Church & Dwight: Muted Return Expectations (NYSE:CHD)


The consumer packaged goods industry has historically been an excellent place to look for wealth creation potential. As long as investments are made to keep the strength of the brand name, the business boils down to a quasi-subscription-based service with plenty of recurring revenue.

While Church & Dwight (CHD) doesn’t have the same cachet or recognition as some of the larger consumer packaged goods businesses, that doesn’t mean that it should be ignored. The business has a rich history of stellar returns as well as returning ample excess cash flow to shareholders over time.

Dividend History

The bulk of my investment capital is invested in companies that have a history of paying and growing their dividend payment over time. That means that I’m primarily invested in well-established businesses that generate plenty of cash flow that can then be returned to shareholders. A lengthy dividend growth streak is not a guarantee that the business is sound; however, I do believe that it helps to get you “fishing in the right waters.”

Church Dwight Dividend HistoryImage by author; data source Church & Dwight Investor Relations

According to the CCC list, Church & Dwight is a Dividend Contender with 24 consecutive years of dividend growth. Church & Dwight’s dividend record dates back much further though to at least 1976 after a pause in dividend growth in 1995 and 1996.

Of the 24 years during Church & Dwight’s current dividend growth streak, year over year dividend growth has range from 3.3% to 119.4% with an average of 16.3% and a median of 8.2%.

In the 19 rolling 5-year periods, annualized dividend growth has ranged from 5.2% to 45.8% with an average of 17.7% and a median of 9.6%.

There’s been 14 rolling 10-year periods during Church & Dwight’s streak and annualized dividend growth has ranged from 6.9% to 27.3% with an average of 20.6% and a median of 24.2%.

The 1-, 3-, 5- and 10-year period annualized dividend growth rates since 1976 can be found in the following table.

Year Annual Dividend 1-Year 3-year 5-Year 10-Year
1976 $0.0074
1977 $0.0080 8.32%
1978 $0.0086 7.68%
1979 $0.0093 7.15% 7.71%
1980 $0.0105 13.35% 9.36%
1981 $0.0111 5.89% 8.75% 8.45%
1982 $0.0122 9.99% 9.70% 8.78%
1983 $0.0139 13.63% 9.79% 9.96%
1984 $0.0151 9.00% 10.86% 10.33%
1985 $0.0163 7.35% 9.96% 9.14%
1986 $0.0171 5.13% 7.15% 8.98% 8.71%
1987 $0.0179 4.87% 5.78% 7.95% 8.36%
1988 $0.0192 6.98% 5.66% 6.65% 8.29%
1989 $0.0217 13.04% 8.24% 7.43% 8.87%
1990 $0.0250 15.39% 11.75% 9.00% 9.07%
1991 $0.0283 13.34% 13.92% 10.65% 9.81%
1992 $0.0317 11.76% 13.48% 12.07% 9.99%
1993 $0.0350 10.53% 11.87% 12.80% 9.68%
1994 $0.0367 4.77% 8.97% 11.10% 9.25%
1995 $0.0367 0.00% 5.01% 7.96% 8.48%
1996 $0.0367 0.00% 1.56% 5.29% 7.94%
1997 $0.0383 4.54% 1.49% 3.90% 7.90%
1998 $0.0400 4.35% 2.94% 2.71% 7.63%
1999 $0.0433 8.33% 5.73% 3.40% 7.18%
2000 $0.0467 7.69% 6.78% 4.94% 6.44%
2001 $0.0483 3.57% 6.51% 5.68% 5.49%
2002 $0.0500 3.45% 4.89% 5.46% 4.67%
2003 $0.0517 3.33% 3.45% 5.25% 3.97%
2004 $0.0567 9.68% 5.44% 5.51% 4.45%
2005 $0.0600 5.88% 6.27% 5.15% 5.05%
2006 $0.0650 8.33% 7.95% 6.10% 5.89%
2007 $0.0750 15.38% 9.79% 8.45% 6.94%
2008 $0.0850 13.33% 12.31% 10.47% 7.83%
2009 $0.1150 35.29% 20.95% 15.21% 10.25%
2010 $0.1550 34.78% 27.38% 20.90% 12.75%
2011 $0.3400 119.35% 58.74% 39.22% 21.54%
2012 $0.4800 41.18% 61.01% 44.96% 25.38%
2013 $0.5600 16.67% 53.44% 45.80% 26.91%
2014 $0.6200 10.71% 22.17% 40.07% 27.03%
2015 $0.6700 8.06% 11.76% 34.01% 27.29%
2016 $0.7100 5.97% 8.23% 15.87% 27.01%
2017 $0.7600 7.04% 7.02% 9.63% 26.06%
2018 $0.8700 14.47% 9.10% 9.21% 26.19%
2019 $0.9100 4.60% 8.62% 7.98% 22.98%
2020 $0.9600 5.49% 8.10% 7.46% 20.00%

Table and calculations by author; data source Church & Dwight Investor Relations

*FY 2020’s annual dividend assumes a $0.24 payment in Q4.

