Finally Time To Buy Clorox (CLX) And Church & Dwight (CHD)?

Introduction

The Clorox Company (NYSE:CLX) and Church & Dwight Co., Inc. (NYSE:CHD), two well-known manufacturers of household products, are undeniable winners from the pandemic. Both companies manufacture and distribute a variety of personal care, fabric care, household care products and nutritional supplements, but of course Clorox’s focus on disinfectant products sold under its namesake brand ensured particularly strong sales growth in fiscal 2020. However, as people in general stocked up on supplies as they were spooked by lockdowns to contain the spread of the then-emerging SARS-CoV-2 virus, Church & Dwight also benefited greatly. As a result, shares of both companies soared, reaching almost bubble-like valuation levels. Now that the pandemic is largely over (at least in the Western world), but also due to ongoing supply chain issues and inflationary pressures, valuations have returned to much more reasonable levels. Both companies are undoubtedly facing challenges at the moment, but with Mr. Market so often throwing the baby out with the bathwater, it seems right to ask whether CLX and CHD have already reached the buy zone.

In this article, I will take a deep dive into the fundamentals of both companies and explain which one is better in terms of profitability, balance sheet stability and overall management qualities. I will analyze the main risks of the two companies and the impact of the current challenges on their operations, and provide a comparative valuation assessment.

Overview Of Clorox And Church & Dwight

Clorox and Church & Dwight are similar in size, with current market capitalizations of $18.6 billion and $20.0 billion, respectively. The two are significantly smaller than industry giants Colgate Palmolive (CL) and Procter & Gamble (PG), but still play an important role in most households.

Clorox manufactures and sells bleach and cleaning products under its namesake brand, but also owns well-known brands such as Pine-Sol, Poett, Glad, Kingsford, Brita, Burt’s Bees, NeoCell and RenewLife. The company is growing both organically and through acquisitions, and its brands are organized in four segments. Health & Wellness is Clorox’s largest segment, with sales of $2.69 billion in fiscal 2022 (38% of total sales), followed by Household ($1.98 billion, 28%), Lifestyle ($1.25 billion, 18%) and International ($1.18 billion, 17%). Unsurprisingly, the Lifestyle segment is by far the most profitable segment (2021 earnings before taxes – EBT – margin of 22%), as it includes high-margin brands such as Brita water filters, Burt’s Bees personal care products and Hidden Valley dressings, dips and condiments. Clorox’s portfolio EBT margin in 2021 was approximately 13%. In my opinion, Clorox undoubtedly has a number of very solid brands (several number one positions in their categories) that give rise to a strong economic moat, but the potpourri of categories confuses me somewhat. I don’t quite understand the potential synergies between dressings, dips and seasonings on the one hand, and water filters and personal care products on the other. On a positive note, the company is aggressively investing in research and development, ensuring continued innovation and differentiation from private label brands. As mentioned earlier, Clorox has benefited greatly from the pandemic with its range of hygiene products and has further entrenched its position – also through its business unit targeting professional customers. Sales in fiscal 2022 (which ended in June 2022) were down 3.2% compared to fiscal 2021, or up 2.8% on a two-year annualized basis, but it’s worth remembering that sales in fiscal 2020 were 9% higher than the previous year. The company is currently combating inflationary pressures through price increases and operational rationalization measures, which only come into effect gradually.

Church & Dwight’s focus lies on household care and personal care products. It is best known through the Arm & Hammer brand, under which the company sells baking soda-based products, cat litter products and laundry detergents. Other brands include Spinbrush, First Response, Nair, Vitafusion, Waterpik, Zicam and Trojan. Like Clorox, Church & Dwight is growing partly organically and through acquisitions. The company also benefited from pandemic-related demand, with sales growth of 12% in 2020 and 6% in 2021 (9.1% on a two-year compounded basis). CHD’s operations are divided into three segments: Consumer Domestic, Consumer International, and the Specialty Products Division, which manufactures and markets products relevant for animal and food production, specialty chemicals and specialty cleaners. The Consumer Domestic segment is by far the largest, with sales of $3.9 billion in 2021 (76% of total sales, EBT margin of 22%), followed by the International segment ($912 million, 18% of total sales) and the Specialty Products Division ($336 million, 6% of total sales), both of which are significantly less profitable, with 2021 EBT margins of 14% and 10%, respectively. Overall, CHD was significantly more profitable in 2021 than Clorox in fiscal 2022, with a portfolio EBT margin of 20%.

