Justin Sullivan
Investment Thesis
Colgate-Palmolive Company’s (NYSE: NYSE:CL) revenue growth should benefit from price increases, and recovering volume growth due to easing comparisons. In addition, increasing advertising spending and promotional offers should also help the company gain market share and deliver sales growth moving forward. This should also help offset near-term headwinds from consumer trade downs in an inflationary environment. In the medium to long term, good consumer demand for Oral care and Hill’s Pet Nutrition business should help sustain the top line.
On the margin front, while inflationary headwinds are still there, the company should be able to offset them through price increases, volume leverage, and increasing efficiency. In addition, lower SG&A as a percentage of sales and easing FX headwinds should also help margin growth. So, I believe the overall outlook for the company’s fundamentals are improving. Moreover, the company is trading below its historical averages and has a good forward dividend yield of 2.61%. This combined with improving fundamentals makes the company a buy. Hence, I am upgrading my rating.
Revenue Analysis and Outlook
In my previous article, I discussed the company’s mixed outlook due to the negative impact of the product recall of Fabuloso Multi-Purpose Cleaners on volume growth. In addition, a slightly higher-than-historical valuation also kept me on the sidelines. The company has reported earnings for its first and second quarter of 2023 since then. While similar dynamics were seen in the company’s Q1 2023 earnings as I anticipated, the forward outlook took a positive turn in the Q2 2023 earnings. With the stock trading below the levels it was trading at the time of my previous article, I thought of taking a deep dive into fundamentals.
In the second quarter, the company’s sales growth saw benefits from higher advertising activities and price increases. In addition, synergies from the recently acquired Red Collar pet food business also helped sales growth. This was partially offset by volume decline due to tough comparisons from the previous year’s quarter and a reduction in promotional activities. Overall, revenue increased by 7.5% YoY to $4.8 billion. Excluding a 1.5 percentage point benefit from pet food business acquisition and a 2 percentage point headwind from foreign exchange, organic sales increased by 8% YoY. The organic sales growth reflected an 11 percentage point benefit from price increases and a 3 percentage point volume decline.
CL’s Historical Revenue (Company Data, GS Analytics Research)
Looking forward, I believe the company should be able to continue delivering organic sales growth as it continues to benefit from price increases. In addition, volume growth should also start recovering in the second half of 2023 due to higher advertising activities, an increase in promotions, and easing comparisons. Further, good strength in Hill’s pet food business and market share gains should help the company sustain its sales growth in the coming years.
Over the last two years, the company has increased its prices meaningfully in order to offset inflationary headwinds. This has benefited the company’s organic sales growth. The company took further price increases in the first half of 2023 and plans to take additional price increases in specific markets where inflation continues to stay elevated. I expect the carryover impact of price increases from the first half of 2023 and additional pricing to continue supporting the organic sales growth.
In addition, volume comps are easing in the back half of the year. The company’s volume comps are getting easier by ~500 bps from Q2 to Q3. This should act as a good tailwind to volume growth recovery and aid in comparable sales growth.
CL’s Historical Organic Sales Analysis ( (Company Data, GS Analytics Research))
Moreover, the company has also increased its advertising activities over the last couple of quarters in order to support the price increases and increase top-of-the-mind awareness among consumers. In the second quarter alone the company increased advertising investments by more than 20% YoY, bringing advertisement as a percentage of sales to 12.5%, well above the pre-pandemic levels. This helped the company build market share in its top categories like toothpaste, sunscreen, and Hill’s pet nutrition. The company plans to keep advertising elevated in the second half as well. This should help the company recover its volume levels by increasing market share and brand loyalty and protecting from consumer trade down moving forward.
Colgate’s Advertising Spend (Barclay’s Global Consumer Staples Conference | September 6, 2023)
Additionally, the company plans to increase promotions to drive sales. In the first half of the current year, the company pulled back on promotional offers in order to offset inflationary costs. This had a negative impact on volume growth in the second quarter due to an increase in the promotional gap with peers. However, moving forward, the company plans to gradually increase promotional activities in order to recover the volume lost to peers in the previous quarters as a result of lower promotions. This should also support the recovery of volume growth and help sales growth in the second half of the year.