When making investments in dividend growth businesses, a big concern is the safety of the dividend payout because inevitably the business will stumble and if the dividend already eats up a big part of profits or cash flow the dividend could be at risk of being reduced. The payout ratio is a way to quickly judge how safe a dividend is for those inevitable speed bumps.

Church Dwight Dividend Payout RatiosImage by author; data source Church & Dwight SEC filings

Church & Dwight’s payout ratio based on net income has averaged 35% over the last decade and 36% over the last 5 years. The payout ratio based on free cash flow has been 29% and 30% over the same respective time frames. Church & Dwight’s dividend is well covered by net income and free cash flow.

Quantitative Quality

When I invest my savings into a business, the intention is to hold the stake for years. That means that my perception of the business quality is priority number one. Before looking forward, I like to see how the business has done across a variety of metrics over the previous 10 years to get a feel for the business.

Church Dwight Revenue Operating and Free Cash FlowImage by author; data source Church & Dwight SEC filings

Church & Dwight has managed solid revenue growth over the last decade through a combination of organic sales growth as well as acquisitions. In total, revenues have grown 68% or ~6.0% annualized. Gross profits have followed revenues higher rising 71% in total or 6.1% annualized.

Operating income outperformed both revenue and gross profit improvement gaining 88% in total or 7.2% annualized. Meanwhile cash flow from operations grew 102% in total or 8.1% annualized. Over that same time, free cash flow improved 117% or 9.0% annualized.

Church Dwight Cash Flow Margins Image by author; data source Church & Dwight SEC filings

With operating and free cash flow both outpacing revenue growth, it should come as no surprise that cash flow margins have been improving. I like to see free cash flow margins greater than 10%, although that’s not a hard and fast rule, and Church & Dwight has easily surpassed that level every year over the last decade. The average free cash flow margin for the last 10 years has come to 15.6% with the 5-year average at 17.1%.

My profitability metric of choice is the free cash flow return on invested capital. The FCF ROIC represents the cash return the business is generating based on the capital that is currently invested in the business. In theory, this is the cash that could be pulled out of the business without affecting the business’s future.

Church Dwight Free Cash Flow Return on Invested Capital Image by author; data source Church & Dwight SEC filings

Church & Dwight has generated solid FCF ROIC levels well above 10% over the last decade. The 10-year average is a very strong 15.9% while the 5-year average is 16.6%.

To understand how Church & Dwight uses its free cash flow, I examine 3 variations of the metric, defined below:

  1. Free Cash Flow, FCF – Cash flow from operations less capital expenditures
  2. Free Cash Flow after Dividend, FCFaD – FCF less total cash dividend payments
  3. Free Cash Flow after Dividend and Buybacks, FCFaDB – FCFaD less cash spent on share repurchases.

Ideally, the business generates ample cash flow from operations to fully cover the entire capital allocation process whether it’s capital expenditures, dividends, repurchases or acquisitions. That means I generally want to see to see a positive FCFaDB although I’m not concerned about any year in particular being negative since opportunities can be fleeting.

Image by author; data source Church & Dwight SEC filings

As we saw earlier, Church & Dwight has been FCF positive every year over the last decade producing a total of $5.36 B in FCF to work with. That’s allowed management to pay out a total of $1.58 B in dividends to shareholders putting the cumulative FCFaD at $3.77 B.

With that $3.77 B in excess cash flow, management has repurchased $2.47 B worth of shares putting the 10-year FCFaDB at $1.30 B.

When funded with cash, I like to see share buybacks as an additional way to generate returns for shareholders. In total, Church & Dwight’s share count declined from 289 M at the end of FY 2010 to 250.7 M at the end of FY 2019. That’s a total decline of 12.7% or ~1.5% annualized.

Church Dwight Shares OutstandingImage by author; data source Church & Dwight SEC filings

As an investor in the equity of a business, I want to see stable levels of debt over time. My preference would be for no debt to be on the balance sheet; however, I understand the prudent use of debt especially over the last 10 years where interest rates have been persistently low.

Over the last decade, Church & Dwight’s debt-to-capitalization ratio has been on the rise climbing from ~15% up to ~44%. The 10-year average level is 33% with the 5-year average at 42%.

Church Dwight Debt to CapitaliationImage by author; data source Church & Dwight SEC filings

Church & Dwight’s total debt load has increased substantially over the last decade increasing 5x. However, debt needs to be taken into context with respect to the underlying business.

The debt ratios compared to EBITDA, operating income and free cash flow have seen a similar rise although I believe they are all at manageable levels given the nature of Church & Dwight’s business.

The 10-year average debt-to-EBITDA, debt-to-operating income and debt-to-free cash flow ratios are 1.5x, 1.7x and 2.1x, respectively, while the 5-year averages are 1.9x, 2.3x and 2.6x.

