Reckitt Benckiser Stock: Undoing Mistakes Will Make The Company Bright (OTCMKTS:RBGLY)

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Concepto de acaparamiento de papel higiénico y productos de limpieza

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Investment thesis

Everything was going well at Reckitt Benckiser (OTCPK:RBGPF) before the acquisition of Mead Johnson in 2017. It is since the acquisition took place, and the subsequent performance weakening of the newly acquired company, that the dividend cash payout ratio has increased considerably as a result of a weakening overall profit margins, greatly reducing the company’s margins of maneuver. Net debt increased by £13 billion, which was mitigated by the sale of the food division, and to the lower margins was added the payment of interest on the debt used for the acquisition. Finally, the company divested some of its businesses in 2021 and is currently paying down part of the debt incurred during the acquisition of Mead Johnson.

Even so, we must not forget that Reckitt Benckiser has 200 years behind it and that its owned brands are legendary on a global scale. Difficult times as a result of poor decisions by CEOs are something that sooner or later occurs within a company even as large as Reckitt Benckiser. If the nature of such a big and important company is not compromised in the long term, share price discounts due to short-to-medium term shareholder damage can often present good opportunities to buy shares at a lower cost and hold them while the company recovers from the consequences of the bad decision, collecting dividends along the way.

CEO Rakesh Kapoor is no longer at the helm of the company, and the new management seems to be focusing on the acquisition of products of industries where the company already has experience, as is the case of the recent acquisition of BioFreeze and TheraPearl. Also, the new management seems to be starting to realize that the best solution, albeit painful and embarrassing, is to end up selling the baby-food business entirely. Therefore, I believe that it is a good time to acquire shares of this behemoth company that has continuously demonstrated its viability for two centuries and hold them forever.

A brief overview of the company

Reckitt Benckiser is a global manufacturer of hygiene, health, and nutrition products, owner of globally well-known brands with a strong presence in Europe and emerging markets, as well as North America. The company’s market cap currently stands at ~$60 billion, which means it’s a large-cap company, employing over 43,000 workers worldwide.

Reckitt Benckiser brands portfolio

Reckitt Benckiser brands portfolio (Reckitt.com/brands)

Its brands are deeply rooted in the countries where the company operates, which ensures the continuity of its operations over the decades. Thus, the company has a continuous revenue stream through repeated sales of its products, and high quality, as well as strong brand power, enable exceptional profit margins and profitability.

The problem began when the company acquired Mead Johnson Nutrition in 2017. Soon after the acquisition, a number of factors caused the newly acquired company not to return the expected results, including increased competence and lower-than-expected birth rates in China, and tougher trading conditions in ASEAN and Latin America, causing a direct impact on gross profit margins and revenue growth. Apparently, the company overpaid for the acquisition and had to take an impairment of £5 billion in 2020. Rakesh Kapoor retired as CEO in 2019, and Laxman Narasimhan, Global Chief Commercial Officer of PepsiCo (NASDAQ:PEP) took its seat that same year.

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Data by YCharts

The results of the Mead Johnson acquisition, which still weigh heavily on the balance sheet, are causing the company’s shares to be down 20% from the highs reached in July 2017. But despite the damage caused to shareholder value, I personally believe that this represents a good opportunity to acquire shares at a significantly lower price in relation to the company’s sales, since the P/S ratio has also fallen considerably, for those investors with a very long-term vision seeking for stable dividend income.

Recent acquisitions and divestitures

In June 2017, Reckitt Benckiser acquired Mead Johnson Nutrition Company for ~$17.9 billion. The management’s intention was to reduce expenses by £200 million per year in order to profit from the acquisition. A month later, the company sold its food business segment, which included French’s, Frank’s RedHot, and Cattlemen’s brands, to McCormick & Company (NYSE:MKC), for $4.2 billion.

In February 2019, the company acquired UpSpring, a manufacturer of healthcare products for pre and post-natal infants based in Texas, USA. After this acquisition, the coronavirus pandemic crisis caused a significant improvement for the company’s results in 2020, and the increase in net cash generated through operations made the management decide to take advantage of said cash to reduce its net debt and pause the M&A strategy until 2021 when a series of divestments began while the company expanded its portfolio of brands dedicated to pain management.

