We think a tie-up deal between Reckitt Benckiser and Colgate-Palmolive is unlikely and if the former is looking to make acquisitions, SSL International would be a much better fit, so awaiting confirmation or denial of the rumours, we are sticking with our 3,011p-per-share fair value for Reckitt and $79 fair value for Colgate. Below is our long-term analysis of Reckitt.
Fair value estimate: 3,011p ¦ Fair value uncertainty: Medium ¦ Economic moat: Narrow
Thesis
(Last updated 23-10-2009)
Reckitt Benckiser's strong performance in the household products arena can be chalked up to its focus on a select group of core brands, smart acquisitions, and a lean operating infrastructure. Although it's not the largest player on the field by any means, we believe the firm has built a narrow moat, as evidenced by its leading market shares and stellar returns on invested capital.
In 1999 Reckitt & Colman combined with Benckiser to form Reckitt Benckiser, a global household products and personal-care manufacturer. Since then Reckitt Benckiser has acquired additional health-care brands, primarily Boots Healthcare International in 2006 and Adams Therapeutics in 2008, in an effort to further expand its health and personal-care offerings in the fast growing over-the-counter (OTC) segment of this market. These acquisitions have served to diversify the firm's product portfolio as well as give it a larger presence in the pharmacy channel in Europe and the United States.
Although we think both of these acquisitions were smart strategic moves, we're most impressed by Reckitt Benckiser's ability to generate above-average organic sales growth in categories like fabric care, surface careand dishwashing. The firm does this by constantly introducing new products, which are not always higher priced but are higher gross margin, and by winnowing underperforming brands and rebranding them as a "power brand." In the US, for example, the firm is in the process of rebranding Jet Dry as Finish, the latter of which is one of 17 power brands the firm aims to support globally. The firm needs this focused strategy for its brands to compete with rivals Procter & Gamble and Clorox.
In addition to tough competition on store shelves there are several other near-term challenges facing the firm. The company's pharmaceutical drug business has lost its orphan drug status, and Mucinex, one of the firm's fastest-growing health-care brands acquired in the Adams acquisition, faces patent challenges. As a UK-based company with most of its sales and earnings in euros or US dollars (but reported in sterling), the firm also faces significant foreign exchange transactional exposure. We don't expect these problems to derail the firm by any means, but they could slow top-line sales growth, which has increased 11% annually during the last three years, excluding acquisitions.
In the meantime, Reckitt Benckiser is extremely well-run and efficient, with low overhead costs, tight working capital management, and negligible long-term debt. We expect the company to continue to deliver strong returns even in a weak economy.
Valuation
Our fair value estimate for Reckitt Benckiser shares is 3,011p per
share. Top-line results at Reckitt Benckiser have been very healthy,
even excluding acquisitions, but they also fluctuate because of swings
in foreign exchange. Additionally, the firm's Suboxone drug now faces
potential generic competition and could see a material drop off in
sales. As such, we've forecasted total sales growth to increase about
7.0% annually during the next five years, and because sales of Suboxone
are also higher margin, we've modelled some gross margin contraction
during this same period. Management keeps tight controls on fixed costs,
which we expect to continue. We expect operating margins to average
about 21.5% during the next five years and returns on invested capital
to average about 24% during this same period.
If we were to increase our expectations for top-line sales growth to 11% and our expectations for the cash flows the firm is able to generate, we would expect to see almost 30% upside to our fair value estimate, or about 3,885p per share. Conversely, should sales growth stall to about 3.0% annually and gross margins contract as the firm loses the benefits of volume leverage, we would expect a downside scenario of about 2,296p.
Risk
In addition to the typical risks associated with global consumer
products manufacturers, such as the need to drive sales growth through
the introduction of successful new products, Reckitt has a number of
unique risks. The firm faces two lawsuits related to its patent
protection for Mucinex, which constituted 80% of Adams' sales when
Reckitt Benckiser acquired the brand in 2008. Additionally, Suboxone, a
controlled substance used to treat opiate dependence recently lost its
orphan drug status. The drug makes up the lion's share of the firm's
£340 million pharmaceuticals business.
