Credit crunch has not bitten down on Colgate

Conor White examines the stock prices of Bayer and Colgate and finds them both to be in good shape, despite the challenges of the current economic climate
BAYER E52.79
Bayer is a diversified group consisting of three primary businesses: Healthcare, Crop Science and Material Science. Healthcare accounts for 46 per cent of group sales and 57 per cent of underlying earnings before interest, taxes, depreciation and amortisation or EBITDA (margin of 26.9 per cent).

The business breaks down into two main sub-segments: (1) Pharmaceuticals (69 per cent of divisional sales), and (2) Consumer Care (31 per cent of sales). Bayer recently announced it had entered into supply agreements with Barr for the latter’s generic version of Yasmin and Yaz for a fixed percentage of revenues.
This outcome is better than had been expected and reduces a key uncertainty for the stock. Nexavar for cancer is the key new drug. This differs from chemo as it specifically attacks cancer cells without attacking other growing cells and comes in tablet form. Treatment for kidney cancer was approved in early 2006 and for liver cancer last year. Peak sales are forecast at E600m-E1bn excluding China (where incidents are highest).
Xarelto has the highest economic value in their pipeline with key sales estimates of E2bn by 2013. One indication is the prevention of thrombosis after orthopaedic surgery, a $150m market. The other indication is stroke prevention. This is a longer-term therapy, with filing likely in 2010 and first significant sales in 2011.
h4. Crop Science
In the Crop Science business (20 per cent of group sales and 22 per cent of underlying EBITDA), Bayer is the world’s largest manufacturer of agrochemical products, marginally ahead of Syngenta, with a 19 per cent market share.
Applying peer group multiples to the Healthcare and Material Science divisions, Bayer’s current share price is implying a multiple for Crop Sciences materially below Syngenta and Yara. Material Science accounts for 30 per cent of group sales and 21 per cent of underlying EBITDA (margin of 14.9 per cent).
The business breaks down into two main sub-segments: (1) Materials (28 per cent of divisional sales), and (2) Systems (72 per cent of sales). Materials is suffering due to weak volumes and pricing in polycarbonate. This is used in DVDs, CD roms, car highlights, bullet-proof windows, etc.
The Systems business is proving more resilient with pricing holding up, despite fears over increasing capacity. This is used in fridge insulation, dash boards and furniture bedding.
Earnings per share (EPS) for Q2 were 7 per cent ahead of consensus. The company is in a positive earnings revision cycle and offers superior earnings growth over the next two years of 11 per cent per annum, which is not reflected in the rating of just 12x 2009 earnings. Pharma newsflow should accelerate through the next 3-6 months. As the Healthcare sales increase as a proportion of group sales, Bayer should be able to re-rate towards the healthcare sector multiple.
In 2008, Healthcare is expected to benefit from realisation of synergies from the Schering integration (target of €800m by 2009). Crop Science will benefit from strong ongoing fundamentals in the agrochemical industry.
h4. Material Science
The Material Science cost savings programme (targeting €300m p.a. by 2009) should help offset some of the decline in profitability anticipated in this division over the next few years. A combination of steady growth, the maturing of the pharma pipeline, the ongoing strength of Crop Science and strong cashflow generation provide scope for a re-rating alongside the prospect of steady EPS growth.
h4. COLGATE $76.23
Colgate dominates the oral care markets of Latin America and Asia, with toothpaste value shares approaching 80 per cent. The company markets toothpaste, toothbrushes, laundry products, liquid and bar soaps, deodorants and dishwashing liquid under such brand names as Colgate, Kolynos, Palmolive, Ajax, Mennen and Soft Soap.
Colgate also sources 10 per cent of sales from specialty pet food under the Hill’s Science Diet and Prescription Diet brand names.
In late July, Colgate reported 2Q08 EPS of 98c, which exceeded the consensus by 4c on better than expected organic sales growth of 9.5 per cent and operating expense control. The company indicated that full year EPS could be up in the mid-teens despite a tougher gross margin outlook.
Driven by double-digit organic growth in Latin America, Asia and Hill’s, Colgate sales rose a better than expected 16.4 per cent, helped by 7 pts of currency. By geography sales in North America increased 6.5 per cent, in Latin America 23.5 per cent, in Europe/South Pacific by 14.5 per cent and in Greater Asia/Africa by 17.5 per cent.
Sales for Hill’s Pet Nutrition increased 19.5 per cent on 6.0 per cent volume growth, an 8.0 per cent increase in pricing, and a 5.5 per cent favourable foreign exchange impact.
h4. Funding the Growth
After last quarter’s revision to margins that took some by surprise, Colgate’s Q2 gross margin was 15bps better than forecast at 56.8 per cent. This is despite raw materials pressure of 430bps. The offset was ‘Funding the Growth’, which generated 160bps of savings.
Agricultural commodities are now 80 per cent hedged for 2008, so some of the variability of materials costs has been eliminated. Restructuring savings were only 40bps in the quarter, well below the $100ml annual run rate of expected savings. This should reaccelerate in the back-half of the year. Advertising spending increased 20 bps as a percentage of sales to 11.7 per cent.
The growth rate in advertising spending represents a sequential acceleration from the 16 per cent seen in the previous quarter. Colgate generated $812 million of free cash flow through 2Q08, a 16 per cent increase over the same period last year.
At a little over 17x FY09 EPS, the stock is trading about in line with its typical premium to the market, but is well below its historical 8.5 per cent premium to the Personal Care peer group suggesting that the stock could see some multiple expansion from here. Colgate’s Q2 results were among the best we have seen by a Staples company, which is especially impressive considering just how challenging the current environment is proving for most consumer-exposed companies with commodity pressure.
The key for Colgate shares is convincing the market that its strong results are not simply a function of a good geographic footprint and defensive categories. Rather, Colgate continues to deliver owing to its ability to generate savings and efficiencies through its core business improvement programmes as it is still in the sweet spot of a restructuring programme.
h4. Reinvest in advertising
This enables it to reinvest in advertising at a fast pace, despite 430bps of commodity cost pressure in the quarter. Following the unforeseen gross margin collapse last quarter, investor scepticism about the sustainability of the defensive Colgate three-legged stool of gross margin expansion driving higher advertising spending driving top-line growth was called into question, with some investors fearful of a developing markets slowdown.
After the Q2 release, many of these concerns were assuaged and we view the stock as a high quality defensive holding.
• Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
• Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
• This publication has been approved by Goodbody Stock-brokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed. All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.
• Stock Prices: Prices in share recommendations are quoted from the close of business on 27 August 2008.