Reckitt Benckiser is a name which came up several times following my recent, mildly negative review of Unilever.
In many ways, Reckitt Benckiser is in the same boat as Unilever. They’re both companies which are highly valued because of their historically low-risk, steady growth characteristics.
That’s why they’re sometimes referred to as “expensive defensives”.
But in recent years, Reckitt Benckiser has generated little in the way of steady growth.
To fix that, management has decided to spend more than £14 billion acquiring Mead Johnson Nutrition, a global leader in infant nutrition.
This could be a smart move, but from where I’m standing the acquisition may have turned Reckitt Benckiser into a high-debt, low-growth timebomb.
Reckitt Benckiser’s growth is going, going gone?
Let’s start with the reasons behind this acquisition; primarily, Reckitt Benckiser’s relatively weak growth over the last few years.
I say “relatively weak growth” because context is important here.
In the good old days of 2012, you would have seen a company riding the crest of a wave. Reckitt’s growth had averaged 17% per year over the previous decade and very steady growth it was too.
This made the company very popular with investors and their enthusiastic buying pushed the share price up from £40 to more than £80 over the last five years.
More recently though, the company has repeatedly failed to live up to the market’s expectations and the shares have fallen back below £65:
Today, Reckitt Benckiser’s ten-year growth rate is a modest 5%. Even more worrying is that growth over the last five years has virtually ground to a halt.
Yes, the 2016 results saw a decent uptick, but that was largely to do with Brexit and the subsequent devaluation of the pound.
How so? Because more than 90% of Reckitt Benckiser’s revenues are generated outside the UK, so when the pound goes down, Reckitt Benckiser’s revenues (reported in GBP) go up.
So if we ignore Brexit then the company’s recent growth has barely kept up with inflation.
This is not good and there are myriad reasons behind these results. They range from one-off mistakes to potentially wide-ranging changes in how consumers view global premium brands (i.e. not as favourably as they once did).
I’m sure many of the institutional investors who jumped on the Reckitt Benckiser bandwagon are not especially pleased with the way things have gone these last few years.
I think it’s likely that huge amounts of pressure have been put upon management, by investors, to pull their fingers out and start generating some growth, pronto.
In response, management decided that if they couldn’t generate growth organically, they’d simply go out and acquire it.
Growth by acquisition can be a dangerous game
And by “acquire” I mean big acquisitions, starting with the acquisition of Mead Johnson for a little over £14 billion.
That’s a huge acquisition, even for a £45 billion company like Reckitt Benckiser.
It is, in fact, more than seven times Reckitt’s recent post-tax profits. And for context, I define any acquisition which exceeds a company’s recent average profits as “large”, so this acquisition is seven times bigger than my definition of large.
There are pros and cons to an acquisition of this size, of course.
On the positive side, Reckitt Benckiser’s revenues, earnings and dividends will jump up in its next annual results.
That’s because Mead Johnson brings with it revenues of around £3 billion and post-tax profits of around £0.4 billion. These will provide a healthy boost to Reckitt Benckiser’s existing revenues and profits of almost £10 billion and £2 billion respectively.
So revenues, earnings and dividends will all increase and Reckitt Benckiser will own the world’s leading infant nutrition franchise. What’s not to like?
In a word, debt.
To afford this £14 billion acquisition, Reckitt Benckiser has increased its debts from an attractively prudent £2.4 billion in 2016 to an eye-watering £17.2 billion today.
In terms of the important debt-to-profit ratio, that increase takes Reckitt from 1.4 in 2016 (comfortably below my preferred maximum ratio for defensive companies of five) to a palpitation-inducing 9.7 today.
This is, in my humble opinion, insanely high and fortunately, it seems that management agrees.
To reduce debt and re-focus the business around its health and hygiene core, the food business (which includes famous brands such as French’s Mustard) has been sold.
This should raise around £3.2 billion, which will be used to reduce the company’s enormous debt pile to about £14 billion.
And let’s not forget, the acquisition will boost profits by about 25% which will also reduce the debt-to-profit ratio.
However, even accounting for these factors, Reckitt Benckiser will still have a debt-to-profit ratio of more than six, which is comfortably above my preferred maximum for defensive companies.
A one-off unsustainable growth spurt
Another problem with debt-fuelled acquisition strategies is that they are usually unsustainable.
In this case, Reckitt Benckiser has boosted revenues, earnings and dividends by 25% or so by borrowing money to buy another company.
However, that’s a one-off event and post-acquisition growth for the combined business is expected to be low single-digit.
If management wants another easy acquisition-driven growth spurt, they’ll have to take on even more debt, which will make the company even more risky than it is today.
Hopefully they won’t do this, but you never know.
Expensive defensive or high debt, low growth timebomb?
