Pandemic Demand Has Not Solved Church & Dwight’s Problems (NYSE:CHD)


Church & Dwight (CHD) was among the companies that benefited heavily from the pandemic related demand, stockpiling and pantry loading. Gummy vitamins, cleaners and baking soda all saw exceptional demand over the last couple of months and with that drove the share price of CHD to record levels.

ChartData by YCharts

As a result CHD has become the most expensive stock among its peers in the personal and home care space as both P/S and EV/EBITDA multiples reached extreme levels.

Source: prepared by the author using data from Seeking Alpha

Although CHD would most likely continue to experience tailwinds in demand due to the pandemic, the company’s sky high valuation is the most at risk given:

  • the unimpressive Return on Invested Capital which is one of the lowest in the peer group;

Source: prepared by the author using data from annual & quarterly reports

  • the high risk strategy behind the company’s Free Cash Flow growth;

The impressive story of high Free Cash Flow growth

The outstanding growth of CHD Free Cash Flow is one of the main reasons why the stock has been the best performer within its peer group over the past 5 years.

ChartData by YCharts

The stock more than doubled over the past 5 years as its Free Cash Flow did the same over the period.

Source: prepared by the author using data from annual & quarterly reports

Operating profitability did not improve materially over the period, which leaves topline growth, capex reduction and working capital management as the main drivers behind the outstanding Free Cash Flow performance.

ChartData by YCharts

Apart from the CHD’s acquisition frenzy, which resulted in one of the highest Goodwill and Intangible Assets to Total Assets ratios in the industry, the company’s management has also praised its very high Free Cash Flow conversion rate.

Source: Church & Dwight Investor Presentation

The low reinvestment within the business in the form of Capital Expenditures is one of the main reasons for the high FCF Conversion rate, alongside the company’s working capital efficiencies which I will cover later.

Source: Church & Dwight Investor Presentation

Although all this might sound impressive on the surface, the strategy behind the FCF growth brings in a lot of additional risk for a future reversal.

Risk 1 – Excessive Deal Making

Similarly to CHD’s impressive Free Cash Flow growth since 2015, the company has also achieved the highest sales growth over the same period.

Source: prepared by the author using data from annual & quarterly reports

Given the organic growth of between 3% and 4% over the period, the impressive topline growth came from acquisitions in every single year since 2014.

Source: Church & Dwight Investor Presentation

Thus, CHD Goodwill & Intangible Assets to Total Assets ratio has reached one of the highest levels in the sector which is often a red flag as excessive deal making could often spell a disaster for shareholders. As it did for Reckitt Benckiser (OTCPK:RBGPF), Kraft Heinz (NASDAQ:KHC), Coty (NYSE:COTY) and many more large cap consumer staple companies with a Goodwill & Intangible Assets to Total Assets ratio of more than 70%.

Source: prepared by the author using data from annual & quarterly reports

Although CHD has a long history of acquiring and integrating all kinds of brands within its portfolio, such a strategy often reaches its limits as integration risks start to outweigh the benefits of reinvigorated topline growth.

Source: Church & Dwight Investor Presentation

What is also worrisome in the case of CHD is that apart from the excessive deal making, the management does not seem to be pivoting towards a certain product segment where the company will have competitive advantages that would allow it to fend off any future competition. On the contrary, the newly acquired companies are from such a wide variety of product segments that they rarely share any common traits.

Risk 2 – Low Reinvestment in the Business

As companies engage in ever increasing M&A activities, they are often required to dial up investments in order to integrate those new businesses. Moreover, more spending on marketing and advertising is necessary to support a broader brand portfolio or to create a unified marketing strategy.

Against all odds, CHD seems to be doing exactly the opposite as the company continued to spend less and less on marketing relative to sales.

Source: prepared by the author using data from annual & quarterly reports

It has to be recognized that the sharp drop in marketing spend during the last couple of months came as pandemic related demand allowed management to dial down advertising and promotions. However, this downward trend would most likely start to reverse over the coming months as:

Just to add to that, Steve. We – for marketing, remember we have those two big launches, CLEAN & SIMPLE, a lot of support moved to the second half. And then we’ve got the ABSORBx, really cool new cat litter. And then remember, lunch and learns, where we can’t really do those at the — at dental offices. So we’re going to be ramping up the advertising for WATERPIK.