Church & Dwight Performs Like Clockwork, Clorox Not So Much

A closer look at the profitability of the two companies reveals that in 2019 CHD and fiscal 2020 CLX, the two companies were on par in terms of profitability, with EBT margins of nearly 18%. Both companies currently face inflationary pressures due to supply chain disruptions and other consequences of pandemic-related measures, but so far Church & Dwight has done a much better job of managing inventories, keeping selling, general and administrative expenses at bay, and passing on price increases to consumers. As a result, gross margin has declined only 1.9 percentage points, while Clorox’s gross margin has declined more than 9.7 percentage points over the past three (fiscal) years to 35.8%. In 2019 CHD and fiscal 2020 CLX, gross margins were still on par at around 46%. However, due to the difference in reporting periods, the comparison is not entirely fair. A comparison to Church & Dwight’s second quarter 2022 P&L shows a 3.7 percentage point decline in gross margin over the last three years, which is still a much better performance than Clorox. A comparison of CHD’s third quarter of 2022 with CLX’s first quarter of fiscal 2023 (July through September period) confirms that CHD’s gross margin has indeed stabilized at respectable 41.7%, while Clorox is still struggling to return to somewhat acceptable gross profitability, as evidenced by its margin of 36.0% during Q1. I have no doubt that Clorox will be able to implement price increases and strengthen its supply chain in the long run, thereby improving gross profitability. However, given that Clorox is vertically integrated in some businesses (e.g., it co-owns clay mines that manufacture cat litter product precursors), the company’s current weak performance is nonetheless a bit surprising.

Church & Dwight also appears to be much better managed over the longer term, as shown by the margin comparison (Figure 1 – Clorox, Figure 2 – Church & Dwight). The figures compare operating and normalized free cash flow (nFCF) margins of the two companies. Free cash flow (FCF – operating cash flow less net capital expenditures) has been normalized for working capital movements, stock-based compensation expenses and recurring impairment charges. Those interested in how to calculate sustainable free cash flow should take a look at my detailed article. Church & Dwight’s margins are rock solid. Clorox has improved its cash flow profitability over the years, but the fact that its cash conversion cycle (CCC) remains at 33 days (with the exception of fiscal years 2021 and 2022) suggests room for improvement in working capital management. In 2012, CHD’s and CLX’s cash conversion cycles were still very similar, but thanks to increasingly rigorous accounts receivable management and stretched payment terms with suppliers, Church & Dwight has overtaken Clorox over the years, which is one of the main reasons for the higher free cash flow margin.

As my regular readers know, I tend not to look too much at a company’s income statement and spend much more time on the cash flow statement. By putting normalized free cash flow in relation to invested capital, cash return on invested capital (CROIC) can be calculated, which I think is the go-to metric for evaluating profitability. Unlike ROIC, which is based on after-tax net operating profit and thus is an entity-centered metric that should be compared to the weighted average cost of capital, CROIC is compared to the cost of equity (COE). A company that is consistently able to generate a return above its cost of capital is what we should be looking for as long-term oriented value investors. Instead of the Capital Asset Pricing Model (CAPM), my estimates for COE are based on my own assessment of the two businesses and I believe a 5% risk premium on the risk-free rate (the yield of 30-year treasuries) seems reasonable. Church & Dwight is the more reliable company in that it generates very consistent CROIC (Figure 3), which underscores the qualities of its management team. However, Clorox’s CROIC (Figure 4) improved to a higher level than CHD’s between 2012 and 2015. This is due to the relatively faster expansion of invested capital at Church & Dwight. Comparing historical balance sheets, it becomes evident that Clorox’s net property, plant & equipment (PP&E) grew at a compound annual growth rate (CAGR) of 2.1%, slower than sales (ten-year CAGR 2.7%). Similarly, goodwill, trademarks and other intangible assets (GTI) grew at a CAGR of 3.4%. Clearly, Church & Dwight is growing at a much faster rate, as evidenced by its ten-year sales CAGR of 6.6%, PP&E CAGR of 2.6%, and most importantly, GTI CAGR of 12.5% (with a slight skew toward growth in trademarks and other intangibles). Investors in Church & Dwight should therefore watch for future impairment charges. While the company’s cash flow statement does show recurring impairment charges, they are not really significant and have already been accounted for in Church & Dwight’s CROIC calculation. Given CHD’s emphasis on growth through acquisition, it is fair to assume that the company is integrating its acquired businesses very well, otherwise the cash conversion cycle would not be at such a low level and/or the CROIC would be deteriorating. As an aside, it seems worth noting that CHD’s inventory days (also a component of CCC) have increased in recent years, but the impact of optimizing accounts payable and accounts receivable management outweighed the slightly negative impact of inventory management. Going forward, conservative investors should keep a close eye on Church & Dwight’s inventory management and the integration of newly acquired businesses.