Okay, perhaps “timebomb” is an overstatement.
Reckitt Benckiser is still a defensive company selling market-leading, premium-branded health and hygiene consumer goods.
But it is a statement of fact that the company has produced very little real growth in recent years and that it is more indebted than almost any other defensive company in the FTSE All-Share.
So although Reckitt Benckiser is still defensive (i.e. not particularly affected by recessions), I don’t think it’s a low-risk company. Its debts are simply too high for that description to be appropriate.
And because I don’t think it’s a low-risk company, I don’t think it deserves a premium price, and yet a premium price is what it has today.
With the shares at £65.50, the dividend yield is just 2.4%. Even if we assume that next year’s dividend is 25% higher than this year’s, the yield only goes up to 3%.
That’s still below the FTSE 100’s dividend yield of 3.9%, or perhaps 3.5% or so if you buy an index tracker.
Or if you don’t trust the dividend yield as a valuation metric, you might want to look at price relative to earnings over the past decade.
And here again, Reckitt Benckiser does not exactly look cheap. PE10 (which is what I call this ratio) is about 18 for the FTSE 100 and about 28 for Reckitt (or 26 if we factor in 25% higher profits in 2017).
That’s a big difference and it underlines my feeling that Reckitt Benckiser is not only a high debt, low growth defensive stock, it’s also an expensive defensive stock.
I would buy Reckitt Benckiser if…
I still think Reckitt Benckiser is a reasonably good company and I would invest again (having done so not once but twice before), but only under these conditions:
- Debts are reduced – Those debts would have to fall below £11 billion at least, and preferably below £10 billion (and preferably much lower than that), and
- The price is reduced – The share price would have to fall below £55. At that point, the forecast yield could be as high as 3.5% and, more importantly, the company would enter the top 50 stocks on my stock screen.
However, my guess is that the debt-reduction process will take many years, so don’t expect to see Reckitt Benckiser in my portfolio anytime soon.
John – speaking of expensive defensives you could always lump in National Grid into the mix — It’s borrowings are close to £24bn and it’s after tax profits are less than £2bn. Everyone thinks it’s illogical that the market has reduced it’s price from 1100 to 866 — personally despite it’s pseudo monopolistic position, it’s not without risk, even at sub 700.
Back to RB, It’s amazing how views are polarised on a big business like RB. I don’t know one way or the other really, however :-
JPM Morgan see 7500 as a bit of cinch in the short to medium term and 9000 beyond, and that there is significant additional debt reduction capability in the possible sale of the Health and Nutrition division.
On the acquisition of Mead Johnson, is it expensive?
One man’s expensive is another man’s bargain — and not just any man — take Warren Buffet for example, perhaps not to be categorised as any man.
He paid 20X earnings for Heinz which tops RB’s price ratio for Mead Johnson.
Buffet also paid 18X for Burlington North Santa Fe and I guess he has a few other examples.
There are also some strategic market reasons for RB to take on Mead Johnson, despite it being slightly off the main theme of RB’s product portfolio. These are territorial gains in that Mead has 50% of it’s business in ASIA (where all the people are) and 17% in South America (also where al the people) — perhaps adopting the distribution channels and combining them will boost RB’s existing business reach as well.
In terms of affordability RB paid $90 a share (a 29% premium) but Mead’s share price had already fallen 27% in the year.
In terms of affordability, this is the view from the analysts :-
“””Easily. The company – which has a market value of £49bn – had revenues last year of £8.8bn, made a profit of £2.2bn, and has debt of only £1.6bn. A purchase would push its debt ratio up from 0.6 times earnings before interest, tax, depreciation and amortisation to 3.5 times – far from unmanageable.””””
Was it a good price?
“”””A $90 a share price implies a valuation of 18.3 before synergies, according to Liberum. This is lower than the 21.7 times Danone paid for Numico and closer to the 15.7 times Nestlé paid for Gerber and the 19.8 times it paid for Wyeth Nutrition.
Mead shares are down about a quarter over the past six months, so Reckitt could have swooped now to take advantage of their weakness.””””
Maybe all is not what it seems and RB will turn out to be a relative bargain at 6xxx
It also is worth mentioning that RB is a high operating margin business in general and has chunky ROCE — it could be churning out even more high margin growth if it doesn’t screw up the acquisition.
LR
Hi LR, I thought you’d have something to say about this review! Here are a few off the cuff responses:
“On the acquisition of Mead Johnson, is it expensive?” – I didn’t say it was expensive, I just said it was very large and has given RB a mountain of debt. Of course, whether or not it’s expensive is an important point, but I didn’t have time to go through all of Mead’s past results. Just looking at the current PE multiple, the price doesn’t look bonkers, so perhaps it’s an okay purchase. But those debts still have to be repaid!
