Should Investors Bite Into Dan Loeb’s Latest Target?
Activist investor Third Point LLC Released its Q3 2022 investor letter on October 18. One of the highlights was founder Dan Loeb’s $1 billion investment in Colgate-Palmolive (CL) in the third quarter.
The consumer products company’s shares jumped on the news.
The billionaire gave four reasons why they invested in Colgate. I’ll consider each of Loeb’s arguments before deciding if investors ought to bite into the activist investor’s latest target.
Colgate Has Pricing Power
We are living through an inflationary period like we haven't seen for some time. As a result, investors are looking for defensive positions that will retain their value due to their pricing power.
Loeb believes Colgate is such a beast.
“Colgate has a strong portfolio of brands and operates across four categories that should perform well across most economic conditions: oral care, home care, personal care, and pet nutrition,” Loeb stated in the Q3 2022 investor letter.
“Although Colgate has delivered organic sales growth of 5-6% over the past few years, earnings growth has been disappointing, and the stock has become a perennial underperformer.”
Colgate’s share price has gained 3.6% over the past five years. This compares to a gain of 44% for the S&P 500. So, it’s safe to say Loeb’s right about failing to deliver for shareholders.
As for pricing power, he believes that some of the company's headwinds, such as inflation and supply chain disruption, are easing. At the same time, investments by the company in product innovation and digital capabilities are starting to gain traction. When combined with price increases, the company is in a position to begin growing earnings again.
The Pet Food Business Is Valuable
Colgate’s Hill's Pet Nutrition business is the star performer in the company’s lineup of brands. The Hill’s Science Diet and Hill’s Prescription Diet brands are available through specialty and veterinarian channels.
“Hill’s has been growing sales organically at 11-12% over the last several years, generates mid/high 20’s operating margins, and is on track to contribute about 20% of Colgate’s sales and profits in 2022,” Third Point’s investor stated.
More importantly, the division has acquired three pet food manufacturing plants from a third party to ensure its future sales growth. The time is right, Loeb argues, to spin it off as an independent public company.
Third Point values it for as much as $20 billion -- 25-30x the unit’s earnings per share -- as a standalone business.
Consolidation Happening
Third Point makes the case that several happenings in the consumer health industry make future consolidation in the industry a foregone conclusion.
For starters, you've got Haleon (HLN), the combination of GSK (GSK) and Pfizer’s (PFE) consumer health businesses. Its brands include Sensodyne, Aquafresh, Polident, Otrivin, Flonase, Voltaren, Advil, and many more. It will likely look to add to and subtract from its collection of brands.
Third Point also mentions that Johnson & Johnson (JNJ) wants to spin off its consumer health business.
Colgate could use the $20 billion it might reap from separating Hill’s to grow its consumer health brands.
Valuation
Third Point values Colgate at 20x its fiscal 2023 earnings per share. It believes it is low, given its projected earnings growth over the next few years and its attractive dividend yield.
Further, its current valuation doesn’t consider Hill’s spinoff or the consumer health sector.
Procter & Gamble (PG) currently trades at 23x its 2023 earnings estimate of $5.84 a share. Were it valued similarly to P&G; its shares would trade at least $10 higher. On a price-to-sales basis, Colgate currently sells at 3.48x sales, below its five-year average of 3.92x, and PG at 4.06x.
Loeb’s right. It’s relatively cheap at the moment.
The Bottom Line
Colgate’s history with Hill’s dates back to 1976 when it acquired Riviana Foods, an owner of several rice brands, for $166 million in stock. In addition to the rice business, Riviana owned Hebrew National Kosher Foods, a maker of Kosher hot dogs and deli meats.
It also owned Hill’s Packing, a maker of pet food, which became Hill’s Pet Nutrition. Colgate sold Riviana Foods in 1985 but hung on to the Hill’s business, which it has owned for 46 years.
I point out that it has gotten plenty out of nearly 50 years of owning Hill’s. To spin it off at this point, generating $20 billion or more in the process is an excellent way to end Colgate’s long and profitable relationship with pet food.
The downside to Loeb’s plan is it would be losing its most significant growth driver.
In the first six months of 2022, the Pet Nutrition business experienced sales growth of 15.5%, excluding currency. Its Oral, Personal, and Home Care business generated 4.5% sales growth, excluding currency, compared to a year earlier.
Once it loses this growth, it’s not guaranteed that future acquisitions will replace it.
It’s like a major league baseball team getting rid of an up-and-coming pitcher that it drafted and developed from Class A ball to the majors. You don’t get that many opportunities.
The value created by spinning off Hill’s won’t be fully understood for years after it’s completed. It’s a risky move that could result in significant value destruction.
However, given the lack of performance from Colgate’s stock over the past five years, Loeb’s got the right idea. It’s a chance worth taking.
If you’re an aggressive investor, I’d consider buying on Third Point’s participation.
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