In 1999 Reckitt & Coleman merged with Benckiser to form Reckitt Benckiser (RB).  At the time Reckitt & Coleman were a leading global household products company with most of their turnover generated by brands with number one or two market positions.  Benckiser was in a similar position with household cleaning products, especially their dishwasher brands including Finish, and the water softener Calgon.

At the time the CEO to be, Bart Becht said “Reckitt Benckiser will be the world number one household cleaning company and has the potential to create significant value for shareholders” and that “the merged company will benefit from new growth opportunities and a clear growth strategy, through focus on high growth core categories, raising the rate of innovation and brand investment, and from cross selling opportunities and scale benefits”.

Over the last decade the merged company has pursued a strategy of focusing on a small number of world leading brands in growth markets and backing those brands with lots of marketing and product innovation. 

A successful history

To say that the strategy has worked would be an understatement.  Since 2000 turnover has grown from £3.1 billion to £8.4 billion, profit before tax has gone from £500 million to £2.1 billion and the dividend has gone from 25 pence to 115 pence.  In the last ten years revenue and profit have grown in every year and the dividend has increased in all years bar one.  Earnings have grown by more than 15% a year.  

And there’s more.  Return on shareholder equity has averaged 35% and that figure has been achieved with little gearing.  Free cash has been generated in every one of the last ten years and capital expenditure has averaged only 13% of cash flow.  Free cash has also grown in eight out of ten years.

That’s a nice history to have, but investing is about the future, not the past; so before I get out my crystal ball and look deep into the future, I need to ask:

Where did that success come from?

For a start, many of their products have a durable competitive advantage, mostly due to the strength of their brand names.  Brands like Durex are used as generic terms for the products they represent, and that’s a big advantage.  However, most of their products do not have a low cost durable competitive advantage.  Products like Dettol, Clearasil, Vanish and many others need constant product innovation and marketing to keep them growing.  These are the sorts of products that always need a ‘new improved’ sticker on the front, informing users of the amazing new technology bound up inside the bottle.  But given the amount of free cash that is typically generated

I don’t think the marketing and innovation spend is holding the company back, and on the upside, many of these products are seen as non-discretionary, especially in the more developed markets and that certainly helps to maintain earnings in tough economic periods like now.

I think it’s reasonable then to assume that RB will be able to grow well within their growth markets as global income expands (assuming that it does).

After that brief summary it seems that RB is a seriously good company, growing well with products that are non-discretionary to western shoppers (condoms, dishwasher powder, acne creams, disinfectants, etc) and brands that are almost the de facto choice (Dettol, Durex, Strepsil, Calgon, Finish, Cillit Bang, Gaviscon and more).  It’s a company I’d like to own, but:

Is the price right?

As I write this the share price is 3,172 pence.  With the current adjusted earnings per share at 226 pence that gives an initial earnings yield of 7.1% which above what I can get from a basket of corporate bonds and so at this point the bonds are less attractive. 

The current price to earnings ratio is 14 and with earnings growing at over 15% a year the historic price/earnings/growth or PEG ratio is below 1. 

Another price to earnings sanity check is to use a simple proxy of a full discounted cash flow calculation using a discount rate of 15%.  The simple proxy is 6.5 plus half the earnings growth rate so in this case with earnings growth at 15.3% over the long term the required PE equals 6.5 + (0.5 * 15.3) which is 14.2, i.e. above the current level.

Yet another way to see if you are getting a good price is to look at the historic average PE.  If it’s above the current PE (assuming current earnings are approximately normal) then the odds may be stacked in your favour that the PE will rise again as long as the company’s future performance is broadly similar to the past.  In this case the average PE is 19 and we’re a long way below that at present.

Finally, before getting into future projections I want to make sure that it’s sensible to assume that all of the earnings have value to me.  Over the last ten years almost half of all earnings have been retained by the company.  If they are not producing a good return on those retained earnings then the earnings should not be counted in any valuations.  A simple way to look at return on retained earnings is to say that in the last ten years they have retained 598 pence of earnings and that earnings have grown by 183 pence in that time.  Assuming that earnings growth is attributable to the retained earnings means that they have earned over 30% on what they have retained.  That’s a good rate of return in anybody’s book and far better than I’m likely to achieve with the free cash they pay out as a dividend.

So if the current price looks reasonable, then:

What returns might be achievable?

Projecting into the future using returns on equity can be done by taking the average ROE of about 35%, removing the average amount paid out as a dividend which is about 16%, and growing book value by the amount retained, which is about 19%.  So in this scenario book value grows by 19% a year and earnings grow at the same rate.  Earnings are at the historic ROE so for example if the current book value is 699 pence, in year five it would be 1,655 pence.  Earnings will be 35% of that at 584 pence and at a price to earnings ratio of the historic average of 19 the share price would be 11,135 pence.  Add in the dividend and the gain to year five is over 280%, which is 31% compounded.  Over ten years it’s 25%.

Doing the same thing using the historic earnings growth rate of about 15% (note that growth is lower in this example than the 19% above which is a handy reminder that these projections are licked-finger-in-the-air guestimates) gives a year five return including dividends of just over 200% which is 25% compounded.  Over ten years it’s 20%.

Both of the above projections show that perhaps it is not entirely unreasonable to expect healthy returns in the longer term.

Now comes the final hurdle.  If the company has a great track record and can be reasonably expected to continue earnings and dividend growth into the future:

Why is the share price attractive? 

What has gone wrong to scare the short term investors away and is it something that the company can overcome in the longer term?

The price to earnings ratio has been gradually dropping for the last decade.  In the early 2000’s it was over 20 and has moved steadily toward the current 14.  The share price stalled at 3,000p in late 2007, which coincides with the financial crisis, and so that’s a likely cause of some of the weaker price.  

Since 2008, RB have been involved in allegations of abusing their dominant market position with their heartburn product, Gaviscon.  Recently they have agreed to pay a £10 million fine for these actions and the NHS is in the process of suing RB. 

The final nail in the share price coffin is current and estimated earnings.  The 2010 Q4 earnings missed analyst’s estimates and to make matters worse RB predicted slower revenue growth going forward into 2011.

The recession, the missed earnings and the slower forward growth for 2011 are only of minor importance to me.  They are all short term issues in what has been a long term success and are therefore an opportunity rather than a risk.

Of more concern is the Gaviscon story.  Is this a one time survivable problem?  The largest figure I have seen for the potential payout is £700 million, or around 96 pence per share.  If this were due it would be about half of one year’s profit, so a very large amount but certainly not life threatening; in fact it’s less than a single year’s free cash flow.  I don’t see how losing this case would have a large negative impact on the rest of the business in the long term.  In the short term yes, especially the share price, but five and ten years from now I don’t think it will be important.  On that basis I think even in the worst case this is probably a one time survivable situation.

At this price, I’m a buyer

Given my upbeat analysis it shouldn’t be a surprise that I’ve put RB into one of my twenty investment ‘slots’ alongside JD Sport, Interserve and Mears as part of my push for quality at a fair price. 

In between Mears and RB I did look at Sage, the accounting software company.  They ticked all of my predictability and growth boxes, but the price was just a little too high.  Perhaps the next bear market or correction will bring the price down to where I cannot resist.  Next in line for a review (assuming it all works out okay) is a certain defence company making munitions and countermeasures.