February 2006 Update and Company Reports

 

Church & Dwight (CHD 34) is a relatively small consumer products company with an exceptional track record of investment performance.  Over the past ten years, revenues and earnings per share have grown at annually compounded rates of 15% and 27%, respectively; driving a 29% annualized return to shareholders over this period.  The company has paid dividends for 115 years.  Although the name of this company, founded in 1846, has little recognition, its foremost brand certainly does:  Arm & Hammer Baking Soda.  The company draws 52% of its revenues from the household care segment and 48% from health and beauty.  It has products in more aisles of grocery stores than any other company and is a leader in most of its product categories.

 

Category	Rank	Brand name(s)
Baking soda	1	Arm & Hammer
Household and carpet deodorizers	1	Arm & Hammer, Fresh ‘N Clean
Pregnancy and ovulation kits	1	First Response, Answer
Condoms	1	Trojan, Elexa
Depilatories	2	Nair
Clumping Cat Litter	2	Arm & Hammer
Laundry detergent and Fabric Softener	3	Arm & Hammer, XTRA, Nice ‘n Fluffy, Rain Drops, Delicare
Toothpaste and battery powered toothbrush	4	Arm & Hammer, Close-Up, Mentadent, Aim, Pepsodent, Pearl Drops, Spin Brush, Rigident
Deodorant	4	Arm & Hammer Ultramax, Arrid, Ladie’s Choice
Household cleaners		Brillo, Scrub Free, Scrub ‘n’ Toss, Parson’s, Cameo

 

The management of this company knows how to build brand name based businesses.  The growth toolkit includes new product introductions, organic volume growth, cost-effective advertising, marketing insights, acquisitions, cost controls, tax planning, and sensible utilization of debt financing.  Free cash flow is substantial at $150 million, powering acquisitions.

 

Church & Dwight has grown revenues at a 20% annual rate over the past five years by adding shrewd acquisitions to organic growth.  Recent acquisitions include USA Detergents (2001), the Unilever personal care brands (2003), and the Carter Wallace consumer brands (2001 and 2004.)  The most recent acquisition, Crest SpinBrush, originated when Procter & Gamble was required to divest it in order to complete the acquisition of Gillette (which owns the Braun electric toothbrush business.)  Church & Dwight took advantage of the forced liquidation by purchasing this $100 million revenue business for less than 1 times annual revenues.

 

Church & Dwight continues to address organic growth opportunities, but will need acquisitions to continue to grow revenues at a double digit rate.  International constitutes only 20% of revenues, much less than larger competitors.  Forays into China and Brazil are just getting underway and are likely to add to future growth.  Analysts’ consensus earnings estimates over the next four years of $1.96, $2.23, $2.55, and $2.90 imply growth at a 13% annual rate.  This supports the growth of intrinsic value from the low $30’s presently to about $50 in five years.  While the stock appears fully priced, Church & Dwight would be a very nice acquisition for a larger consumer products company.

 

Boston Scientific (BSX 24) overpaid for Guidant.  In order to prevail over Johnson & Johnson in this takeover battle, Boston paid $20 over my $60 estimate of Guidant’s intrinsic value.  An exercise in mathematical simplicity, the overpayment was taken out of the price of Boston’s stock, to the tune of about $7 per share.  So, one must ask why Boston Scientific, 20% owned by management and truly managed with a strong sense of ownership, paid up for Guidant:

 

1.       Guidant’s Cardiac Rhythm Management (CRM) business shows huge potential.

2.       Guidant generates a flood of free cash flow that will grow in the future.

3.       Guidant will diversify Boston’s product portfolio and reduce its dependence on the Drug Eluting Stent (DES) business.  Although the DES business is highly profitable for Boston Scientific, it is not expected to grow much over the next several years.

4.       Guidant should double the revenue growth of Boston between 2008 and 2010.

 

Boston realized 20% annually compounded growth over the past five years as it built its lead in the drug eluting stent business.  This business grew so fast that it now dwarfs Boston’s other businesses: catheter systems, guidewires, infusion devices and endoscopy devices.  With the entrance of several powerful competitors, little growth is expected for Boston’s drug eluting stent business in the future.  Boston is in the process of introducing its second generation DES, the new Liberte super-flexible stent pictured above.  A meaningful boost to future revenue growth is anticipated to result from the Guidant acquisition.

 

Boston has given some pro-forma (including Guidant) earnings per share guidance for the combined companies: $1.40 in 2006, $1.52 to $1.66 in 2007, $1.98 to $2.17 in 2008, $2.24 to $2.54 in 2009, $2.61 to $3.02 in 2010, and $3.13 to $3.59 in 2011.  Since history is “water under the bridge” in the stock market, the question now for Boston investors is, “If I could purchase a company that will grow earnings from $1.40 in 2006 to $2.50 in 2009, how much should I pay for it?”  On a simple P/E basis, one could justify 18.5 times 2007 earnings of about $1.59, or $29.41.  That is somewhat below the industry average P/E of 22.  Five years from now, if Boston’s guidance proves correct, one could multiply the median guidance of $2.81 by a 20 multiple for a share price projection of $56.

 

Company	Current price	Analyst Consensus Estimate 2007 EPS	P/E on 2007 EPS	Analyst Consensus Est. Growth Rate 2006 to 2009	Compared to BSX
Medtronic	$56	$2.92	19.2	15.0%	Superb quality, faster growth
St. Jude Medical	$49	$2.03	24.1	17%	Faster growth
Abbott Laboratories	$44	$2.81	15.6	10%	Higher quality, slower growth
Johnson & Johnson	$59	$4.10	14.5	10%	Higher quality, slower growth
Average of above co.’s			18.4	13%	Slower growth
Industry Average			22	14.4%	Modestly faster growth
Boston Scientific	$24	$1.59	13.9	15%

 

Stand-alone Boston has an intrinsic value, based on discounted cash earnings, of $30.  Financial statements from the combined companies are not available yet, so we have constructed our own, essentially by adding the two companies together and adjusting capital for the acquisition cost.  Intrinsic value grows substantially because of the acquisition.  

 

The major risk of owning Boston Scientific is acquisition related.  First, Boston has to integrate and manage a large, competitive, and fast moving new business.  Guidant’s well publicized pacemaker quality problem has hurt sales, and Boston will have to continue to repair and rebuild confidence in Guidant’s products.  Boston itself has had recent problems with the FDA, and is working to address the FDA’s concerns.  Finally, Boston may be overestimating the earnings growth guidance it has given for 2007 to 2011.

 

It will take at least two years for Boston to absorb the dilution from overpaying for Guidant.  Despite that, it appears Boston Scientific is drastically undervalued.  Even better, one can clearly see and understand the cause of the undervaluation.  The cause of that undervaluation will evolve to an advantage over the next several years.

 

Steven L. Ré, CFA                                                                                            February 17, 2006

 

This report contains the current opinions of the author and such opinions are subject to change without notice.  It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities.  The information contained herein is from sources deemed reliable but is not guaranteed.  It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results.  Earnings projections often miss, and markets go up and down.  The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.