Reckitt Benckiser (RB.) closed the books on a year to forget in 2017 with a fourth quarter that showed that although it is far from firing on all cylinders, the core business appears to be stabilising, say Morningstar equity analysts.
These results show that RB is not immune from the ongoing structural changes in consumer staples retail, but with a portfolio that is increasingly skewed to businesses with pricing power, a key reason for our wide moat rating, we think RB has a better chance than most in its peer group of reigniting organic growth. The near term may remain ugly due to the return of commodity inflation, the recovering British pound, and pricing pressures in the weaker parts of the portfolio, and although we may temper our near-term assumptions as a result, this should have minimal impact on our £74 fair value estimate. After a significant retracement over the past nine months, we think the stock is now trading close to an attractive margin of safety, and we recommend investors kick the tires.
Fourth-quarter like-for-like growth of 2% reversed the trend of organic declines in the first nine months of the year, and ensured RB's continuing operations finished the year flat. Mead Johnson was also flat in the full, which may fuel continued investor scepticism of the deal. With its traditional retail channel infrastructure, Mead is clearly underperforming Danone, which last week reported a 30% increase in nutrition sales in China. Nevertheless, we see few barriers to entry to Mead/RB expanding its direct-to-consumer platform in the coming years.
Another reason for optimism in another gloomy quarter is the apparent rebound of the consumer health business. The firm has cycled through a strong period in 2016, in which it successfully launched a Scholl/Amope product but failed to replicate that innovation this year. While like-for-like sales were flat year over year, fourth-quarter organic growth in the health segment was 5%.
Pricing Power Equals Profits
Although it is difficult to see the benefits of the Mead Johnson acquisition in these results, we agree with the strategy to reposition RB into consumer health categories with pricing power. The announced restructuring of the portfolio into two separate businesses, health and hygiene home, is now operational, and could in our view give RB some flexibility in jettisoning some of its less powerful brands in order to make another transformative acquisition. One opportunity to continue recalibrating the portfolio may soon appear if Pfizer disposes of its over-the-counter, or OTC, assets, which include Advil and Centrum.
This business would be a natural fit with RB, and we expect the company to be interested. Advil possesses strong brand equity, a key competitive advantage that has previously acted as a barrier to entry against RB's own Nurofen brand. However, having leveraged the balance sheet for the Mead acquisition to three times net debt/EBITDA, RB would probably finance any deal for Pfizer's OTC business, which media speculation suggests would be valued at around $15 billion-$20 billion, at least in part with asset sales.
We are under no illusions that this was another soft quarter for RB, but we think the long-term prospects are attractive. The home segment, like-for-like sales down 3%, was again affected by the humidifier issue in Korea, and although we do not expect sales to recover, we believe RB has now cycled the worst of the impact. Finally, we estimate that the cyber attack in June wiped around GBP 90 million from full year sales, owing to disrupted operations.
All of these issues seem temporary to us, and we think that in the long term, RB can increase free cash flow faster than most of its large-cap consumer product peers because its portfolio, led by the jewels in its crown of consumer health and now infant formula products, enjoys stronger pricing power.
