The Clorox Company -- Almost Fully Valued

The Clorox Company—Almost Fully Valued

Company Overview

The Clorox Company (CLX, Financial) is one of the world's largest manufacturers of consumer household and professional products. The company's products are primarily comprised of laundry additives (including bleach products, stain fighters and color boosters); home care products (including drain openers, floor and tile cleaning products, natural cleaning products, disinfecting sprays and wipes, carpet cleaners, toilet bowl cleaners, charcoal, cat litter and plastic bags, wraps and container products); and lifestyle products (including water-filtration systems and filters, dressings and sauces, and natural personal care products).

Clorox manufactures its products in more than a dozen countries and sells them in more than 100 countries. Sales are made primarily to mass merchandisers, grocery stores, warehouse clubs, dollar stores, and other types of retail stores through its direct sales force and through brokers. The company's institutional, janitorial, and food-service versions of its products are sold through distributors and medical supply providers. As of fiscal year end 2014, CLX employed approximately 8,200 employees worldwide and generated over $5.6 billion in sales. The companies top three selling products include liquid bleach (13% of revenues), trash bags (13% of revenues), and charcoal (11% of revenues).

Purchase Considerations and Reasons for Caution

What we like most about CLX are its phenomenal brand positions. Some of its most well recognized consumer brands include its namesake bleach and cleaning products, Kingsford charcoal, Pine-Sol cleaners, Liquid-Plumr, Poett home care products, Fresh Step cat litter, Glad bags, wraps and containers, Hidden Valley and KC Masterpiece dressings and sauces, Brita water-filtration products and Burt’s Bees natural personal care products. Some of the company's most well recognized professional brands include Clorox Healthcare and Dispatch infection control products for the healthcare industry. Overall, the company holds the No. 1 or No. 2 market share positions in 80% of its product categories. Very impressive!

CLX's brand strength provides it with substantial pricing power and has allowed it to achieve a high rate of inflation pass-through. It has also allowed it to operate very defensively, with net earnings barely impacted during the recession/financial crisis.

What we also like about CLX is management's strong shareholder orientation. Management is committed to continuing to produce strong returns on assets and cash-flows, dividends have grown steadily for the last 15 years, the dividend payout rate is nearing 60%, and the firm continues to purchase shares. To support growth, management is aligning the company’s activities to build new capacity and expand sales channels in countries with profitable growth potential and to take advantage of global megatrends in the areas of health and wellness, sustainability, consumer fragmentation and affordability/value.

What concerns us most about CLX is the growing propensity of consumers to switch away from brand name products towards generic substitutes. We also dislike how long it has taken CLX to really boost its international presence. The company is also highly sensitive to commodity price fluctuations, of which energy price spikes can quickly eat into profits. We also dislike CLX's growing dependency on Wal-Mart, which now accounts for 26% of the company's sales. This dependency is unlikely to change and gives Wal-Mart substantial negotiating power.

Financial Highlights

About $5,591M in revenues moved through CLX's door in 2014. CLX’s revenues for the June 2005 to June 2014 period clocked in at an average annual rate of growth of 2.7%. Revenues grew at an annual rate of 2% over the last 3 years and by 1% annually over the last 5 years. Year-over-year CLX continues to make substantial sums of money off revenues after subtracting costs of goods sold, with gross profits reaching $2,360M in 2014. Gross profits have grown by 2% per year over the last 10 years and 1% per year over the last 3 years.

CLX's production costs appear well under control, with COGS rising by 3% per year over the last 10 years against revenue growth of 3%. CLX does not appear to be experiencing any difficulties passing on the cost of inflation to consumers. Gross margins have compressed minimally, falling from 43% in 2004 to 42% in 2014. While a positive sign, gross margins are, however, only moderately strong. As a general rule, we want to see consistent gross profit margins above 50% for firms in the sector. CLX has not been able to meet this requirement in any of the last 10 years. That being said, gross margins consistently between 40% and 50% for firms in the sector is, in our opinion, indicative of a firm with at least a reasonably strong competitive advantage and substantial pricing power.

CLX spends about 50% of gross profits on hard costs associated with selling expenses, advertising, management salaries, payrolls, advertising and legal fees. We consider spending about 50% of gross profits on SG&A an acceptable result. Cost of SG&A have also been increasing at a stable rate, rising by 1% per year over the last 3 year and 5 year periods. We consider this a positive sign when viewed against annual revenue growth of 2% and 1% over the same periods respectively.

CLX has shown continued strength and reasonable stability in its operating earnings picture, rising by 2% per year over the last 10 years and by 14% per year over the last 3 years. The long-term trend in operating income has been upward, rising from $781M in 2005 to $966 in 2014. CLX has earned on average about 17% in operating earnings on total revenues over the last 10 years--an acceptable result. CLX carries a moderate amount of debt on its books and, consequently, pays out about 11% of operating income on interest payments annually. This is higher than desired but aligned with much of the competition.

Bottom line results show a flat long-term trend in earnings, with minimal volatility, growing at an average annual rate of 1% over the last 5 years. Earnings are expected to tick upwards in 2014 and 2015 as energy prices fall (which have a major impact on Glad bags, wraps, and container production costs) and sales of Burt's Bees personal care products continue to rise. CLX’s strong competitive position has allowed it to maintain net margins of 10% and 12% over the last 5 year and 10 year periods. We do not expect to see much margin expansion from this company over the short- to medium-term without revitalized Brita water-filtration sales.

Diluted EPS have remained fairly flat, rising slightly from $4.09 per share in 2012 to $4.23 in 2014. We like seeing that earnings growth has outpaced revenue growth by 1.5% per year over the last 5 years. To us this is a sign of earnings quality strength. We also like that the firm's share-base continues to fall, with diluted shares falling by about 50M since 2005. CLX's ROE performance is not particularly meaningful. Its ROA performance, however, has been exceptional, averaging 14% over the last 10 years.

Valuation

A company’s fair value estimate can be calculated as the present value of expected future free cash-flows to equity. Free cash-flows to equity represent the amount of cash-flows available to common stockholders after all operating expenses, interest and principal payments to lenders have been paid and necessary investments in capital equipment and working capital have been made to maintain and grow operations.

Here we estimate fair value in 5 steps:

1. we forecast the firm’s free-cash flows to equity for the next 10 years using econometric processes;

2. we discount those cash-flows to the present;

3. calculate a terminal value for the firm 10 years out based on a long-term expected growth rate and terminal discount rate and discount it to the present;

4. add the discounted terminal value to the discounted value of free-cash flows to equity over the next 10 years; and

5. divide the present value of all cash-flows by the diluted number of shares outstanding.

Table 1 presents our free-cash flow estimates. Table 2 presents valuation inputs and results. Table 3 presents a valuation matrix illustrating how CLX's price target changes based on different terminal growth and discount rate estimates.

Table 1: Free-Cash Flow Estimation

Table 2: Valuation Input and Results

Table 3: Valuation Matrix

Conclusion

CLX’s per share earnings in 2014 were $4.23. Historical earnings per share grew at an annual rate of approximately 2% per year since 2009. CLX’s sales per share in 2014 were $42.44. We project that sales will grow at a rate of about 2.5% per year between 2015 and 2024. We expect stable gross and net margins. Interest expenses will remain at recent historical levels in the amount of approximately 2% of sales. As such, our fair value estimate of CLX equals $109.70. At a current price of $101.91, this suggest that CLX is underpriced by about 8%.