In this sense, in June 2021, the company sold Scholl, a foot care products brand, to Yellow Wood Partners. Soon after the sale, in July of the same year, the company acquired Biofreeze, a topical pain relief brand, and TheraPearl, a hot and cold therapy brand for pain management, from Performance Health.

In September 2021, Reckitt Benckiser sold its Infant Formula and Child Nutrition business in China to Primavera Capital for $2.2 billion. And in November of the same year, the company sold its Mead Johnson Nutrition Argentina stake, which includes SanCor Bebé and SanCor Bebé Premium brands. These brands were distributed to Argentina, Bolivia, Paraguay and Uruguay. The deal also means that Reckitt Benckiser won’t commercialize EnfaBebé, Nutramigen, and Enfamil in those countries for 10 years.

In December 2021, the company the proposed sale of its E45 brand, a science-based skincare products brand generating over ~£40 million in revenues per year, to Karo Pharma for ~£200 million. And currently, the management is eyeing the possibility of fully divesting its baby-food business.

Net revenue declined in 2021 due to divestments

Net revenue increased by 8.9% during 2020 due to strong demand in response to the coronavirus pandemic crisis, and net cash from operations increased as a result. This was a breath of fresh air for the company, which saw its net debt decrease after being stagnant in the previous three years.

Reckitt Benckiser net revenue

Reckitt Benckiser net revenue (Annual reports)

In 2021, net revenues declined by 5.4% as divestitures impacted net revenues by 3.8% and foreign exchange rates by 5.1% (in a like for like basis, revenues actually grew by 3.5% year over year as volumes increased by 0.6% while price/mix caused a further improvement of 2.9%). In the quarters to come, sales should continue to decline due to the sale of the baby-food business, but I believe that it is completely necessary to get rid of debt in order to be able to concentrate on the other segments of the company. The upside to all of this is that sales continue to increase on a like-for-like basis, meaning that even though the company is selling off parts of its business, sales of its remaining products continue to increase.

Also, the company is very well geographically diversified. Net revenue in Europe represented 31.97% of the total in 2021, while 30.76% took place in North America and 37.27% in developing markets.

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Data by YCharts

As a consequence of the Mead Johnson acquisition, the price to sales ratio has fallen considerably since 2018, which means investors are not willing to pay as much for sales as before the acquisition. In my opinion, this opens up a good opportunity to buy shares in this giant and stable company now that the new CEO is willing to undo the mistakes by the past management.

Margins are strong despite recent weakness

Now we come to one of the company’s strongest points: its ability to convert sales into actual cash. The company’s gross profit margins, which are well above 50%, allow it to generate cash year after year.

Reckitt Benckiser gross profit margins

Reckitt Benckiser gross profit margins (Seeking Alpha)

These profit margins are a clear reflection of the power of its brands as shoppers are willing to pay a premium for the company’s products, although these have deteriorated in recent years. The problem now is that the dividend is eating up a large part of the company’s profits as the cash payout ratio is increasing to dangerous levels, and if we add the declining margins to the payment of interests on incurred debt, we have a less profitable company than before the acquisition of Mead Johnson. Although margins picked up in 2020 as a result of strong demand during the coronavirus pandemic, increased production costs due to inflationary pressures have damaged margins again in 2021.

The current plan of the management is to get rid of the baby-food business, which would make it possible to reduce the debt to levels similar to those the company enjoyed before the acquisition of Mead Johnson, with which the company could pay the dividend more easily and have some spare cash after each year. Still, it all depends on the management’s ability to find a buyer who will make a good offer for the business. The good point is that gross margins of 58.9% during the second half of 2021 showed a slight improvement vs. 58.1% during the first half.

Net debt reduction is a top priority

Net debt climbed from £1,578 million to £14,751 million as a result of the acquisition of Mead Johnson but declined fast to below £11 million thanks to the sale of the food business. As a consequence, the company acquired the obligation to pay the interest on said debt. In 2020, interest expenses were £267 million, but it declined to £222 million in 2021 and is expected to keep declining as the company keeps divesting some businesses in order to pay down more debt.

