Church and Dwight Remains An Attractively Priced Long-Term Growth Story

Updated: Jun 29

Executive Summary

Continuing the series of presenting high-quality SWAN stocks to our readers, Church and Dwight (CHD) has made it to the list because of its outstanding track record and bright prospects. In these challenging economic times, many companies have already withdrawn their guidance as the outcome of the COVID-19 pandemic remains uncertain. There are, however, reliable growth companies out there which are set to thrive in this market environment. Church and Dwight definitely meets all of my system criteria. Nonetheless, sceptisists argue that its acquisitions haven't been properly integrated into its existing business model and that there is a lack of future visibility and strategy execution. In my opinion, CHD should be seen as a consumer staples conglomerate acquiring #1 brands that are already reliable cash cows. By combining 3% annual organic growth from the existing business, 10% growth from EBITDA margin expansion over the next 3 years, 1.5% reduction in its share count and a starting FCF yield of 4.1%, there's a decent buying opportunity for long-term oriented investors.


Business Overview

Church & Dwight is a diversified consumer staples company that manufactures and distributes products under a number of well-known names like Arm & Hammer, Trojan, OxiClean, Spinbrush, First Response, Waterpik, Nair, Orajel, and XTRA. CHD has a rich company history as it was founded in 1896. It operates in a land of mammoths where category growth (given low brand loyalty) and acquisitions are the only two ways of boosting both top and bottom line growth .

(Source: CHD investor presentation)


Most of CHD's sales are derived from its domestic business, representing 75.8% of total revenues in FY2020 up from 75.0% in FY2014. To the detriment of the Speciality Products Division ('SPD'), 'Consumer International' sales now contribute 17.4% to total revenues, up from 16.2% five years ago.


In terms profitability for each of CHD's business segments, Consumer Domestic enjoys the highest EBIT margin, which is now stabilizing at around 20%. Nonetheless, the company's overall EBIT margin has come down over the past years as its gross margin has since started to contract despite the positive contribution of productivity programs. 

(Source: Author's work based on Church and Dwight reports)


Because of fierce competition in international regions, CHD achieves rather mediocre EBIT margins for its 'Consumer international' segment. This is more than offset by volume growth, twice the growth rate of its 'Consumer Domestic' (US), and robust pricing/volume mix.

(Source: Author's work based on Church and Dwight reports)

(Source: Author's work based on Church and Dwight reports)


The key driver behind future revenue growth will be its Consumer International business. Barring adverse FX changes, growing international presence has been very good to CHD's top line, propelled by both organic growth and accretive acquisitions.     

(Source: Author's work based on Church and Dwight reports)

(Source: Author's work based on Church and Dwight reports)


Outstanding Track Record Of Organic Sales Growth

Thanks to new product launches, Church & Dwight has demonstrated its capability of growing sales at an average annual rate of 3.6%, thereby exceeding its 3% target laid out in its Evergreen Model. Moreover, there's a long runway for growth for its two most recent acquisitions, namely WATERPIK and Flawless, which saw record revenues last year. Expanding the pipeline into both the domestic and international space paves the way for high-single digit organic growth in 2020. Product line extensions for its ARM & Hammer laundry detergent are also expected to boost top line growth in 2020 and beyond. 

(Source: Church and Dwight investor presentation)


It's reassuring that most of that organic growth is driven by increasing volumes, whereas pricing/product mix has been quite stable over the six five years. However, it should be noted that in FY 2019 volume growth fell sharp of its 5-year average of 3.9%. This was more than offset by strong pricing of 3.4%. In response to the coronavirus outbreak, demand for CHD's products (especially cleaners and hygiene products) rose sharply in Q1 resulting in organic growth of +9.2%. 

(Source: Author's work based on Church and Dwight 10-Q)


Consistently Growing Free Cash Flows

At the end of the day, free cash flows (excluding changes in working capital requirements) demonstrate the true shareholder value creation as free cash flows cannot be manipulated by non-cash charges. As can be noticed from the bar chart, CHD's cash distributions (i.e. buybacks and dividends) are typically well covered by its free cash flow. From FY 2022 onwards, CHD should be able to generate annual free cash flows of at least $900 million.

(Source: Author's work based on Church and Dwight 10-Q)

(Source: Author's work based on Church and Dwight 10-Q)


Chasing Accretive Acquisitions Is Inherent In Church & Dwight's Business Strategy

As stated in the executive summary at the beginning of this investment thesis, Church & Dwight should be perceived as a consumer staples conglomerate, looking to expand its current brand portfolio. Many argue that CHD's management hasn't properly integrated its acquisitions.

Since Church & Dwight primarily focuses on established brands that are already #1 in their category and highly cash-generative, it's difficult to squeeze synergies out of its acquisitions and integrate them in its own distribution network. This is especially true for the Waterpik takeover of $1B which saw only $10M in operating cost savings. However, the critical piece that cannot be overlooked is that by acquiring Waterpik and Flawless, CHD smartly added 30+% EBITDA margin market leaders with international presence to its diversified brand portfolio.

(Source: Author's work based on Church and Dwight investor presentation)


Moreover, thanks to attractive category growth and growing international presence, CHD's brands continue to take a nibble out of their biggest competitors' market share. Consequently, the whole process of targeting #1 brands, boosting profit margins and reducing the debt level (based on FCF) should be barely affected in these uncertain economic times. Also, the fact that 37% of its brands are value-priced is set to be a competitive advantage as many households start keeping an eye on their spending behavior.

