Clean Up with These Household Products Picks

"Even if you look at the U.S. economy over the last three to six months, most of the consumption from borrowing more on your home went into discretionary items.... People are not reducing tooth-brushing incidence. They are not going to the bathroom less often. They are not shaving meaningfully less often."
A.G. Lafley, CEO, Procter & Gamble
Second-quarter conference call, Jan. 31, 2008

With more and more dismal news coming out each day, it seems there is no escaping the credit problems cascading through all sectors of the market. The companies on display at the Consumer Analyst Group of New York (CAGNY) conference we recently attended are certainly not immune to many of these problems, particularly the impact of rising oil prices and commodity costs. Still, there is bedrock to these firms, because many of their products are not discretionary. If we are headed for a protracted period of low or negative growth and inflationary pressure, many of these companies should be fine--but some will certainly struggle. The question becomes which companies are best positioned to survive and prosper in a downturn.

Based on what we saw at CAGNY, there are just as many company-specific issues facing firms in the household and personal care (HHPC) product sector as there are bigger-picture macroeconomic issues. My colleagues Mitchell Corwin and Greggory Warren kicked off this series of articles two weeks ago; they addressed our insights from CAGNY and covered a lot of the bases. I won't spend much time discussing the key points that they've already thoroughly discussed, such as the impact of commodity costs or the role of private-label brands. Instead, I'll focus on two slightly different but common themes specific to HHPC companies. I will also incorporate some explicit issues facing each of the companies that presented at CAGNY.

New Product Cycles: Where Is the Disruptive Technology and Value Brands?
Based on what we saw at CAGNY, there are not a lot of new products to get excited about in the HHPC sector. By design, analysts don't have a lot of visibility into new product pipelines. Much of the marketing excitement around new products is built into the launch of the product, so there is often little notice about new products that are set to hit shelves until they are already on the shelves.  Procter &Gamble's  (PG) launch of its Fusion razor was a rare exception. The company was set to close on its acquisition of Gillette, and management wanted to give analysts and the public a glimpse into its new product pipeline, despite the fact that Fusion wasn't going to be rolled out until early the following year. The strategy worked well for P&G, and the brand had an incredibly strong launch, partly due to buzz about the product.

Currently, we don't hear much buzz about blockbuster new products. In our opinion, most of the companies in the HHPC sector have their hands full with acquisitions, divestitures, or cost-cutting initiatives. The big new product launches--the ones that are born out of "disruptive technology," as CEO of Proctor & Gamble A.G. Lafley calls it, and come along every seven or eight years--aren't on the horizon in the near term. Prior to attending CAGNY, we had been thinking that the HHPC sector was in a bit of a downcycle for breakthrough products, and nothing we saw from the companies at the conference really challenged this view. Colgate is busy improving its at-the-shelf promotions and merchandising, Energizer is digesting its acquisition of Playtex, and Clorox is integrating Colgate's bleach business and its Burt's Bees acquisition. Moreover, if consumers are becoming more selective about their purchases, this is a difficult time to introduce ground-breaking new products.

Gaining awareness for new products is much more difficult and expensive now than it was 10 years ago, because brands are more narrowly targeted and dispersed through more retail channels. New brand rollouts and big product launches are risky ventures, and even in the staid HHPC sector there doesn't appear to be much appetite for risk.  Avon  , for example, recognized it needed to do a better job of balancing the number of "super hits," core new product introductions, and product restages, and from 2005 to 2007 the firm shifted its product emphasis across these categories. While we are always excited about new products that open up whole new categories and tap into previously unknown consumption opportunities, these are harder to come by. When the macroeconomic environment is as choppy as it has been, we think companies will lean toward a reliable stream of more modest innovations and safer line extensions.

So if no big blockbuster products are hiding in the shadows, what should we expect to see on the shelves from HHPC firms over the coming months? All of the companies have been pushing consumers up the new product food chain over the past several years, as they have pursued strategies of "premiumization." By adding more benefits to products, HHPC companies are able to command higher prices for everything from diaper swim pants to razors, all the while protecting margins from input cost inflation and keeping private-label competitors at bay. P&G calls this "pricing with innovation." HHPC firms were able to move up the food chain when home prices were rising at a rapid clip, and consumers felt wealthier. Now that home prices have crashed back to Earth, and consumers no longer have imaginary home value to borrow against, we are seeing evidence that they are starting to become more cautious in their spending. In the absence of breakthrough innovation, will these higher prices appear worthwhile to the consumer?

So far, these companies aren't reporting that consumers are trading down to lower-priced offerings, but we wouldn't be surprised to see this happen. Most companies across the HHPC sector need to raise prices to offset higher costs, and almost all seem to assume that the consumer will have no trouble maintaining brand loyalty and absorbing these higher prices. We're not quite so dismissive of the 5%-6% increases these companies are implementing, however. At some point the consumer might seek relief wherever it can be found, and it may be in the form of the value-brand shampoo that was spurned for so long.

Few companies have been talking about the value segment of their categories, since profitability of value-priced offerings has been slowly eroding. The value end of categories is where private-label products have had the greatest impact and taken the most market share. Should value brands come back into vogue, it will take some time for these firms to reposition themselves and unwind their focus on the premium end of the spectrum. We've been slowly dialing back our expectations for margin expansion over the past year, both to account for commodity cost increases and for the possible mix shift away from the higher-margin products that have been fueling margin expansion over the past several years. The presentations at CAGNY reinforced our view that the conservative assumptions we've been making are warranted.