Management & Stewardship
Bart Becht has been with Reckitt Benckiser since 1988 and has been the
firm's CEO since 1999. He serves with a diverse group of directors that
appear to set fairly good corporate governance standards. Although
directors are not elected annually unless they have served more than
nine years, the firm separates the CEO and chairman roles and uses a
variety of key indicators to determine performance, including earnings
per share, management turnover, and net working capital. If target
performance levels are met, then 80% of the CEO's remuneration is
variable, and the firm uses the upper quartile of its peer group to
benchmark itself. Base salaries increased 4% in 2008 and are expected to
increase this much in 2009, but long-term incentives, including options
and performance shares, only vest if EPS growth targets are met. Senior
executives and directors have share-ownership requirements, giving them
further stakes in the firm's performance.
Overview
Growth: Top-line growth for Reckitt Benckiser has been extremely
strong during the last three years, increasing 11% annually, excluding
acquisitions. We expect sales growth will continue to be healthy, but to
average about 7% annually during the next five years as the firm loses
orphan drug status in its pharmaceutical business.
Profitability: Operating margins have improved more than 300 basis points during the last five years as Reckitt has increased sales organically and made acquisitions while keeping fixed costs in check. With the loss of Suboxone's patent protection, however, we expect operating margins to pull back from their peak and average about 21.5% during the next five years.
Financial Health: Reckitt Benckiser has very little long-term debt on its balance sheet, preferring to use commercial paper when it needs financing for an acquisition. The company has negative working capital because it's able to turn over its inventory quickly while paying off its suppliers more slowly.
Profile: European firms Reckitt & Colman and Benckiser combined in 1999 to form Reckitt Benckiser. The firm's products include a variety of household product and personal-care brands, such as Calgon, Lysol, Finish, and Mucinex, many of which hold the number-one or -two positions in their categories. Roughly 50% of total sales are generated in Europe, another 27% from North America and Australia, and the remaining 23% from developing markets and the firm's pharmaceuticals division.
Strategy: Reckitt Benckiser focuses its efforts on 17 "power brands" that hold leading market shares in their categories. The firm operates in a number of niche categories, such as air care and garment care, and drives growth with a constant stream of new products. Management is rebranding less viable brands as power brands and expanding into new markets.
Bulls Say
1. Reckitt's household products hold leading market shares in their
categories and generate steady, consistent cash flows. The firm has been
able to consistently grow its brands at above-category average growth
rates.
2. Dishwashing detergent is a less commoditised category than fabric detergent, with dishwashers having only 60% penetration in developed markets, compared with 90% penetration for washing machines. Reckitt's Finish brand holds leading global market share in the automated dishwashing category.
3. The firm operates a tight ship from a cost standpoint, and overhead costs as a percentage of sales have declined during the last five years while the firm's top-line has increased significantly from acquisition activity. We wouldn't be surprised to see future bolt-on acquisitions, particularly in the health and personal-care arena.
4. Reckitt is quite cautious about leverage and effectively has only commercial paper, used for the Adams acquisition, as long-term debt obligations on its balance sheet.
Bears Say
1. Currently there are two outstanding lawsuits contesting the firm's
patent protection on Mucinex, which has significantly contributed to
sales and earnings growth since it was acquired. We don't know whether
the litigation will play out in Reckitt's favor or not, but the suits
create an unhelpful distraction in the meantime.
2. Private-label penetration in most of Reckitt Benckiser's categories is much higher in Europe than in the United States. Over time we believe this will limit the market share gains for the firm's products in these markets.
3. The firm faces more regulatory hurdles in the roll-out of its OTC brands, such as Mucinex, particularly as it tries to penetrate European markets.
4. By having so much of its sales coming from Europe and the United States, while reporting in British pounds, Reckitt Benckiser is fairly diversified from a currency standpoint, but swings in currency can still have a dramatic impact, both negative and positive, on results.