Balance Sheet Quality And Dividend Safety Of CLX And CHD

As mentioned earlier, companies that pursue a strategy of growth through acquisition run the risk of overpaying in their – sometimes desperate – efforts to drive growth. Such companies increase their leverage, and since goodwill and other intangible assets must be written down if it turns out that the acquired entity cannot grow as expected, or the synergies do not materialize, the quality of the balance sheet deteriorates. In the case of the two companies under review here, material impairments are very rare, and the robust excess CROICs mentioned earlier underscore that both Clorox’s and Church & Dwight’s acquisitions were very well integrated.

Debt, unsurprisingly, plays a role in the balance sheets of both companies. As can already be deduced from the much stronger (acquisition-related) growth, net debt at Church & Dwight rose from just $0.8 billion in 2012 to around $2.2 billion most recently. Clorox’s net debt has generally been fairly consistent at around $2.8 billion, but declined temporarily between 2013 and 2017. In relative terms, things look quite different, as Figure 5 (Clorox) and Figure 6 (Church & Dwight) show. Church & Dwight’s debt is very reasonable, as underscored by its robust interest coverage ratio of typically about 15 times pre-interest nFCF. But Clorox’s debt is also nothing to be afraid of – the notional debt repayment period, which assumes Clorox hypothetically suspends dividends to accelerate debt repayment, was four years based on fiscal 2022 nFCF. However, it should be remembered that free cash flow has been normalized with respect to working capital movements, so the number looks a bit more positive than the company’s fiscal 2022 cash flow statement suggests. Clorox’s interest coverage ratio, which is typically around eight times pre-interest nFCF, is also far from alarming, especially considering that the company’s operating profitability has likely bottomed out in recent quarters. As consumers become accustomed to higher inflation rates, I believe that companies selling low-$ items in particular are in a better position to implement price increases that will boost operating profitability.

Both companies have a history of dividend increases that goes back decades. According to MarketBeat, Clorox has raised its dividend for 35 consecutive years, while Church & Dwight does not have such a long history with 26 years of consecutive increases. Clorox’s payout ratio in terms of earnings per share was 127% in fiscal 2022, as the company paid out $586 million to shareholders and noncontrolling interests, but only recorded $462 million in earnings for the year. Needless to say, this rather appalling ratio is not very reassuring. On a cash flow basis, things look a bit better, as the company paid out 110% of its conventionally calculated FCF, or 90% of normalized FCF. In my first article on the company, I discussed some uncomfortable thoughts related to Clorox’s dividend, but as mentioned above, I believe that fiscal 2022 was Clorox’s trough year and things should improve going forward. It should be remembered that Clorox is a market leader in several categories and continues to invest heavily in innovation and marketing. As a result, I think it is reasonable to expect Clorox’s currently high payout ratio to settle back to the 70%-mark long-term investors are used to. I think management has sent the right signal by announcing another dividend increase, albeit a small one. Over the longer term, Clorox’s dividend growth has declined slightly, from 6.7% (ten-year CAGR) to 5.8% (three-year CAGR). However, I believe management will continue to treat shareholders well and return to higher dividend growth when operations allow.

CHD shareholders can probably sleep much better at night, as the company’s earnings and cash flows continued to be very strong in 2021 and so far in 2022, having been only moderately impacted by higher commodity prices, transportation costs, and higher wages. In addition, the dividend payout ratio is much more conservative than Clorox’s and is typically only around 30% of normalized free cash flow. Given that CHD’s management is acting from a position of balance sheet and cash flow strength, it seems surprising that the dividend CAGR also declined when comparing the ten-year CAGR to the three-year CAGR – 8.1% versus 4.9%. The latest increase of only 4.0% could be considered disappointing, but is likely indicative of management’s conservative approach, which should be appreciated by long-term shareholders. Considering that this increase came at a time when interest rates were still at pandemic lows (January 2022) and inflation was just beginning to run rampant, I can understand management’s likely thinking. In this context, it will be very interesting to see if a more significant dividend increase is announced in late January 2023.

Risks Of An Investment In CHD And CLX

As discussed earlier, both Clorox’s and Church & Dwight’s dividends appear safe, but the latter company, of course, has much greater room for increases and, likewise, a stronger buffer capacity in times of operating weakness. Since both companies sell mainly non-discretionary, everyday items, their earnings are not really cyclical. However, in times of economic weakness, low-income consumers will trade down from Clorox’s and Church & Dwight’s typically more expensive branded products. This effect should not be overstated, however, considering that CHD and CLX sales grew 4.1% and 3.4% in 2009 and fiscal 2009, respectively, compared to the previous year. Nevertheless, private labels, which are increasingly available in both online and offline retail, are the companies’ main competitors. Due to the virtually non-existing switching costs, consumer staples companies such as CHD and CLX have a constant requirement for innovation and marketing-related capital expenditures. In the context of customer switching behavior, I believe Clorox has a slight advantage due to its professional segment, but at the same time this increases its cyclicality somewhat. Both companies operate internationally and are therefore moderately exposed to currency risk. Other risks, such as vulnerability to input cost increases, are currently very visible and – I believe – largely priced in. Of course, there is a fine line between not passing on costs to customers and losing market share due to an overly aggressive pricing policy.