“A purchase would push its [EBITDA] ratio […] to 3.5 times – far from unmanageable.” – I don’t like EBITDA unless the company has worked out a way to not pay interest, tax or capex (to cover depreciation and amortisation). But of course I’m quite happy for other analysts to have other opinions because that’s what makes a market.
“Maybe all is not what it seems and RB will turn out to be a relative bargain” – Indeed. I have been wrong many times before and I could be wrong again! And I don’t actually expect RB to fall over, I just think the debt is a potentially serious problem and so is its lack of growth, and the fact that management have decided to go down the debt-fuelled acquisition route. I’d rather see them focus on the core business, and perhaps for investors to admit that RB’s high growth days could be behind it.
John – I don’t like EBITDA either, it’s a fudge along the lines of “organic” or “underlying” or “adjusted”, it brings accounting into fantasy land — give me the facts will ya fercryinoutloud he hollers!!
RB is a relatively modest portion of my portfolio and it’s not going to shoot the lights out for a good while, but I’ll probably hang on in there. Being 31% in cash after more than a few offloads in the last 6 months is frustrating enough — but the market is such that from here on in I want reasonable bargains — they are out there if you dig deep enough and look long enough and hard enough, and are patient enough.
Any company that reports these days, good bad or indifferent results, gets shot down for mentioning it.
Did you opt for WPP in the end?
If so, you might like to read this article and the view from the top of Proctor and Gamble — not sure how much influence it will have on the actual ad content rather than the distribution mechanism, for which the CEO seems most concerned about, but useful input in any case :-
https://www.campaignlive.co.uk/article/procter-gamble-chief-issues-powerful-media-transparency-rallying-cry/1422599
Regards LR
No, no position in WPP just yet. I’m getting ready to buy something next week, so we shall see.
Great analysis here. I recently opted against buying RB as I found the price too high.
I’m sure I will own it one day though!
Thanks RMIL. I still like the company so hopefully they can sort themselves out and we can both invest in RB once again.
Maybe the timing of the Mead Johnson acquisition has something to do with Trumps new best mate Xi in China, who has just allowed the announcement of large cuts in import duty in many consumer goods including a 0% tariff on baby milk products.
https://www.bloomberg.com/news/articles/2017-11-24/china-to-slash-import-tariffs-on-consumer-products-from-december
RB, P&G, Nestle and Unilever could all see a much larger share of the growing Chinese market since the cuts are quite significant.
LR
Possibly, although the US election cycle is only four years, so the deal might be reversed by the next president before it gets any traction.
John, I doubt the US election would make a lot of difference to whether Xi is in charge in China — It was Xi’s decision to lower the tariff’s in the stark realistion that should trade not flow a little more evenly he’d see pretty big barriers slapped in his face at the ports of the US of A.
LR
John — Just revisiting this one in the context of me trawling through all my stocks with a view to deciding the performance of my shrunken portfolio for the 2017 year and if there is anything I want to err dump and anything else to add. WPP, DMGT and NEXT have all been added as they each individually got destroyed by negative sentiment and I did indeed buy RB at around 65XX.
Looking again at your point here on PE10 and I like the idea of it and the relative measure against the FTSE :-
“”””And here again, Reckitt Benckiser does not exactly look cheap. PE10 (which is what I call this ratio) is about 18 for the FTSE 100 and about 28 for Reckitt (or 26 if we factor in 25% higher profits in 2017).”””
During the last 5 years and the current position, the P/E has never gone above 23.9 as these are the figures for 2012 onwards :-
2012 — 14.6 — obviously this was a good year possibly to have bought and I suspect you did.
2013 — 21.3
2014 — 22.3
2015 — 23.9
2016 — 22.5
2017 — 20.7
Projected for 2018 — 19
So this is now well below trend and the dividend yield at the current share price (6733) as I type is 2.4% for this year and projected at 2.6% for 2018.
Granted these are not stellar numbers and the debt is indeed a worry, but are there further cost savings to be had – hard to say?
On balance it’s still not cheap, but nowhere near the P/E disparity of 28 compared to the FTSE 18 suggested.
Maybe you’ll see £55 — it’s possible.
I mean if bitcoin can hit 100,000 anything seems possible doesn’t it?
LR – is Bitcoin the 21st century revolution in hard currency or the equivalent of Tulip Mania?
Hi LR, my basic point on RB is that its ho-hum growth record does not justify its premium price, i.e. its low yield and high PE (in my opinion). To me it only makes sense if you must invest in “bond proxies” for some reason or other, such as fund managers with a specific investment mandate.
Although obviously I could be wrong.
As for bitcoin, it certainly looks like a speculative mania but to be honest I don’t know much about it and don’t want to really, just in case I get sucked in by its incredible price rise.