Reckitt Benckiser net debt

Reckitt Benckiser net debt (Annual reports)

In this sense, the company will most likely have to continue divesting some of its businesses, and I believe that the current management is pointing in the right direction by considering a possibility as painful as it is convenient: reversing the damage caused in the past by selling its baby-food business. Considering that the remaining operations of the division hold £5.4 billion of net assets, the divestment would certainly put the current debt of £8.4 billion at very manageable levels and open the door to a new era in the company.

The dividend should keep frozen for a while

As we can see in the table above, net cash generated through operations suffered strongly in 2019 and, despite a rebound in 2020, has again suffered a large deterioration in 2021. As a consequence, the cash payout ratio has increased to dangerous levels.

Year 2013 2014 2015 2016 2017 2018 2019 2020 2021
Net cash from operating activities (in millions) £2,121 £2,099 £1,784 £2,422 £2,491 £2,524 £1,411 £3,518 £1,697
Dividends paid (in millions) £992 £988 £924 £1,036 £1,145 £1,187 £1,227 £1,257 £1,263
Cash payout ratio 46.77% 47.07% 51.79% 42.77% 45.97% 47.03% 86.96% 35.73% 74.43%

Source: Annual reports

By 2021, net cash from operations reached almost 75%, with £434 million left over, which was used to cover the capital expenditures of £441 million. The management decided to freeze the dividend in 2021 as a consequence. In this sense, the company managed to continue reducing its debt thanks to the divestitures carried out in 2021, and this should add some room for dividend payments in the future. Still, investors shouldn’t expect raises until the balance sheet looks healthier and inflationary pressures are under control.

In this sense, inflationary pressures impacted gross margins by over 400 basis points in 2021 and the management already took pricing actions throughout the year. Therefore, the increase in product prices should stabilize the cash payout ratio in the coming quarters, allowing the company to generate some excess cash after meeting all payments. Still, more inflationary pressures in 2022 would result in further difficulties to cover the dividend.

Risks worth mentioning

Net revenues are at risk of suffering a strong deterioration as a consequence of the future divestments that the company will have to carry out with great probability to undo the mistakes made by the previous CEO. If the company fails to get rid of the baby-food business on favorable terms, it could be forced to keep selling other segments that are part of the company’s core portfolio in order to get rid of debt.

Also, the dividend has lost a lot of room for growth due to the increase in the cash payout ratio. Gross profit margins were significantly impacted in 2021 by increasing logistic costs, labor shortages, supply chain issues, and increased cost of raw materials. These inflationary pressures are expected to continue throughout 2022, so the company’s ability to generate enough net cash from operating activities to cover the dividend with ease will also be compromised in 2022 if the management fails to increase the price of products in time. In this sense, the dividend runs the risk of remaining frozen for longer than just 2021, with which investors would be the ones to whom the increase in costs that could not be covered with the pricing actions would be transferred.

Conclusion

Reckitt Benckiser is a company you can buy and hold forever, and that has not changed despite the bad decisions of past management in recent years. Now, the current CEO seems determined to undo the mistakes of his predecessor and, after some divestments and significant debt reduction, is ready to try to sell the baby-food segment entirely. In this way, the company would return to its state prior to the acquisition of Mead Johnson, with some damage suffered along the way but with the door open to continue expanding the company with acquisitions more in line with the company’s core brands.

Although sales decreased in 2021 as a result of divestments and unfavorable foreign exchange rates, they increased by 3.5% on a like-for-like basis with an increase of volumes of 0.6%, which is a good sign that the company’s brands continue on a healthy path. The company’s margins continue to be very strong and the management’s decision to pause dividend raises means that it will have more and more room to cover it as the price of its products are passed on to customers.

For all these reasons, I believe that the ~20% decline in the share price is a good opportunity to buy Reckitt Benckiser shares and hold them forever or sell them once the company’s prospects improve and shares are sold at higher prices.



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