3 Consumers To Sell, 1 To Buy
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In an uncertain economic landscape, macro investors are naturally on the fence about some consumer good companies. Despite this expressed sentiment, Procter & Gamble (NYSE: PG), Colgate-Palmolive (NYSE: CL), and Avon Products (NYSE: AVP) all trade at high PE multiples—north of 20x. In my view, and that of the Street, these stocks are too expensive to justify a current investment. These companies also have matured past the steep part of their growth curves, so investors are advised to look elsewhere for better earnings yield. While making venture capital investments is the obvious way to play growth, buying shares in recent IPOs can also be lucrative. Pazoo (PZOO.OB), for example, went public late June and has more than doubled with strong momentum. I recommend buying shares in emerging consumer good firms and holding off from the mature brands for now.
Procter & Gamble
P&G is a perfect example of a company that is neither a poor nor good investment. It trades at a respective 21.3x and 15.8x past and forward earnings, that’s high, given that the historical average PE multiple of the S&P 500 has been around 15x. Moreover, the stock is right around its 52-week high. On the positive side, however, the dividend yield is at 3.4% and forecasted annual EPS growth is fairly strong at 8.5%.
4Q12 earnings results were 6.5% better-than-expected with top-line organic sales growth at 3%. Fortunately, the company has become increasingly slanted towards high-growth developing markets, which now contributed nearly two-fifths of business. China, Brazil, and India saw organic growth rates of 9%, 17%, and 21%, respectively. Pricing has contributed four points to organic growth—a positive sign the company has credible bargaining power over consumers. In fact, pricing was able to expand gross margins by 220 bps and offset the negative 200 bps impact of higher input costs. Market sales in developed markets were down, however, relative to competitors.
Going forward, management is focused on improving productivity through trimming unnecessary costs. It is disconcerting, however, that there appears to be limited value-creating opportunities. A change to the mix effect has had a negative impact of around 200 bps per quarter. I am further concerned that profit growth seems to be overly reliant on domestic momentum. Under such high multiples, I recommend holding out.
Colgate is another expensive consumer goods firm. It trades at a respective 20.8x and 17.9x past and forward earnings with a 2.4% dividend yield and high double-digit ROA, ROE, and ROI. The PE multiple has not been this high since around September 2008 - all years dating back to 2004 were above 20.8x. Stock volatility is less than half of the broader market.
Free cash flow has steadily gone up over the years with TTM production of $1.7B by 2008's end. By 2011's end, that figure reached $2.6B for a CAGR of 23.7%. Much of this, however, was the result of acquisitions. Monthly revenue growth has slowed from the historical average of 5.8% average while gross profit margins have struggled to stay at reasonable levels given the competition.
Second quarter EPS was in-line at $1.33, but management pitched performance as if it went extremely well. To the company's credit, organic sales growth went up in every major category as emerging markets saw double-digit returns. Greater Asia/Africa business remains particularly attractive with a 12% gain in Latin America and rising toothpaste share in Asia. In India, the company has a majority of the market in toothpaste at 53.8%. Toothpaste share climbed 150 bps to 33.7% in China. All in all, top-line data was phenomenal but costs could have been contained more, which led to merely in-line results.
After rejecting the $10B buyout from Coty, Avon is now valued at 31% below the bid. It still offers a leading 5.7% dividend yield; but, at a multiple of 28.1x past earnings and 15x forward earnings, the snail-like growth of the company simply will not do. In fact, analysts forecast annual growth to be virtually flat over the next 5 years.
Even if Avon is able to grow EPS 5% annually over the next half decade, 2016 EPS will come out to around $1.23. At a generous multiple of 18x, the stock would be worth $22.14 at that time. Discounting backwards, again generously, by 8% yields a present value of $15.07. Especially if the Obama dividend tax hikes get implemented, shareholder value faces much more down pressure than up pressure. That is to say, even optimistic assumptions suggest the stock is currently overvalued.
It should be noted that, despite floundering fundamentals, the company is well below its historical average PE multiple of 21.2x. How have the fundamentals floundered? Well, free cash flow in the TTM was $432.3M by 2008's end. By the end of 2011, free cash flow declined to $379.1M. Revenue growth has also struggled and was -9.3% for June 30, 2012. Average growth over the past 5 years has been 4.1%, but it has been nothing but negative over the last six months. At the same time, gorse profit margins have been flattish despite strong room for cutting. The combination of managerial missteps, intense competition, and a weakening brand identity for Avon warrant holding out for now.
At less than a $30M valuation, Pazoo is one of those emerging plays that are positioned at the steep part of its growth curve. Since beating the market is a matter of game theory, it only matters what the market thinks you think. And the presumption is that you think there is plenty of risk in a micro-cap stock, right? While Pazoo may not have a long operating history, it's the fundamentals that matter in the long haul as discount rates fall. With Pazoo rolling out a National TV branding effort, it can tap into previously unseen demand and, accordingly, demonstrate that upside outweighs downside.
The company specializes in the health & wellness market for humans and pets. I am particularly attacted by Pazoo's attempt to build a social community that vibes with today's culture. Towards that end, Pazoo offers expert consultants who can help consumers with their individual personal and pet needs. This provides meaningful cross-selling opportunities for the product segment and builds a sustainable foundation.
The CEO recently expressed that "[Pazoo] ha[s] only scratched the surface" in showcasing its services to the global market. If the company can expand from online retail into direct selling through brick-and-mortar distributors, it will be able to reach thousands of new eyes. 60% of US households already have pets, and there has yet to be an established "authority" social network for pet lovers. Ultimately, Pazoo is attempting to build this network through Pazoo.com and recently closed a $1M investment to do so. As mature brand name peers struggle to grow in a challenging economy, investors are likely to turn to those that are just starting to build a moat and generate free cash flow. While speculative, it's an exciting thing to be a part of and worth making an investment in.
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