Furthermore, the company’s Oral Care business is gaining market share in both developed and emerging markets. This is due to the company’s increased innovation across different price tiers, especially in the whitening category. The company is actively launching high-quality value products at entry price points ($4 to $6) to bring consumers into the whitening category and make them trade up to premium products (>$25) once they get used to the category and require more efficacy. This has improved the demand for the company’s oral care products in its top 8 markets, resulting in a market share gain of 180 bps YTD in 2023. I expect further innovations and elevated advertising to support the category in other divisions and markets across the globe and help gain further market share moving forward. This should help sales growth.
Colgate’s market share gains in Whitening (Barclay’s Global Consumer Staples Conference | September 6, 2023)
Lastly, Hill’s Pet Nutrition division is also experiencing good consumer demand. This is due to increased pet adoption during the pandemic years and now post-pandemic these new pet owners require nutritious pet food and products related to pet hygiene. This is helping the company’s Hill’s Pet Nutrition business. However, last year, the company faced capacity constraints to serve this demand, which led to a market share loss. To tackle this issue, the company acquired the Red Collar Pet food business in September 2022, which helped it gain additional capacity and meet consumer demand. Further, the company is all set to open an additional Pet Food facility in Tonganoxic, Kansas by the end of the third quarter. This should further increase the distribution to better serve the current demand and boost sales for the business.
Hence, management execution in the recent quarters has provided some visibility on volume recovery in the quarters ahead and I believe the above-mentioned tailwinds should help the company sustain growth in its business in the second half of 2023 and beyond.
Margin Analysis and Outlook
In the second quarter of 2023, the company continued to face inflationary raw material costs, which contributed to a headwind of 540 bps YoY. In addition, start-up costs associated with the additional Pet food facility and lower-margin private label volume associated with Red Collar’s business also impacted margins by 70 bps YoY.
However, the company was able to more than offset it through price increases which provided a 450 bps YoY benefit to gross margin, and cost savings initiatives which provided a benefit of 240 bps YoY to gross margin. This resulted in an 80 bps YoY increase in gross margin to 57.8%. The adjusted operating margin benefited from lower SG&A as a percentage of sales due to moderating logistics costs, and operating leverage, despite elevated advertising spend. This resulted in a 60 bps YoY increase in adjusted operating margin to 20.6%.
CL’s Historical Adjusted Gross Profit Margin and Adjusted Operating Profit Margin (Company Data, GS Analytics Research)
Looking forward, I believe the company should be able to continue delivering margin growth. As discussed in the revenue analysis, the company took price increases in the first half of 2023 and plans to further increase prices in specific regions having very high inflation. These incremental price increases and the carryover impact of price increases from 1H23 should help the company’s margin growth moving forward as well. Moreover, the company’s margins should also see benefits from improving volume leverage as volume growth recovers in the back half.
Additionally, while inflation of agricultural raw materials is expected to remain elevated YoY, overall inflation should be less of a drag on the company’s margins due to moderating logistics costs. This should relieve some inflationary pressure from margins moving forward. Management expects FX headwinds to also ease in the second half, supporting margin expansion. Further, the company’s newly acquired pet food capacity with its Red Collar Pet Food business acquisition, had some private label production in it prior to the acquisition, which had low margins. The company gradually decreased this volume mix post-acquisition and expects private label volume to completely come off the mix in the second half. This should result in a favorable volume mix and help margin growth. Lastly, I also expect the new pet food facility opening in Tonganoxic, Kansas in the second half to increase operational efficiency by increasing utilization, which should also help in margin growth. Hence, I am optimistic about the company’s margin growth prospects ahead.
Valuation and Conclusion
Colgate is currently trading at a 23.22x FY23 consensus EPS estimate of $3.17 and a 21.33x FY24 consensus EPS estimate of $3.45. This is below its 5-year historic average P/E of 24.51x. The company also has a decent forward dividend yield of 2.61%. I believe the company has good growth prospects benefiting from price increases, recovering volume growth, higher advertising investments, increasing efficiency, and a favorable cost structure.
While consumer trade down in an inflationary environment is a concern in the near term, I believe the company should be able to weather it and deliver revenue and margin growth, thanks to management’s efforts to sustain the top and bottom line during uncertain macroeconomic conditions. The company’s overall fundamentals seem to be improving with the visibility of volume recovery. This combined with lower than historical valuation, makes me upgrade my rating to a buy.
