As an income investor, it pains me to write a bearish opinion of such a notable dividend stock like Colgate-Palmolive (CL). The company has one of the longest running dividend histories and will continue to pay out well after I have stopped needing their products. Unfortunately, the enormous run in the stock price over the last few years has pushed the valuation beyond anything I can recommend. There are stronger names in the personal care products industry and investors may want to avoid Colgate until the shares come down.
• 119 years of dividends and 51 consecutive years of dividend increases makes Colgate Palmolive one of the longest-running income investments in the market
• The company sells necessity products and sales fluctuate little, even during economic downturns
• Despite its attractiveness on an income basis, shares are relatively expensive and investors may want to seek a higher yield and cheaper valuation in other names
Colgate-Palmolive is a $62.8 billion giant in consumer products and has some of the most recognizable brands in the world. The company has a strong command of the personal products industry with brands like Colgate, Palmolive, Speed Stick, Ajax, and Protex. The company controls nearly half (46%) of the global oral care market and is a strong leader in other personal care segments.
The company books approximately 13% of sales from its Hill’s pet nutrition segment, which doesn’t seem to fit with the rest of the company and could be sold or spun off. An announcement of a spin-off or sale could provide a temporary boost for shares but management has repeatedly supported the segment as important for the company’s relationship with veterinarians.
Besides a rich valuation, investors may have to contend with weakness in sales due to the rising value of the U.S. dollar against other currencies. Colgate books 78% of its sales outside the United States, much of it in emerging markets. While the company is betting that faster growth will push sales in these markets, it also runs the risk of missed estimates when profits are converted back to dollars. Profits are held in the foreign currencies until repatriated and are worth less in dollar terms if the greenback appreciates against the local currency. With relatively strong economic growth in the United States and the Federal Reserve being one of the few developed market central banks to pull back from monetary easing, it is likely that the dollar will appreciate over the next year.
Shares have returned 22.3% over the last year, after adjusting for dividends, and have returned an annualized 17% over the last five years. Much of the strong gains can be attributed to investors searching for higher yield as rates on bonds stagnate around historic lows. While shares of Colgate may not fall as much when the rest of the market takes a nosedive, they may not do well when interest rates rise because of the relative attractiveness of other income investments.
Sales grew just 1.9% last year to $17.4 billion against a 3.8% rate over the last three years. Operating expenses jumped last year on $202 million in restructuring charges and the company’s operating income fell by 8.5% from the year before to $6.6 billion. This is a relatively infrequent expense and the company has managed to grow its operating income by an annual rate of 0.6% over the last three years.
Cash on the balance sheet nearly doubled last quarter to $1.8 billion though it is still relatively low against current liabilities of $4.7 billion and long-term debt of $5.7 billion. Obviously, Colgate is not in danger of any liquidity problems but the company could work to improve its balance sheet health. The company uses debt to finance 80.3% of its capital structure and pays a marginally higher rate for its bonds than other similar size companies because of the financial risk.
As with most companies in the industry, Colgate is a strong cash producer with $3.2 billion from operations last year. The company increased its capital spending for growth last year to $670 million, causing free cash flow to fall from the year before but still booked $2.5 billion in free cash flow.
Dividends and Growth
Shares are paying a current yield of 2.1%, just under the five-year average of 2.3% and slightly above the rate paid by stocks in the S&P 500. Higher operating expenses drove net income lower last year and boosted the payout ratio to 59% from an average of just 31% over the last five years. While the current yield is lower than the longer-term average, the company’s high debt load and payout ratio may limit dividend increases over the near-term.
Colgate has paid a dividend since 1895 and has increased its per share payment for 51 years. The dividend increased by an annual rate of 11% over the last five years though growth has slowed to 8.4% over the last three years. The company bought back $1.5 billion in shares last year and has returned an average of $1.67 billion annually over the last five years in the form of share repurchases.
Shares of Colgate are trading for a significant premium at 29.5 times trailing earnings against a five-year average of 20.7 times and an industry average of 22.6 times earnings. Over the last ten years, shares have only traded this richly in 2006 when the multiple averaged 26.5 times earnings.
Running through a discounted cash flow analysis supports the idea that shares are overvalued. Estimating an 8% dividend growth over the next ten years and a terminal growth rate of 5.5% presents a fair value 12% lower than the current price. Even if we increase dividend growth to 9.5% and the terminal growth rate to 7%, the fair value only rises to $68.63 per share. While the company’s cost of capital is extremely low, it risks increasing over the next couple of years as interest rates rise and the company pays more on its issued debt.
While the high proportion of debt used for financing lowers the company’s cost of capital, it also increases financial risk and the burden could limit growth in the dividend payment. Investors may like the nearly half century over which the company has increased dividends but should not ignore the current share price relative to earnings and the outlook for cash flow. Colgate is in no real danger as a company but investors may want to avoid shares until a more opportune time.