Productivity Cycles: Which Companies Have Opportunities Now?
Part of the reason we don't foresee a cycle of blockbuster new products rolling out is that the focus from many of the HHPC companies right now is either integrating acquisitions or extracting more efficiencies out of their current operations (or both). Energizer is a good example of this. In October 2007, the firm completed its acquisition of Playtex Products. In April 2007, however, Playtex purchased Hawaiian Tropic and had only just started integrating the sun-care manufacturer before being acquired by Energizer. Now the battery and razor manufacturer is getting up to speed on new categories such as feminine care, sun care, and infant care and is looking to funnel Playtex products into its broad international distribution network.

Clorox is another good example of a company with a lot on its plate, although some of it is new product news with its Green Works launch of organic household cleaners. Commodity costs are wreaking havoc on the firm's margins, so finding ways to mitigate cost pressures is a large priority. Commodity cost inflation negatively impacted Clorox's gross margins by 170 basis points in the second quarter and the firm estimates the biggest impact for the year will be in the third quarter.

Both Energizer and Clorox have a lot going on as they grapple with acquisitions and commodities, but like other companies in the sector, namely P&G, there are opportunities as well. Energizer has already stated it will achieve more synergies from its Playtex acquisition than initially anticipated. Clorox will enjoy some distribution synergies as it expands Burt's Bees into mass and grocery channels, as well as cost savings as it exits private-label trash bag manufacturing and brings more charcoal manufacturing in house.

During CAGNY, P&G talked about improving productivity in brand support, marketing, and merchandising and operations, and the firm formalized its plans by announcing headcount reductions and a reorganization of its international operations. P&G has had its hands full ensuring a smooth transition as Gillette was integrated. Now that the integration is complete, the firm can step back and take a harder look at its operations and better align its resources with its opportunities.

Standouts at Reasonable Prices
Given current market conditions, there are certainly a lot of bargains around. While the HHPC sector won't likely garner investors eye-popping returns, we think the market has unfairly punished many of these companies, giving investors with a long-term horizon a chance to buy solid firms that can withstand the test of time. Many of these companies offer healthy dividend yields, and they all generate strong cash flows and have solid balance sheets.

 Clorox (CLX)
Moat: Narrow | Price/Fair Value Ratio*: 0.78 | 5 Stars
We went to CAGNY most concerned about our outlook for Clorox. The company has its hands full with its Burt's Bees acquisition and its commodity exposure, potentially distracting it from its legacy brands. We were quite reassured by what we heard at CAGNY. The firm has solid plans to boost growth in core categories and to exit unprofitable business segments. Expansion overseas appears to be more measured than in the past, so the firm seems to have learned its lesson from problems it encountered in Brazil years ago. Most importantly, we see real upside to the Burt's Bees acquisition, and in talking to management, it's clear that the company is well aware of how it needs to tread carefully with plans to expand distribution or else it risks destroying the brand's strong niche appeal. We recognize that Burt's Bees is not the most natural fit with Clorox, but the company is on a path to reinvent itself with products that are health- and wellness-focused. In our opinion this is a smart strategy and one that can give the company a solid growth trajectory for the long run.

 Energizer  (ENR)
Moat: Narrow | Price/Fair Value Ratio*:  0.86 | 4 Stars
We have an above-average risk rating on Energizer for one basic reason: lack of transparency. The company hardly ever talks to analysts and provides no guidance, which gives us little visibility into its strategic plans and makes estimating the company's cash flows and earnings much more challenging. One of the only places where Energizer management speaks to the analyst community is at CAGNY. What we heard from CEO Ward Klein was the same no-nonsense, matter-of-fact strategies that we've come to expect from the company, which fares quite well in both batteries and razors when competing against P&G, a much larger competitor. While the first quarter after the Playtex acquisition offered up more surprises than usual, in the form of higher corporate expenses and receivables, we believe these are only temporary problems for the firm. Longer-term problems are input costs for zinc and nickel, but Energizer has done a decent job with hedging against these costs. More importantly, the firm has a battery business that includes premium batteries, such as lithium and rechargeables, both of which capitalize on consumer trends in portable electronic devices. We expect the company will apply the same discipline to integrating Playtex as it did to its Schick-Wilkinson Sword acquisition; at CAGNY the firm announced that it anticipates synergies from the deal will be roughly $70 million, or $13 million higher than it initially estimated.

 Kimberly-Clark (KMB)
Moat: Narrow | Price/Fair Value Ratio*:  0.88 | 4 Stars
Of the HHPC companies that presented at CAGNY, Kimberly-Clark seemed to have the least amount of news. Little has changed in the firm's strategies over the past year; the company is still relentlessly focused on reducing costs and accelerating growth in developing and emerging markets. It has, however, stepped up its marketing investments. The company is a solid cash-flow generator with a trailing annual dividend yield of nearly 3.5%. We'd like to see more innovation on the new product front from Kimberly-Clark, but the firm remains a solid performer.

 Procter & Gamble  (PG)
Moat: Wide | Price/Fair Value Ratio*:  0.88 | 4 Stars
P&G remains one of the best-positioned companies in the HHPC sector. During the firm's CAGNY presentation, CEO A.G. Lafley came out swinging, reminding the audience of all of the market ups and downs that the company has experienced. The firm is coming off several years of strong new product introductions and the integration of a massive acquisition. We're pleased to see the increased focus on productivity because without a push like this every several years, large firms like P&G risk becoming too bloated. Given the aggressive goals the company put forth, we're much less concerned about overhead costs growing too fast. Only a handful of countries where P&G operates receive a half overhead growth (HOG) designation, which means they warrant investment where overhead is allowed to grow to only half the rate of sales. Corporate functions are allowed zero overhead growth (ZOG) and those businesses not meeting targets must show overhead declines or negative overhead growth (NOG). Lafley has been a strong steward for P&G since taking over the company prior to the last downturn in the market. The company continues to prove it has some of the strongest brands and the best marketing insight in the HHPC industry.

* Price/Fair Value Ratios based on closing prices as of Wednesday, March 19, 2008.