Clorox Is Cleaning Up

 Clorox (CLX) competes in categories with high levels of private-label penetration and derives the bulk of its revenue from mature, developed markets. Despite this, we think the household product company's strong brands (nearly 90% of which are number one or two in their respective categories) and relative cost advantages will continue to drive healthy results.

We regard Clorox as one of the more innovative firms we cover, which enhances its ability to raise prices; management anticipates garnering 3 points of growth from new products again in the current fiscal year and longer term, which should help the firm maintain its competitive positioning throughout varying operating landscapes. We've long believed Clorox’s brand equity and investments in product innovation and marketing support are a plus (in aggregate representing about $600 million of spending annually, or 11% of consolidated sales). Our thinking seems to be supported by management's commentary that shipments of its Glad premium trash bag products (which includes Glad OdorShield and trash bags with Febreze) have held up, indicating to us that consumers are still willing to pay up where they see added value.

While the firm competes in the household and personal-care markets against significantly larger rivals, its focus on niche categories has served it well, and its lean cost structure has resulted in operating margins in the midteens, comparable with those of leading industry peers like Procter & Gamble (PG). Beyond maintaining a tight focus on its cost structure, we think Clorox's efforts to expand into adjacent product categories--with the aim of reducing its dependence on product lines like trash bags and food containers, where consumers are probably more inclined to shop on price--are paying off and helping it stand out from the competition. From our perspective, this type of expansion can smartly leverage a strong brand like Clorox or Glad, while also boosting margins.

Brand Strength Is Undeniable
We afford Clorox a Narrow Morningstar Economic Moat Rating on the basis of its strong brands and relative cost advantage, which allow the firm to sustain leading market share and generate solid returns and excess cash flow for shareholders. Clorox's brand strength is undeniable, as nearly 90% of its portfolio (which includes leading brands such as Clorox, Glad, Hidden Valley, Kingsford, and Brita) holds the number-one or -two spot in the aisle. The brand equity inherent in its product lineup is further evidenced by the fact that since 2005, the firm has taken 66 price increases across its business, and 64 of those are still in place--a 97% success rate. We also think Clorox is a valuable partner for retailers, as its brands (like Clorox bleach and Kingsford charcoal, which compete in categories where private-label offerings maintain substantial share) drive traffic in stores--a characteristic that value offerings can't tout. Further, Clorox has amassed scale and subsequently is able to garner a lower cost per unit than its smaller peers. In fact, Clorox's margins (at nearly 18%) are not out of whack compared with those of its significantly larger peer, Procter & Gamble (around 19%). These factors, combined with the fact that Clorox boasts returns on invested capital (which have averaged 23% over the past five years) far in excess of our 7.7% cost of capital estimate, support our stance that the firm maintains a narrow economic moat. However, Clorox operates in categories where competitive pressures abound, particularly from private-label offerings, and as such, we don't believe the firm garners a wide moat. In addition, there are no meaningful switching costs among products, and consumers have a choice of multiple brands in almost every category.

Risks Include Commodity Costs and Weather
Clorox is influenced by the commodity-driven nature of its business, and volatile commodity costs can have a significant impact on profitability. Further, cold weather throughout the U.S. has plagued charcoal sales this year, and persistent economic challenges and price controls in Venezuela and Argentina are taking a toll on the firm's international business--an adverse predicament that has proved fairly common over the past several years. Private-label penetration is high in many of the company's categories, and management has more recently called out heightened competitive pressures, particularly in the laundry additive and disinfecting wipe categories, as a challenge. As such, the company plans to step up its merchandising efforts and invest behind its brands, which we view as an appropriate response, but we caution that promotional spending isn't a sustainable long-term strategy. Forty-five percent of total revenue is concentrated with only five domestic retailers (26% from Wal-Mart alone), indicating that Clorox maintains significant exposure to the consolidation among retailers, which could weaken Clorox's pricing power.

While the firm has looked to acquisitions to build out its product and geographic footprint, the timing of the Burt's Bees deal was poor; at 2008 prices, management had to write down $258 million in goodwill in 2011 when the optimistic projections underpinning the purchase price failed to materialize. However, we don't disagree with the aim of product diversification or the focus on the natural or organic niche. The issue is more about growth, and as Clorox has come to realize with its Green Works brand, consumers are willing to pay for natural or organic products, but not necessarily the premium that was once expected.

Shares Look Attractive
Our fair value estimate of $95 per share implies fiscal 2014 price/earnings of 20 times, enterprise value/EBITDA of 12 times, and a free cash flow yield of 4.9%. The cold weather throughout the U.S. has plagued charcoal sales recently (which we think is a temporary setback), and persistent economic challenges and price controls in Venezuela and Argentina have taken a toll on the firm's international business. In addition, elevated levels of unemployment at home will probably keep a lid on consumer spending over the near term. Despite this, we anticipate that over our 10-year explicit forecast, Clorox will ultimately benefit from its solid brand portfolio as well as investments in new products. We forecast top-line growth of 3.3% in fiscal 2014 (in line with management's 2%-4% guidance). Longer term, we expect sales growth of 4.2% (consistent with Clorox's 3%-5% long-term target).

Input cost inflation has made margin expansion difficult to come by over the past few years, and management expects an uptick in input costs equating to a 100-basis-point headwind in fiscal 2014. However, we think the firm's cost-management efforts should lead to modest profit improvement during our forecast period. While we think that a portion of any savings generated will be reinvested in the business in the form of advertising spending and product innovation, we forecast operating margins will expand to nearly 19% by fiscal 2023, about 100 basis points above the average margin generated over the past five years. Throughout the next 10 years, we expect return on invested capital to average 25%, well in excess of our 7.7% cost of capital estimate, supporting our opinion that Clorox maintains a narrow economic moat. We place a low degree of uncertainty around our fair value estimate for the shares, as we think projections of the company's cash flows fall within a fairly narrow range.