(Source: Author's work based on Church and Dwight investor presentation)


CHD's Debt Service Coverage Ratio is Among Best in Consumer Staples Industry

As discussed above, pursuing acquisitions is an essential and maybe the most important part of CHD's long-term strategy. Fortunately, Church and Dwight can rely on rock-solid free cash flow generation to finance takeovers. As such, aggressively pursuing acquisitions hasn't led to an enormous debt burden. In fact, the company should be capable of completely digesting a substantial takeover in just 2 years.

(Source: Author's work based on Church and Dwight 10-Q)


More importantly, the positive contribution of reduced working capital requirements to net debt has been nothing but small, pointing to real strength in CHD's debt management.

(Source: Author's work based on Church and Dwight 10-Q)


When it comes to improving the underlying profitability, there's still some room to push the cash conversion cycle down to even lower levels. This will lead to more efficiency, expressed by working capital not being tied up for long.

(Source: Author's work based on Church and Dwight 10-Q)


FCF Per Share Growth Drivers

Let's now take a look at the main levers for future free cash flow per share growth.


1) EBITDA Margin Expansion From Acquisitions

Over the past six years, FCF growth has exceeded sales growth because of a substantially lower tax rate (thanks to the fact that intangible assets associated with its acquisitions are deductible for tax purposes) and improving operating margins by keeping marketing expenses as a percentage of total revenues under control.Consequently, CHD's FCF margin has increased from 14.2% in FY 2014 to 17.5% in FY 2020, leading to frequent double-digit YoY growth. It should be stated, though, that it is unrealistic to still bank on this kind of growth over the long haul.

There's still considerable upside in EBITDA and FCF margins because of the latest acquisitions, but infinite margin expansion is simply not sustainable. I currently expect CHD to increase its EBITDA margin from 23% up to 25% by FY 2022. If one would ignore future (organic) revenue growth, this margin expansion alone can easily boost free cash flow growth by 10%.

(Source: Author's work based on Church and Dwight 10-Q)

2) Debt Refinancing

With most of its investment-grade debt issued at fixed rates and interest rates plunging due to the Covid-19 crisis, CHD's management team should consider refinancing the $1B outstanding debt with maturity in FY 2022. Such a move could boost FCF growth by another 200 bps over the next 3 years.

(Source: Author's work based on Church and Dwight 10-Q)


3) Share Buybacks

Going forward, I bank on an annual reduction in CHD's share count of approximately 1.5%. Over the last 5 years, average free cash flow per share growth has been more than 14%, buoyed by buybacks, margin expansion and accretive acquisitions.

(Source: Author's work based on Church and Dwight 10-Q)


4) Proven Track Record of Delivering On Its Guidance

Organic growth from CHD's existing business will be of key importance to compound shareholder wealth. Historically speaking, it has very few times missed its operational targets outlined in its long-term Evergreen model. Going forward, I bank on 3% recurring annual free cash flow growth .

(Source: Author's work based on Church and Dwight 10-Q)

(Source: Author's work based on Church and Dwight 10-Q)


5) External Growth

With Flawless and Waterpik being its two most acquisitions, Church and Dwight continued its expansion. Now the question becomes: will these transactions lead to shareholder value creation?


Let's first consider the Flawless takeover of $475 million and the additional maximum earn-out of $425 million, thus totaling to $900 million. In 2018, Flawless generated $55 million in EBITDA with a 30% margin. Utilizing a 70% cash conversion rate, we end up with $39 million in free cash flow. Stated differently, CHD's management team gets a 4.3% FCF yield on that transaction, which is quite reasonable without mentioning Flawless' expected revenue growth rate of 15% in FY 2020.


For the Waterpik acquisition, Church and Dwight paid 17.9 times the annual free cash flow. Again, an accretive transaction given Waterpik's high-single digit revenue growth for this year and the fact that CHD's stock is trading at a free cash flow multiple of 24.7.


Peer Comparison & Valuation

CHD currently trades at a FCF Yield of 4.2%, meaning its multiples are at the upper end of their range. However, as pointed out above, there are several long-term key drivers that will likely result in forward total annualized returns of 8%-9%. Moreover, during the next 3 years there are some additional kickers that come into play in the form EBITDA margin expansion, debt refinancing and acquisitions.


Compared to its peers, CHD's unmatched operational efficiency will likely persist in the long run.

(Source: Author's work based on Church and Dwight 10-Q)


Covered Call Writing Backtesting 

By selling 2% out-of-the-money covered calls on a monthly basis and not adjusting our strike prices during corrections, we would have reduced the standard deviation by 18% while generating 8.7% higher annualized returns. The drawdowns tend to be smaller leading to a higher probability of succes and thus more consistency in our returns.

(Source: Option Generator Research)

(Source: Option Generator Research)

(Source: Option Generator Research)


Conclusion

CHD should be seen as a consumer staples conglomerate acquiring #1 brands that are already reliable cash cows. By combining 3% annual organic growth from the existing business, 10% growth from EBITDA margin expansion over the next 3 years, 1.5% reduction in its share count and a starting FCF yield of 4.1%, there's a decent buying opportunity for long-term oriented investors. Its current valuation might look a little stretched but by selling covered calls, the odds of long-term success with this investment should be thrown in our favor.

©2019-2020 by Option Generator - All rights reserved