Source: CHD Conference Call Transcript Q2 2020

The uptick in marketing spend would most likely then continue into the future as the company is rapidly expanding into new product categories at a time when most of its peers are busy optimizing and streamlining their portfolios.

Source: Church & Dwight Investor Presentation

In terms of Capital Expenditures, CHD is once again at odds with its peers. Contrary to other names in the personal and home care space, CHD spent significantly less on Capex over the past decade, while the cash outflow on acquisitions skyrocketed.

Source: author’s calculations based on data from annual & quarterly reports

Over the last twelve months CHD has spent even less on Capex as a share of its Cash Flow from Operations. When compared to peers, CHD spent only 7% of its Cash Flow from Operations on Capital Expenditure, compared to an average of 22% of its peers. Source: author’s calculations based on data from annual & quarterly reports

Although becoming a more asset light business has a favorable impact on margins, it does increase risk by relying on third parties for production.

On one hand older equipment would sooner or later require significant investments, while tariffs and supply chain disruptions also present significant risks.

Turning to gross margin. The first half gross margin expanded 150 basis points. We expect that second half will contract by a similar amount. Half of it is simply the year-over-year impact of acquisition accounting. The balance reflects incremental COVID-19 costs as well as WATERPIK tariffs, new product support that Matt mentioned, incremental manufacturing and distribution capacity investments.

Risk 3 – Aggressive Working Capital Practices

The final reason for CHD’s high cash flow generation has been the company’s working capital efficiency and leading cash conversion cycle.

Source: author’s calculations based on data from annual & quarterly reports

When compared to peers, CHD’s cash conversion cycle seems to be running ahead of the company’s size, even if we don’t factor the company’s highly fragmented product portfolio.

Source: author’s calculations based on data from annual & quarterly reports

As CHD’s Days of Inventory Outstanding has been worsening and could signal a potential inventory problem in the future, CHD has been doing whatever it can to offset that.

Source: author’s calculations based on data from annual & quarterly reports

As we saw in the graph above, Days Payable Outstanding (DPO) has been stretched aggressively since 2015 to match the worsening Days of Inventory Outstanding.

CHD stretched its payables to 76 days in the last twelve months, which is significantly higher than its similarly sized peer – Clorox (NYSE:CLX) which has DPO of only 56 days.

Source: author’s calculations based on data from annual & quarterly reports

Furthermore, as I mentioned in my last article, CHD seems to be the only company in its peer set to disclose receivables factoring.

The Company entered into a factoring agreement with a financial institution to sell certain customer receivables at discounted rates in 2015. Transactions under this agreement are accounted for as sales of accounts receivable and were removed from the Consolidated Balance Sheet at the time of the sales transaction. The Company factored an additional $26.0 in 2019, resulting in a total of $138.9 and $112.9 as of December 31, 2019 and 2018, respectively.

Source: CHD 10-K SEC Filing 2019

None of CHD’s peers reviewed above disclosed any amounts being sold to factoring companies, which explains CHD’s exceptionally high Days Sales Outstanding.

Although CHD’s aggressive working capital strategy has been working so far, free cash flow implications over the long term could differ materially.

Conclusion

Church & Dwight has been outperforming its other large cap peers of many years now as the company has engaged in many M&A deals, reduced the business reinvestment rate relative to its size and adopted aggressive working capital management practices. The strong share price performance culminated over the recent months as pandemic related demand gave the company a much needed boost in sales and margins alike.

The pandemic however will not provide a solution to the company’s too aggressive practices to boost Free Cash Flow, while at the same time it brought CHD’s multiples to unsustainable levels as well. Thus, the risk-reward ratio is skewed significantly toward the downside as the risk of Free Cash Flow decline could also be accompanied with a downward multiple repricing.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in UL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies’ SEC filings. Any opinions or estimates constitute the author’s best judgment as of the date of publication, and are subject to change without notice.

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