arguably larger companies with greater scale. In addition to scale benefits relative to its smaller competitors, Clorox garners cost advantages through its sourcing and logistics. It co-owns mines to obtain specific clay for its cat litter products, and it procures charred wood, the main raw material for charcoal, from mills located in close proximity to Clorox’s manufacturing facilities. Further, Clorox is focused on bringing to market new value-added products that cost less to manufacture, such as compacted bleach, lightweight charcoal, and lower-resin trash bags.
In light of its brand intangible assets and cost edge, we are confident that Clorox’s returns on invested capital will continue to exceed the company’s cost of capital for the next 20 years, warranting our wide-moat rating.
Fair Value and Profit Drivers| by Erin LashUpdated Mar 23, 2021
We're increasing our fair value estimate for Clorox to $173, from $163, to reflect hardy first-half results and time value. In this vein, management again boosted its full-year projections, which now call for 10%-13% organic sales growth (from 5%-9% most recently) and EPS of $8.05-$8.25 (from $7.70-$7.95), in line with our updated 10.9% and $8.10 respective marks. We concede that consumers’ proclivity for personal and household cleaning is unlikely to temper in the near term, propping up sales in these aisles for at least the next several quarters. However, over the medium to longer term, we don't think this lofty trajectory has staying power, particularly as vaccine distribution becomes more widespread and concerns surrounding the virus ultimately fade. As such, we’re holding the line on our long-term forecast for 3%-4% annual sales growth and operating margins approximating 20% by the end of the next 10 years (about 100 basis points north of the level achieved in fiscal 2020). Our valuation implies a fiscal 2022 enterprise value/adjusted EBITDA of 15.
In the near term, we expect a portion of its recent gains will get eaten up as Clorox incurs higher costs associated with ensuring proper safety protocols to protect its labor force, as well as higher transportation and logistics, as it works to keep its product stocked on shelves. And while we aren’t blind to the resiliency of its fare regardless of the economic backdrop, we don’t think its inflated sales trajectory will prove sustainable either, particularly as the bump from COVID-19 fades and competitive intensity ramps up. As such we don't posit promotional spend will remain dormant over a longer horizon (as has been the case since March 2020 given the extent to which demand has been outpacing supply in categories throughout the store), as competitors muscle for share gains.
But even prior to the pandemic, Clorox had started on a path to fuel improvement in its mix, anchored in spending behind innovation and marketing to more effectively align with consumer trends that should steady the business over time. In this vein, we think the company’s ability to manage costs while still fueling brand spending (we forecast around 10% of sales spent on advertising and 2%-2.5% spent on R&D annually, equating to about $1.1 billion in aggregate annually) will lead to modest operating margin gains. As such, we project operating margins to rise around 100 basis points from 2020 levels to 20% by 2030.
Risk and Uncertainty| by Erin LashUpdated Mar 23, 2021
Clorox faces a number of risks in the highly competitive consumer packaged goods space. For one, given consumers make frequent purchases and typically face no switching costs, firms must continually invest behind their brands to drive sales. In several of the categories in which it plays, Clorox’s primary competition is private-label fare, so product innovation and subsequent marketing support is essential to ensure differentiation from these lower-priced offerings.
Greater consumer acceptance of private label, whether due to an economic downturn or consumer preferences, could threaten Clorox’s margins or sales growth. However, we think its business has proved quite resilient even in recessionary climates, as evidenced by the mid-single-digit quarterly organic sales growth posted in 2008-09). Despite reports that younger generations are more likely to accept private-label products at the expense of brands, Clorox seems to be withstanding these pressures, as it has posted low- to mid-single-digit annual sales growth over the last several years and more than 200 basis points of operation margin expansion since fiscal 2012--to the high-teens. But if its new products fail to resonate with consumers, results could falter.
Clorox also is subject to input cost volatility, and heightened inflationary pressures have been a headwind for the better part of the past two years. Clorox could face margin erosion if it refrains from passing these costs onto consumers. Conversely, if it seeks to conserve profits, it could be subject to deteriorating volumes if consumers balk at higher prices.
In addition, Clorox relies heavily on only a few retailers (almost 50% of sales come from five, with Walmart accounting for around one fourth of Clorox’s sales), which could hinder its negotiating power. And although Clorox has a successful history of acquisitions and imposes disciplined criteria to assess potential targets, any misstep in timing, execution, or valuation could constrain returns.
Stewardship| by Erin LashUpdated Mar 23, 2021
We assign Clorox an Exemplary Capital Allocation rating, premised on its sound balance sheet, appropriate shareholder distributions, and investments we find as fair.
In this context, leverage isn't a concern; net debt/EBITDA has held below 2 times since fiscal 2013, and we forecast that will remain the case over the duration of our explicit forecast. And we contend its solid balance sheet appears even more pristine when juxatposed with the low cyclicality that it boasts from a top-line perspective.
Despite the recent change at the top (with former-CEO Benno Dorer stepping down in September), we haven't seen (nor do we anticipate) any change in the firm's strategic course with Linda Rendle, a 17-year company veteran, now at the helm. Under Dorer and his predecessor, Donald Knauss, we surmise the firm had demonstrated a superior ability to execute and allocate shareholder capital, as evidenced by wise acquisition and divestiture decisions. The firm purchased Burt’s Bees in 2008, and although the timing was not optimal, the brand has turned into one of Clorox’s fastest growers (prior to the pandemic). Management has long evidenced a clear understanding of where its competence is and which companies and brands are best suited as acquisition targets--with its focus centered on small to midsize tie-ups where the sales base is concentrated on its home turf and which possess leading brands in faster-growing categories, such as natural personal care and health and wellness (given its established competitive edge in these categories and markets)--and it adheres to those criteria while closely scrutinizing valuation. However, we don't believe the company is merely looking to drive top-line growth at any cost, as it opted to abandon its unprofitable Venezuelan business in 2015 and sold its noncore Armor All brand in 2011.
The jolt in demand for disinfecting wipes and cleaners since last spring has put Clorox in a constrained supply position, and it has yet to catch up. To rectify the dislocation, management has been pursuing a multiprong approach that has included investing in its own manufacturing footprint as well as working with third-party manufacturers. However, we don’t believe its recent investments will saddle the business with excess capacity over a longer horizon. Our conversations with management lead us to believe Clorox intends to build capabilities to meet 75%-85% of its demand outlook with a planning cycle that extends over the next three to four quarters--a wise approach, in our view, that should ensure the company maintains the resources to reinvest in its operations while also juicing shareholder returns through dividends and share buybacks. We forecast that dividends will grow at a mid- to high-single-digit clip each year through fiscal 2030 (maintaining a payout ratio of around 60%), while also repurchasing a low-single-digit level of shares outstanding annually (which we view as prudent when shares trade at a discount to our assessment of intrinsic value).