Church Dwight Debt RatiosImage by author; data source Church & Dwight SEC filings

Valuation

For valuing potential investments, I use multiple methods to come up with a fair value range. The methods I use are the minimum acceptable rate of return, “MARR,” dividend yield theory and a reverse discounted cash flow analysis.

The MARR analysis requires you to estimate the future earnings and dividends that a business will generate, apply a realistic multiple on those future earnings for a terminal valuation and then determining whether the expected return exceeds your hurdle rate.

On average, analysts expect Church & Dwight to report FY 2020 EPS of $2.81 and FY 2021 EPS of $2.99. They also expect Church & Dwight to show annual earnings growth of 9.5% per year over the next 5 years. I then assumed that Church & Dwight could manage 5.0% annual earnings growth for the following 5 years. Dividends are assumed to target a 35% payout ratio based on net income.

For the realistic multiple that future earnings will trade at, I like to use history as a guide to see how Church & Dwight’s earnings have been valued historically. As you can see in the following YChart, Church & Dwight has historically been valued between ~15x-30x TTM EPS.

ChartData by YCharts

The following table shows the potential internal rates of return that an investment in Church & Dwight could provide across various exit multiples. Returns include dividends taken in cash and are calculated with a purchase price of $92.95, Friday’s closing price. Returns are run through the end of 2025, “5-Year” and 2030, “10-Year.”

IRR
P/E Level 5-Year 10-Year
30 7.6% 7.0%
25 4.0% 5.2%
22.5 2.0% 4.2%
20 -0.2% 3.1%
17.5 -2.6% 1.9%
15 -5.3% 0.5%

Alternatively, I calculated the purchase targets in order to generate the returns I desire from my investments. My baseline hurdle rate is a 10% IRR for Church & Dwight but I will also examine 8% and 9% levels as well.

Purchase Price Targets
10% Return Target 9% Return Target 8% Return Target
P/E Level 5-Year 10-Year 5-Year 10-Year 5-Year 10-Year
30 $84 $72 $88 $78 $92 $85
25 $71 $61 $74 $67 $78 $73
22.5 $64 $56 $67 $61 $70 $67
20 $58 $51 $60 $55 $63 $60
17.5 $51 $46 $53 $50 $56 $54
15 $44 $40 $46 $44 $49 $48

Dividend yield theory is built on the idea of reversion to the mean which has historically been pretty pervasive in the financial markets. Sometimes that reversion can happen quickly and other times it takes much longer to play out. Dividend yield theory uses the 5-year average dividend yield as a proxy for the fair value of a business.

Church & Dwight Dividend Yield Theory Passive Income PursuitImage by author; data source Church & Dwight Investor Relations and Yahoo Finance

Shares of Church & Dwight currently offer a dividend yield of 1.03% compared to the 5-year average yield of 1.45%.

I use a reverse discounted cash flow analysis as a sort of reality check to see what the current share price implies about investor growth expectations. It’s a way to reverse engineer the cash flows required to support the current share price. I use a simplified version of the DCF built on revenue growth, a static EBIT margin and one that increases by 10% over the 20-year period, a tax rate of 21% and a 4% terminal growth rate. I use both 8% and 10% hurdle rates to discount the cash flows back to the present.

In the 8% hurdle rate with the static EBIT margin, Church & Dwight needs 6.6% annualized revenue growth to support the current price. Required revenue growth declines to 6.1% for the 8% hurdle rate with 10% EBIT margin improvement scenario that results in a terminal EBIT margin of 21.6%. The revenue growth required in the 10% hurdle rate scenarios are 10% and 9.5%, respectively.

Conclusion

While Church & Dwight, the business, is excellent and one that I want to add to my portfolio, I just can’t get past the current valuation in order to purchase shares.

Dividend yield theory suggests a fair value range of $60 to $73. The fair value range based on a 10% IRR would be somewhere in the $55 to $65 area. While an 8% IRR hurdle rate suggests a fair value range $67 to $80 area.

The reverse DCF seems to imply that Church & Dwight is relatively close to fair value assuming an 8% hurdle rate based on what I believe are reasonable revenue growth assumptions moving forward.

Church & Dwight has historically used acquisitions as a way to fuel growth. Management has proven keen at doing so; however, that’s a lot of “betting on the come,” to borrow a phrase from gambling, given the current valuation sitting near decade highs across most metrics.

Ideally, I’d like to purchase shares somewhere below $80 preferably in the $75 range. With Church & Dwight being what I believe to be a quality business, a forward P/E of ~25x seems reasonable. Realistically, I’d be tempted to initiate a position somewhere in the mid-to-low $80s which I believe would still be a rich valuation. However, I also know myself enough to know that I will pay more attention to drops if I already own a “starter” position in the business.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CHD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice.

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