Comparative Valuation Of Clorox And Church & Dwight

Both CHD and CLX have declined significantly from their exuberant pandemic highs and have recovered slightly recently. However, the historical valuations in Figure 7 and Figure 8 show that the stocks still cannot be considered cheap. A look at the discounted cash flow sensitivity analyses (Figure 9) confirms this from a different perspective: at a cost of equity of 8.8% (risk premium of 5% on the 30-year treasury yield), the free cash flow of CLX and CHD would have to grow by 4.2% and 5.0%, respectively, in perpetuity to justify their respective current stock prices. I would not call either stock grossly overvalued, but certainly overvalued even though CLX and CHD have been able to grow their normalized free cash flow at a CAGR of 6% and 8%, respectively, over the past decade.

The fact that CHD and CLX are at least fully valued (not to say overvalued) is understandable given that we are obviously in a late stage of the cycle where defensive consumer staples and pharmaceutical stocks tend to have solid valuations (see my recent article on whether it is time to sell Big Pharma stocks).

In closing, I would like to present my FAST Graphs-inspired charts for CLX and CHD, relating their stock prices to their respective normalized free cash flow per share. Figure 10 shows that Clorox’s stock price has tracked its normalized free cash flow quite well, with the exception of the exaggeration in 2020. CHD’s free cash flow profile in Figure 11 nicely illustrates the company’s clockwork-like performance. Church & Dwight’s share price has already decoupled from fundamentals in 2019, and of course the “staples trade” in 2020 has pushed the already high valuation to an almost bubble-like level. In 2022, CHD’s valuation has pretty much reverted to fundamentals. To be fair, however, it should be added that CHD’s cash flow reliability is to some extent attributable to share buybacks. Between 2011 and 2021, the company reduced its diluted shares outstanding by 13%, increasing free cash flow (and earnings) per share by 16%. Clorox’s repurchases over the last ten fiscal years have been much more modest, as the company reduced its share count by only 7%.

The two figures illustrate that neither CLX nor CHD are cheap from a historical cash flow perspective, but they aren’t overly expensive either. It appears that the era of cheap credit has come to an end and speculative excesses may therefore be a thing of the past for the foreseeable future. This should benefit classic value stocks like CHD and CLX and put a floor under their share prices. On the other hand, if central banks return to easy money policies in an emergency, thereby fueling further speculative excesses, I expect stocks of companies like CHD and CLX to decline in value further.

Conclusion

Clorox and Church & Dwight have undoubtedly benefited greatly from the pandemic, further cementing their strong positions with consumers through their proven brands, targeted marketing initiatives and focus on innovation. Of course, both companies are currently facing supply chain headwinds and must pass on price increases to consumers in order to restore gross profitability. Church & Dwight is in a better position in this regard due to its higher-margin brand portfolio, better focus and stronger management. However, even though Clorox’s operating profitability looks rather bleak at the moment, I believe that fiscal 2022 was the company’s trough year and it will restore its 40%+ gross margin by improving its supply chain and – slowly but surely – passing on price increases. Clorox is the market leader in many of its product categories, and the fact that the company also has business relationships with professional customers should not be forgotten either. CHD and CLX are significantly smaller than industry giants Procter & Gamble and Colgate Palmolive, but they still benefit from economies of scale that give them an edge over smaller competitors. Competition from private label brands, which are increasingly accepted by younger consumers, is a legitimate concern, especially with the threat of recession looming, but I don’t think the trustworthiness of either company’s brands should be underestimated. I’m not too big a fan of Clorox’s management and think Church & Dwight’s long-term prospects are better, especially from the perspective of an income-oriented investor. CHD is undoubtedly the better dividend stock, even though management seems rather conservative in terms of growing the dividend.

Given that we are late in the cycle, it is hardly surprising that the valuations of both companies’ stocks are holding up quite well – except for the unsurprising pullback from the speculation-fueled highs of 2020. It is difficult for me to conclude that CHD and CLX are grossly overvalued – from a free cash flow perspective, they appear fully valued or slightly overvalued. I do not currently intend to add either company to my portfolio. However, at the right price, I could see myself building a small position in Church & Dwight, which I think is a great and also well-run company. I expect the share prices of consumer staples stocks to approach more reasonable valuations during the next economic expansion, which should lead to funds flowing back into fast-growing companies in modern economy sectors. Likewise, the return to cheap credit and associated speculative excesses in ultra-high duration stocks (see my recent article) should also give investors the opportunity to build positions in defensive stocks at more reasonable valuations.

Thank you very much for taking the time to read my article. In case of any questions or comments, I am very happy to read from you in the comments section below.