Colgate Shows Its Competitive Edge

After digesting third-quarter results, which included 5% organic sales growth and a 70-basis-point increase in adjusted operating margins to 25.3%, we stand by our contention that the combination of

Transactional foreign exchange headwinds again ate away at the benefit from higher prices and cost savings, as adjusted gross margins ticked up just 20 basis points to 58.8%. The more pronounced expansion in operating margin reflected a retreat in ad spending, which tumbled more than 20% from a year ago, equating to just 8.2% of sales in the third quarter, down from its 10% historical average. While we tend to view material declines in brand marketing unfavorably, we've been struck by management's comments that increased promotional spending can be useful in reaching consumer groups more difficult to target and that increased couponing surrounding new product launches can more effectively drive trials, particularly in the United States; this sentiment seems supported by continued market share gains around the world. We don't think Colgate is merely looking to beef up its near-term share and profitability at the expense of the long-term health of the business, as management has repeatedly stressed the importance of a constant stream of locally relevant product innovation. As such, we think the firm is investing to ensure its brand intangible asset isn't eroded and will continue to drive top-line growth balanced between volume and price.

Without providing much detail, management increased the scope of its current restructuring plans that aim to drive supply chain and manufacturing efficiencies. We think efforts to extract further costs from operations will fuel further brand spending, which is particularly prudent given the competitive global landscape in which Colgate plays.

From a segment perspective, North America (20% of sales) posted muted sales growth of just 2%, while in Europe (18% of sales including South Pacific) sales faltered, down 1%. However, increased promotions weighed on price levels in both regions, activity that we anticipate will persist as competitive pressures remain intense. In the firm's emerging and developing markets (around half of worldwide sales), higher prices reflecting foreign currency pressures contributed nearly all of the 8% increase in underlying sales, with volume increasing just 1%. Despite decelerating growth around the globe, management said its categories in emerging regions continue to post mid-single-digit volume growth, even in China, so we don't believe local consumers' spending power for everyday items like oral care has shown signs of meaningfully eroding. Given favorable emerging-market demographic and disposable income tailwinds, combined with the firm's long tenure operating in these markets and solid brand intangible assets, we think Colgate's competitive position is unwavering.

New Products Are the Difference The consistency and balance with which Colgate performs stands out in the consumer product space and underscores the firm's wide economic moat, which is based on its solid brand intangible asset and low-cost operating model. The global toothpaste market--which boasts healthy margins, low private-label penetration, and high levels of brand loyalty--is quite attractive. In addition, the economies of scale that stem from Colgate's geographic reach--more than 80% of sales derived outside North America, including 50% from faster-growing emerging markets--are impressive. However, we think Colgate differentiates itself by constantly bringing to market new products that are tailored to win with local consumers around the world.

Despite the brand strength of Colgate's namesake lineup, we aren't convinced this extends to other areas of the firm's portfolio. For one, the Hill's pet nutrition business (14% of consolidated sales) doesn't seem to fit in Colgate's portfolio, even though management says the importance of relationships with veterinarians is similar to the oral-care segment and dentists. While Colgate is proactively launching new products and has chalked up modest volume growth lately, heightened competitive pressures persist in pet care. As such, it will take a few more quarters before we can gauge whether recent improvements are sustainable.

200 Years of Brand Building With the inherent brand equity in its product portfolio and its vast geographic reach, we think Colgate has garnered a wide economic moat. The size and scale Colgate has built over many years enables it to realize a lower unit cost than its smaller peers, resulting in a cost advantage. Returns on invested capital have averaged 27% over the prior five years, compared with our 7.2% weighted average cost of capital estimate, providing further support for Colgate's wide moat. A focus on the high-loyalty oral-care category has helped the firm build a sustainable edge around the Colgate brand and more than 45% worldwide market share in toothpaste (greater than 3 times its next-closest competitor)--including more than 50% share in India, 70% in Brazil, and 30% in China--which confers tremendous scale. The firm's leading share positions extend beyond oral care to include other personal-care and home-care categories in select markets around the world, further showcasing the brand strength the firm has built up over its 200-year history.

Local Brands Pose a Threat Despite an established, leading position in many of the markets in which it plays, hungry, nationally branded competitors are constantly looking to bite off a larger piece of share, particularly as developed market growth languishes. Local brands could also prove to be more of a threat in overseas markets, since these players possess a solid grasp of the tastes and preferences of in-market consumers.

Further, the firm grapples with wide foreign currency swings in such as markets as Venezuela, where currency devaluations have weighed on results in the past. For example, in fiscal 2014, Colgate disclosed that it incurred a one-time aftertax loss of around $214 million (approximately $0.23 per share) to adjust its balance sheet in Venezuela. Beyond the potential for further devaluation of the Venezuelan bolivar, we think price controls restricting the firm's ability to offset rampant inflation and currency fluctuations could continue to hinder Colgate's reported results over the next several years.

Promotions have at times run rampant in consumer products in the recent past, and with such a narrowly focused product assortment, at some point Colgate may see diminishing returns as it reaches a ceiling on its market share potential. However, given the firm's consistent long-term record, we expect Colgate's gross margins will ultimately show improvement (after dipping to just 57% in fiscal 2011, significantly below its goal of 60%), especially as competitors return to more rational levels of spending. We also suspect the company's stringent focus on cost management will enable it to profitably manage through potential headwinds over the longer term.

Stewardship Is Exemplary Management does an outstanding job of staying focused on its core competitive advantage in oral care, isn't seduced by unsuitable acquisitions, and doesn't overspend in pursuit of market share. The company has a strong bench of talent that seems very much on board with Colgate's strategic focus. Further, management's commitment to returning excess cash to shareholders is evident in the fact that the company has raised its dividend payment consecutively for more than 50 years, a trend we expect to continue over our explicit forecast.

CEO and Chairman Ian Cook has been with the firm since the mid-1970s and has led it since 2007. In fiscal 2014, Cook earned $9.7 million in salary, stock, and options, which seems reasonable to us. We like that 75%-90% of executive pay is performance-based. In addition, we are encouraged by the stock-ownership requirements for senior management, which amount to 8 times base salary for the CEO and 4 times base salary for other named executive officers, as this tends to align management's interests with those of shareholders.