Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Josh Peters. He's the editor of Morningstar DividendInvestor and also our director of equity income strategy. We're going to take a closer look at Clorox and see if it still looks appealing to dividend investors.
Josh, thanks for joining me today.
Josh Peters: Good to be here, Jeremy.
Glaser: I think that most viewers are probably familiar with Clorox, but can you give us just a little bit of background about the company and why it's one that you found so attractive in the past?
Peters: Clorox combines three of the favorite things that I find when I am looking at any one business. First, it has an above-average dividend yield, which is a little over 3% at current prices. You've got decades of history of the dividend being paid and rising every year without fail, going back more than 20 years. Second, it's economically defensive. People are going to continue to buy things like bleach even during recessions; that gives the company a very stable cash flow profile with which to fund that dividend.
And then, it's the company's competitive position. We've recently upgraded our economic moat rating to wide from narrow. Not much has changed about the business, but watching the company perform over the last couple of years has given us that much more confidence that the very high profit margins and returns on capital that Clorox has been generating in recent years are going to continue long into the future. And that economic moat helps both protect the dividend on the downside and encourage profitable growth. So, between the high dividend yield, economically defensive characteristics, and the wide economic moat rating, it's really a triple play.
Glaser: Let's look at that dividend growth then. Clorox is obviously not a fast-growing business. Will they be able to generate that cash flow to keep growing that dividend enough to keep investors' total return looking good?
Peters: I think so. Clorox is very much a total-return story. The company doesn't have a whole lot of exposure to emerging markets. It's mostly a North America-focused business. The company hasn't wanted to barge into all sorts of markets far afield that they might not have those competitive advantages in. I think that's a sign of corporate discipline that I find very attractive.
So you're really looking at maybe 3%, 4%, 5% type of revenue growth going forward. The company has been emphasizing new products more recently and having good success with that. We can see perhaps where growth can get a little bit better than the 3% average of the last decade.
But if you think about it, that level of growth, that's just maybe 1 or 2 percentage points of volume growth a year plus inflation. Now those are not heroic assumptions. From there, because the company's competitive position is so strong, we have confidence that the company will gently become a little more profitable over time, that net income will grow faster than revenues. And the company also has the opportunity, with its excess free cash flow over and beyond what it pays in the dividend, to buy back shares every year, reducing the share count and making the dividend a little bit larger on a per-share basis in the years that follow.
So, when you add these different factors together, I think you're looking at a roughly 7% rate of long-term dividend growth for Clorox. That's a little bit lower than it's been in the last few years. The company's payout ratio has been growing as management's become more confident about their ability to make a very generous dividend payment and keep making it.
But with a 7% long-term dividend growth, assuming that the stock price moves up in tandem with that, which is what I would expect, plus that 3%-plus yield, then you are looking at a total return prospect that's in the 10% area, again, from a business that doesn't have that much risk.
Glaser: How about valuation? Do you have to pay up for some of these defensive qualities right now?
Peters: Well, it depends on how you view it. If you are looking just at the P/E multiple, Clorox is trading at about 20 times this year's earnings estimates for the 2014 fiscal year that will end in June. That sounds kind of expensive. It is a little bit of a premium to the market overall at kind of 16, 17 times forward earnings.
But when you put it in the context of that recession resistance, the ability to preserve cash flow and earnings in a downturn that you don't have as much of from the market in general--you can throw in the ability of this company to convert its earnings into free cash flow that it can use to return to shareholders, in this case mostly thorough the dividend--and those strong competitive characteristics, a little bit above-average multiple is actually quite justifiable. And using our discounted cash flow methodology, we value the shares at $95 apiece. That's a couple of dollars above where the stock has been trading lately. I think it's still an attractive purchase. It's not a bargain-basement stock, but I will take quality over a big, seeming bargain any day.
Glaser: Are there any risks or downsides investors should be aware of?
Peters: The key one is commodity prices. The raw inputs that Clorox uses to make its different products--whether it's bleach, charcoal, water filters, or salad dressings--have been volatile in recent years in both directions. Sometimes, there will be periods where costs are growing faster than the company can push through price increases and that can weigh on margins a little bit in the short term. But in the past, the company's had a great deal of success, being able to raise prices to offset those cost pressures.
And 64 of the last 66 price increases that the company has pushed through have actually stuck. They haven't had to retreat because of competitive pressure. It's not that hard to figure it out. I like to ask people: What is the number-two brand of bleach or of charcoal? There aren't names that come to mind quickly after Clorox and Kingsford for products like this. Or ranch salad dressing--Hidden Valley is one of their brands, and I'm a big fan of it myself. I'm not even sure that anybody else out there has a specific brand dedicated to ranch salad dressing.
With these products, they are not competing head-to-head with the giant companies like Procter & Gamble and Unilever. Their ability to dominate these niches, I think, is part of what keeps the risk profile of the company modest and forms the basis for that wide economic moat.
Glaser: Josh, thanks for your thoughts on Clorox today.
Peters: Thank you too, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
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