FOOL ON THE HILL
An Investment Opinion
Can You Clean Up on Clorox? Warren Gump (TMF Gump)
August 13, 1999
I've been watching consumer products company Clorox (NYSE: CLX) since last year, after writing a column discussing its prior successes and product depth. My conclusion at that time was that although the company's long-term growth prospects looked quite promising, the then-current earnings multiple of 35x fiscal 1999 (June) earnings estimates was a little too steep for my blood. That kind of multiple tends to be more justified by a company growing earnings at 30%+, not the 13% analysts were expecting for Clorox.
Over the past few months, that valuation has started to come down a bit, as the stock eased from a February high of $132 15/16 into the low-$100 range. After the company announced in a conference call yesterday morning that earnings for the next two quarters would fall below estimates, the stock was bleached $16 13/16 to $86 7/16. Does this free-fall indicate its time to stand clear of the company or does it present an interesting buying opportunity? Before figuring that out, it would probably be helpful to discuss what's going on.
Clorox has been doing quite well on its own over the past several years, growing by introducing new products and making scattered acquisitions. While the company is best known for its namesake beach and laundry product, it has developed a battleship of top-rated brands. Here is a partial list: Formula 409, Pine-Sol, Soft Scrub, Tilex, Armour All, Match Light, Combat, Fresh Step, Hidden Valley, and Brita. Last fall, the company decided to embark on its biggest acquisition ever, First Brands, which would bring Glad storage products, STP auto protectants, and Scoop Away cat litter aboard its product lineup.
Clorox knew going into this purchase that it was picking up a company struggling with rising raw material costs, high marketing costs, and inventory cutbacks by key customers. The company expected to overcome these obstacles by reaping overhead cost savings and leveraging off of its renown ability to reinvigorate marketing and launch new products. It now seems, however, that the situation at First Brands was somewhat worse than expected.
During a call with analysts yesterday to discuss fourth quarter and year-end results (that was despicably open only to analysts and not individual investors, although a replay was ultimately made available to everyone), the company cautioned that earnings expectations were too high for the first half of fiscal 2000. For the first quarter, it expects earnings per share to decline in the "low-teens" percentage range, a far cry from the 8% increase that was expected. Looking out further, the company indicated the second quarter would also be weak, but a recovery should start in the second half of its fiscal year as the new products are introduced and problems at First Brands are addressed.
A big reason for this weakness is that products acquired from First Brands are still struggling with an inventory trade issue. In order to increase sales before the acquisition, First Brands offered substantial discounts on products. This boosted sales, but also increased the amount of product at retailers. Right now, Clorox estimates that there is still about $125 million in excess inventory in distribution channels. As this merchandise is cleared out over the next six months, sales from the manufacturer will be weak (particularly when compared to periods when some of the promotions boosted sales dramatically).
While sales from the old First Brand lines are weak, Clorox indicates that the overall integration of the two companies is going well. The company unified its information systems on July 1 and said that progress is being made with new advertising campaigns and marketing research studies. While it would be ideal if these efforts would immediately have an impact on reported results, the fact of the matter is that these types of changes typically take time to have an impact on financial results. Clorox management believes such changes will be evident starting in calendar 2000.
Although the First Brands acquisition was the scapegoat for yesterday's fall, the story also includes some weakness in old Clorox brands that took investors by surprise. Brita filtration system volume sales, which had been a stellar grower, declined 15% in the quarter. The company attributed this decrease to comparisons against a big promotion last year, as well as retail liquidation of competing products at extremely low prices. On a more positive note, sales of replacement filters grew at double digit rates for the year due to the company's commanding share of the systems business. System sales should get a pickup in future quarters from the introduction of a new Brita faucet-mount system.
Another area of notable weakness during the quarter was in cleaning products, where volume fell 4% for the quarter. This quarter's number is being compared with 14% volume growth last year, when the company introduced Tilex Fresh Shower and new Pine-Sol products. Exacerbating the tough comparisons was aggressive advertising by new competitors in the daily shower cleaning market. The company expects that new products will help build market share in these various categories moving forward.
Why did this company's stock fall so hard on a warning about earnings this coming year? Earnings estimates were only knocked down 6% or so for the year, yet the stock was pummeled 16%. People who had invested in Clorox because of its consistent performance may have been part of the reason. With a bump in the road, they no longer felt comfortable sticking with the company. Other sellers may be ones who ascribe to the "cockroach theory," which states that bad news is like cockroaches -- if you see any, more are lurking behind the scenes. These people envision that Clorox will continue disappointing investors for several quarters.
I have no idea exactly what will happen to Clorox over the next year. The company could flounder miserably, post results just in line with expectations, or potentially even surpass projections later in the year as the company addresses its problems. Much more important than the next year should be the company's long-term prospects -- what will happen five to ten years down the road. At this point, I think it is much more likely than not that the company will revert to at least a low double-digit earnings growth path through most of this period. My confidence is inspired by management's strong track record and the strong financial underpinnings of the company.
As mentioned numerous times in the past, I get pretty excited when stocks that I want to own take a tumble. If you're looking at a company, it seems to make so much more sense to buy at $90 rather than at $130. While it is preferable when such a decline is caused by overall market malaise rather than bad company-specific news, you can overlook company problems if you think they will be overcome during your investment horizon. This creates a huge advantage for people looking five to thirty years ahead rather than 90 or 180 days.
Near-term results for any struggling company are uncertain, yet the longer-term prospects are much less dicey when you're dealing with a corporation like Clorox with strong brands, an excellent financial model, and solid management. If you have investing vision rather than myopia, the recent Clorox washout could present a great opportunity to start participating in its future. For those interested in slowly accumulating shares, the company offers a no-cost dividend reinvestment program with an optional cash payment feature after you've acquired at least one share.