Church & Dwight: "Perfect" Company?

What we've done over the last few months is describe an ideal: What would the perfect company, the company with the strongest Rule Making countenance, look like?

I thought I'd do something a wee bit different this week. I want to detail for you the company that I consider to be the near definition of a Rule Maker. It's a little bit small, certainly smaller than most of the companies that would immediately come to mind, like Coca-Cola (NYSE: KO), Microsoft (Nasdaq: MSFT), Starbucks (Nasdaq: SBUX), or the like. It's also not in a market segment that will allow it to pass all of our criteria, but its strengths so outweigh these shortfalls to make them barely relevant. It's a consumer products company, one that you may have only heard of because I've waxed rhapsodic about it in the past.

It's a company with dozens of products, from household cleaning to toothpaste to baking goods, and personal care products. The company estimates that its products are present in 95% of all households in America. Add to this the company's powerful commercial products division and you have a powerhouse.

The company? Princeton, New Jersey-based Church & Dwight (NYSE: CHD), one of a very few companies that I believe an investor could put into a lock box, and come back and revisit in 20 years and make out just fine. This is a company that has, if not no competition, then certainly no competition that matters that much in its core product line -- which goes by the name of Arm & Hammer Baking Soda.

Quick, can you NAME another brand of baking soda? I certainly cannot, and on those occasions that I buy baking soda, I do no price comparison whatsoever. It's not expensive. I trust the stuff in the little yellow box. What more do I need to know? I doubt that my thought process in this sales transaction differs very much from most people's. That Arm & Hammer has formulated itself as a near monopoly provider of a branded commodity is, to my mind, one of the most brilliant marketing jobs in the 20th century.

Sodium bicarbonate, more commonly known as baking soda, is extremely versatile. Growing up we used it as a toothpaste alternative, to clean carpets, in cookie recipes, as an air freshener, and so on. Church & Dwight sodium bicarbonate products were used to clean corrosion off the Statue of Liberty, and is currently teaming up with the National Trust for Historic Preservation to clean up some great old homes using Arm & Hammer products.

All of this is to demonstrate that Church & Dwight may have the single strongest sustainable competitive advantage of any company in America. It's a company with near-universal demand for a product that is completely recession-proof. Its main product has no appreciable competition, and it possesses one of the most valuable brands in America. And the company has been smart enough to take both the power of that brand and extend it into related products.

Finally, Church & Dwight has leveraged its incredible cash creation ability to buy products with similarly strong brands and markets, most recently in its purchase of Carter-Wallace's consumer products division, including such brands as Arrid antiperspirant, Trojan condoms, and the First Response pregnancy detection kit. Heard of those brands, too, haven't you?

In other words, Church & Dwight has completely locked down both of the "must-have" Rule Maker criteria: market dominance and a sustainable competitive advantage that simply seems unbreakable, one that the company relentlessly continues to expand.

What about the rest of the criteria? Well, right out of the gate, we know that we're not going to reach the $4 billion annual sales threshold. For the fiscal year 2001, Church & Dwight's sales totaled only slightly more than $1 billion. We're talking about the minimum threshold as an optional point, though. It exists simply to give investors a nice cut-off point so they don't run too far down the rabbit trail trying to convince themselves that a company is a Rule Maker when it is not. In other words, when you find a company that so thoroughly surpasses the first two criteria, this one matters much less.

What about the others? Dominant for more than a decade? Whew! I'll bet that there is not another company that has had a leading position in its market longer than 150-year-old Church & Dwight has had in baking soda.

Cash King Margin above 10%? More like 5%, but think about it: This is a commodity product we're talking about, and much of the company's sales are on the commercial level. There simply is not going to be room for such significant cash generation for every dollar of revenues. Still, give me the consistent 5%, results I can count on into the distant future, and I'm happy.

Foolish Flow Ratio below 1.25. Yup, it comes in at 1.21, a number I think could be improved given Church & Dwight's market dominance. In fact, the company only meets the threshold when I back out deferred income taxes. Still, this number has been fairly consistent over time.

Best-of-class management: Robert Davies and crew were handed a company from previous ownership that had every advantage in the world based on its ironclad grip on the baking soda market. So what did Church & Dwight do next? They began taking advantage of some of the markets that the company had been leaving on the table for decades. People use baking soda instead of toothpaste? Well, then, Church & Dwight put out an Arm & Hammer branded toothpaste. Same with deodorant. Also, this is a company with shareholder-friendly compensation, with options dilution of less than 2% per year. I don't like the fact that they've set their pension plan returns so high -- at 9.25% -- at all, though.

Return on Invested Capital above 11%: Yup, but not by much. Over the last 10 years, Church & Dwight's ROIC has hovered right at 11%. Of course, the company has significantly increased its capital base over the last decade with its acquisitions. This may continue, or it may not. If it does not, is it a reasonable assumption that returns on a more stable capital base would improve? I'm not ready to say "yes," but I have no evidence to think otherwise.

A reasonable purchase price: Unfortunately, here's where I leave you at the altar. The answer is, at 14 times normalized free cash flow rates over the last five years, there isn't much safety built into Church and Dwight's current stock price. Now, with its competitive advantage and near-monopoly standing, I'd be willing to pay much higher multiples for Church & Dwight than nearly any other company, since I think that the risk of investment impairment even over longer stretches of time is so low. But still, we're looking to get the best companies in existence at a good to great price. After an 18-month period in which the company's stock has doubled, I'm not really prepared to call the current price either good or great.

Still, we're not really talking about buying in this column; we're talking about identifying. And Church & Dwight, as far as I'm concerned, is a nearly picture-perfect example of the type of company we should be looking for.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards.

Bill Mann's just reminded himself that it is high time to replace the box of Arm & Hammer in the ole fridge. He does not own any of the companies mentioned in this article. The Motley Fool is investors writing for investors.