Reckitt Benckiser: An Exceptional Business

by The U.K. Income Investor

Reckitt Benckiser (RB) is having a good downturn so far. Its shares have gained 13% year-to-date, well ahead of the 20% drop posted by the wider FTSE 100 index. On the face of it, it is easy to see why. The manufacturer of Nurofen, Dettol and Lysol has witnessed a surge in demand for its products due to the COVID-19 outbreak. It is one of the few firms expecting a better 2020 than it originally forecast.

The longer-term history here is also one of significant wealth creation. Its stock is up by a factor of around ten since the turn of the millennium, equivalent to annual share price returns of circa 12%. That ignores the small mountain of dividend cash pumped out in that period too. That said, it has struggled in more recent times. Its three-year price chart is nothing to write home about, and before COVID-19 you could have said the same thing about the five-year one too.

First thing’s first, this is an exceptional business – one of the best in the FTSE 100. To understand why, just take a look at its underlying earnings power, which comes in at around the £2,400m point. To put that figure into some context, it is about the same value as Reckitt’s net PP&E. These are the physical assets that make its goods – the factories, machinery, and so on. It earns that amount in just one year, and on an after-tax basis too. That is how strong the company’s brands are. Regardless of short-term ups and downs, this is the context to view the stock in.

Mead Johnson

What, then, had gone wrong here in recent years? Two things in my view. Firstly, its $17,000m acquisition of baby food maker Mead Johnson back in 2017. Inclusive of Mead’s debt, the total enterprise value of the deal clocked in at circa $18,000m. Mead was on for around $1,000m in annual EBITDA at the time, so call it a valuation of 18x EBITDA. That looked pretty steep for a low-growth business, though time will tell.

At the time, Reckitt justified the price-tag on the basis of expected cost savings, as well as a turnaround to Mead’s growth fortunes. Its presence in higher growth emerging markets was also touted as a potential springboard for Reckitt’s wider business.

(Source: Reckitt Benckiser FY19 Results Presentation)

Suffice to say, things haven’t exactly gone to plan since then. Integration hasn’t been as smooth as planned, and long-term prospects in China have weakened. On that basis, the firm recently booked a circa £5,000m write-down relating to the acquisition.

The deal also left Reckitt with a bit of a debt hangover. Pre-acquisition leverage was very modest here. These days, its net debt load stands at around £10,700m, equivalent to circa 3x EBITDA. Reckitt can handle it – interest costs are cheap and the business throws off over £1,000m in retained earnings each year – but debt is higher than I’d like to see. It retains A-/A3 ratings from the big two, though with a negative outlook attached to both.

Valuation

That leads us to the second issue: valuation. When it topped out at around £80 per share back in 2017, the company sported a total market-cap of around £57,000m. Add on circa £10,700m in net debt, and that gave it an enterprise value of around £67,700m. That was quite lofty versus then-EBITDA in the £3,000m per annum region. At the very least, you can’t be surprised to have a few quiet years (in terms of the stock price, that is) when digesting that kind of valuation. None of this changes the fact that it remains an exceptional business.

Outlook

That brings us to its current outlook. As I mentioned in the preamble, Reckitt has seen increased demand for its brands in light of the COVID-19 outbreak. It released its 1Q20 trading update last month, and the numbers look impressive. Revenue clocked in at just over £3,500m in the quarter, up 12.3% on the equivalent period last year. That figure increases to 13.3% once you strip out unfavourable foreign currency movements. Obviously, it would be wise not to extrapolate this growth too much.

On that note, here’s what we are looking at. The shares currently trade around the £70 mark, with earnings power somewhere in the £3.50 per share area. Quick maths therefore puts the stock at around 20x underlying earnings. The company pays out pretty much half of its profit by way of cash dividends, which equates to a current dividend yield of around 2.5%.

(Source: Reckitt Benckiser FY19 Results Presentation)

Management’s longer-term target points to mid-single-digit revenue growth and 25% operating profit margins. It sees that leading to earnings per share growth in the high single-digit per annum area. It will have to invest a bit in order to get there, so it would not surprise me to see another uneventful few years in terms of its finances and share price.

That said, if you plan to hold this thing forever, I guess it is not the worst outlook in the world. At the low-end of management’s earnings target, you’d basically get a 2.5% dividend yield that grows at circa 7% per annum. All other things being equal, you come away with decent, albeit not spectacular, long-term returns.

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