Analyst Note 23/11/10
From what we can see, Reckitt Benckiser's (RB.) newly appointed CFO, Liz Doherty, brings some strong experience to the role. Between the 22 years spent at Unilever and 7 years at Tesco, she has the consumer product background and retail familiarity needed for the position. Additionally, we hope her experience at Brambles in Australia gave her some useful experience with supply-chain management, since this is what Brambles specialises in, and these skills will prove valuable as Reckitt proceeds with the integration of SSL International.
Fair value estimate: 3,494p | Uncertainty: Medium | Economic moat: Narrow
Thesis 09/08/10
Key to Reckitt Benckiser's strong performance in the household products arena has been its focus on a limited number of product categories and a select group of core brands. With the acquisition of SSL International the firm will have several new leading brands to develop, namely Durex and Dr. Scholls. While the acquisition is a smart one from a strategic standpoint, Reckitt Benckiser paid a hefty price and near-term returns on invested capital will likely suffer as a result.
In 1999 Reckitt & Coleman 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, including Boots Healthcare International in 2006, Adams Therapeutics in 2008, and now SSL International. The acquisitions have expanded Reckitt's foothold in the health-care category, diversified the firm's product portfolio, and given it a larger presence in the pharmacy channel in the United States and Europe.
Prior to this year Reckitt Benckiser has been able to generate above-average organic sales growth in its legacy fabric care, surface care, and dishwashing categories by introducing a constant stream of new products and backing fewer "power" brands. Jet Dry, for example has been rebranded as Finish and the latter is one of 17 power brands the firm supports globally. Having fewer brands to support is often an advantage since category growth is limited and market share turf wars are fierce. Rival Procter & Gamble PG recently stepped up efforts in the fabric care category in Europe, putting pressure on Reckitt Benckiser's Woolite and Vanish brands. These pressures, and slowing growth in developed markets, have tempered the company's uncharacteristically strong sales performance in otherwise staid categories.
While rejuvenating growth in fabric care and dishwashing is a longer-term problem, a more pressing issue is Suboxone's expired patent protection. The drug, which is used to treat opiate dependency, has yet to see a compelling generic competitor but the pharmaceuticals business contributes just under 20% of operating profits on average (excluding SSL). With this profit stream eroding, it is vital that Reckitt Benckiser build out new business in SSL's condom and foot care segments. Moreover, to make the deal value accretive, in our opinion, management must achieve the expected 100 million pounds in annual synergies, which will be no small task.
Reckitt Benckiser is a well-run operation, with low overhead costs, tight working capital management, and negligible long-term debt, but it will have its hands full in the coming year as it integrates SSL and combats weakening growth in developed markets.
Valuation
We are raising our fair value estimate for Reckitt Benckiser shares to 3,494p per share from 3,011p per share to reflect the firm's recently announced SSL International acquisition, which is expected to close in the fourth quarter of 2010. The new fair value estimate implies forward fiscal-year price/earnings of 17 times and an enterprise value/EBITDA of 12 times. The firm reports in pounds and trades in British pence on the London Stock Exchange.
In SSL's fiscal 2010, which ended in March, sales for SSL's Durex brand increased 4.8% on an organic basis, while Scholl Footcare increased 4.6% and Footwear 4.8%. We've modelled similar sales increases for SSL through the remainder of this year and next. For Reckitt Benckiser, however, we've modestly dialled back our sales growth assumptions in the firm's fabric care business since for the first half of this year sales in this segment are essentially flat to the first half of 2009 given the intensely competitive environment. At the same time we've raised our expectations for the company's pharmaceuticals business as generic competition for Suboxone is taking longer to come to market than had been expected. The net impact to the base business is negligible but over the next five years the addition of SSL's sales should be significant, boosting Reckitt Benckiser's compounded annual growth rate from 4.6% as a stand-alone business to 6.2%.
SSL sports higher gross margins than Reckitt Benckiser but lower operating margins. We expect the firm will realise most of the estimated 100 million in annual cost synergies as it integrates the business. These synergies should help the company's profitability, but the loss of patent protection on Suboxone will be a counterweight to any improvements. Pharmaceuticals is the firm's highest margin business. Over the next five years we expect operating margins to average 23.5%, which is in line with the historical three-year average. SSL is a strong strategic fit for Reckitt Benckiser, but if potential synergies aren't realised then the firm will have overpaid. We've increased our cost of equity to 11.0% from 10.5% to reflect risks associated with the integration.
Risk
Reckitt Benckiser faces some typical risks such as the need for successful new products, input cost inflation, and volatile foreign currencies, but the firm also has a number of unique risks. Management needs to close the SSL acquisition and realise the associated cost synergies if the deal is to be worthwhile. The firm also faces two lawsuits related to its patent protection for Mucinex, which constituted 80% of Adams' sales when Reckitt Benckiser acquired the brand in 2008. Lastly, Suboxone, a controlled substance used to treat opiate dependence, lost its orphan drug status last year. 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 2009 and are expected to increase 2% in 2010, but long-term incentives, including options and performance shares, only vest if EPS growth targets are met. The target growth threshold for EPS is 6.0% average annual growth, with 9.0% considered an exceptional target. Top senior executives and directors have share-ownership requirements, giving them further stake in the firm's performance.
Overview
Growth: Top-line growth for Reckitt Benckiser has been extremely strong during the last three years, increasing 15.2% annually, excluding acquisitions. As Suboxone begins to face generic competition, however, we expect sales will decline to the mid-single digits, or 6.2% annually, including the acquisition of SSL over the next five years.
Profitability: Operating margins have improved 530 basis points over 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 a modest pull back from peak margins. New health-care brands in the mix should bolster operating margins to average about 23.5% over the next five years.
Financial Health: Even with a significant acquisition likely to close, Reckitt Benckiser is in solid financial shape. The firm has little long-term debt on its balance sheet, preferring to use commercial paper to finance acquisitions, as with its recent SSL International deal. Following the close of the deal, we forecast total debt/EBITDA will be 0.90 and EBITDA/interest expense 28.7 times, excluding restructuring charges. 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 & Coleman 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. The firm is expanding the categories in which it operates via acquisitions and is further diversifying its international sales base with increased exposure to Asia-Pacific.
Straegy: Reckitt Benckiser focuses its efforts on 19 "power brands" (including Scholl and Durex) 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, expanding into new markets, and making acquisitions.
Bulls Say
1. Reckitt Benckiser'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. With the acquisition of SSL International the firm will have 19 "power brands" to support.
2. Dishwashing detergent is a less commodified category than fabric detergent, with dishwashers having only 60% penetration in developed markets, compared with 90% penetration for washing machines. Reckitt Benckiser'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 expect the firm should realise most of the 100 million pounds in annual synergies from the SSL International acquisition.
4. Reckitt Benckiser is quite cautious about leverage. The firm used commercial paper to pay for Adams and is tapping its revolver and a new credit facility to pay for SSL.
Bears Says
1. SSL recently increased its stake in a Russian subsidiary and acquired a condom manufacturer in the Ukraine. These acquisitions, as well as the SAP roll-out SSL has underway, add to the challenge of integrating the company.
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 rollout 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 U.S., 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.
5. Currently there are outstanding lawsuits contesting the firm's patent protection on Mucinex, which has significantly contributed to sales and earnings growth since it was acquired in 2008. We don't know whether the litigation will play out in Reckitt Benckiser's favour or not, but the suits create an unhelpful distraction in the meantime.
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