Slowing Growth Bites Colgate’s Sales, but Profits Sparkle

Unfavorable foreign exchange and slowing category growth took a toll on

Our thinking regarding the sustainability of Colgate’s competitive edge is based on the firm’s strategic bent toward driving balanced and profitable top-line growth, combined with our expectation that the firm is reluctant to veer from this course. Between fiscal 2009 and fiscal 2016, Colgate drove a nearly 5% average top-line increase, with growth fairly balanced between prices (up more than 2%) and volume (up almost 3%). Management’s rhetoric continues to echo the importance of locally relevant product innovation, even at premium prices. Therefore, our forecast calls for Colgate to spend north $1.5 billion (9%-10% of sales) on advertising and promotions and around $300 million (more than 1.5% of sales) on research and development, on par with wide-moat-rated peers Procter & Gamble PG and Unilever UL/UN. This should ensure Colgate maintains its competitive prowess.

While Latin America’s results (24% of sales) were quite robust, with organic sales up 10.5%, the remainder of the firm’s geographic markets were more tepid. In Europe (16% of sales) and Asia-Pacific (18% of sales), region-specific factors constrained sales, which were down 3.5% and 2.0%, respectively. In Europe, Colgate’s sales were hindered by a dispute with a French retailer that has since been resolved, while the unexpected demonetization in India was the primarily driver behind the retreat in Asia-Pacific, with management claiming it would have posted positive gains excluding this event.

Despite recent challenges, management continues to emphasize that its categories in emerging regions are still posting mid-single-digit volume growth, as local consumers’ spending power for everyday items like oral care has failed to show 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 solid competitive positioning will persist over the longer term. As a result, we forecast 5%-7% annual sales growth in Colgate’s emerging regions longer term, versus the 4% growth we expect on its home turf.

The firm continues to churn out robust free cash flow, which shot up to nearly 17% of sales in fiscal 2016 from 14% in the prior year. We think Colgate’s capital allocation will continue to center on reinvesting in the business as well as returning excess cash to shareholders in the form of higher dividends--the firm has raised its dividend payment for more than 50 consecutive years--and additional share repurchases. We believe management does an outstanding job of staying focused on its core competitive advantages in oral care, isn’t seduced by unsuitable acquisitions, and doesn’t overspend in the pursuit of market share gains, and we expect it will remain an exemplary steward of shareholder capital.

Cost Edge and Scale Help Dig Wide Moat The consistency with which Colgate performs stands out in the consumer products space and underlies the firm's wide moat. With a portfolio of leading brands in several categories across the grocery store, Colgate is a valued partner for retailers reluctant to risk costly out-of-stocks with unproven suppliers. Further, it maintains vast resources to reinvest behind its brands; R&D and marketing amount to 11% of sales, or $1.8 billion annually. This has enabled Colgate to entrench itself in retailers' supply chains, supporting the brand intangible asset source of its wide moat.

Colgate’s solid competitive positioning also stems from its cost edge and the economies of scale that result from its broad geographic reach--around 75% of sales are derived outside North America, including 50% from emerging markets. The firm has historically generated operating margins north of 20%, and when adjusted for expenses not directly linked to the production and distribution process, Colgate’s profitability appears to be in the top tier of the industry. As a means by which to support its leading competitive edge, Colgate brings new products to market that are tailored to win with local consumers around the world.

A focus on the high-loyalty oral-care category has helped the firm build a sustainable edge around the Colgate brand. In our view, Colgate’s commitment to bring locally relevant new products to market, even those at a premium price, and tout that fare in front of consumers supports its competitive edge, as evidenced by continued share gains: The firm maintains 45% worldwide market share in toothpaste (greater than 3 times its next-largest competitor), including more than 55% share in India, 75% in Brazil, and 30% in China.

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. But we also think that by maintaining a leading position across a number of categories, Colgate is a valued partner for retailers, supporting another aspect of the firm’s intangible asset moat source. With the resources to launch new products and market them in front of consumers to drive customer traffic, Colgate enhances the stickiness of its retailer relationships, in our view.

The size and scale Colgate has built over many years also enables it to realize a lower unit cost than its smaller peers, resulting in a cost advantage. Returns on invested capital (including goodwill) have averaged nearly 28% annually over the past 10 years, exceeding our 7% cost of capital estimate, and we think Colgate can continue to outearn its cost of capital over the next 20 years, supporting our take that it has amassed a wide economic moat.

Currency and Competition Are Risks While Colgate maintains 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 market growth around the world slows. Local brands are also proving to be a sizable threat in overseas markets, with a solid grasp of the tastes and preferences of in-market consumers. Further, the firm continues to grapple with volatile foreign currency swings, in such markets as Venezuela, where currency devaluations have weighed on results in the past. For example, price controls in the region have historically restricted the firm's ability to offset rampant inflation and currency fluctuations. In fiscal 2015, Colgate incurred a one-time charge of nearly $1.1 billion (about $1.18 per share) to account for the impairment of its Venezuelan operations.

Promotions have at times run rampant in the consumer products space, 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. While input cost pressures have moderated, inflation persists in select commodities and could reignite. However, given the firm’s consistent long-term record, we expect Colgate’s gross margins will continue to improve, especially as competitors return to more rational levels of spending. We also think its stringent focus on cost management will enable Colgate to profitably manage through potential headwinds over the longer term.