Is PZ Cussons’ share price too high?

PZ Cussons is the owner of, among other things, the Imperial Leather brand of luxury soap. A bar of soap might not seem very exciting, but every day millions of people get out of bed and wash, and in the process wear away at millions of bars of soap.

This regular routine of washing means that bars of soap are replaced like clockwork, regardless of whether the economy is in boom or bust. That in turn means that companies like PZ Cussons, which sells mostly non-durable, low price items to consumers, tend to have very stable earnings.

On top of stable earnings, PZ Cussons (and other companies that sell consumer non-durable products, like Reckitt Benckiser or Unilever) can earn a better than average margin on its products by investing in and developing powerful brands – like Imperial Leather.

These brands help shoppers to quickly find products they can trust in to deliver the benefits they’re after, from the vast array of options they’re confronted with. In return, most shoppers are willing to pay a little more for the brands that they trust in.

If you take those ideas of a premium priced, strongly branded, low-cost, non-durable product and apply it to detergents (Zip), white goods (Thermocool), washing up liquids (Morning Fresh) and many other categories, you end up with PZ Cussons’product portfolio which it sells into both mature and rapidly growing markets across the world.

A very long history of progressive dividend growth

The chart below shows how the company has progressed over the past few years:

Those results break down like this:

• Total revenue growth of 7% a year
• Earnings per share growth of 14% a year
• Dividend per share growth of 9% a year
• Combined Growth Rate of 10% a year

The dividend increased in every year (in fact it has increased in every year for the past 41 years), but the overall Growth Quality score is 83% rather than 100% because revenues and earnings have grown less reliably than dividends.

Both Growth Rate and Growth Quality compare well with the FTSE 100 (a reasonable benchmark), which currently has a Growth Rate of just 1.1% and a Growth Quality of 50% (although those are historically weak figures due to the Great Recession).

A company growing at 10% is of course doing very well, but something to watch out for is the company’s slower rate of revenue growth. At 7% a year it’s still good, but unless revenues can grow more quickly that 7% will eventually be an upper limit for both earnings and dividend growth.

Even more worrying is the lack of growth in revenues since 2009. In the last 5 years the company’s revenues have grown by just 3% in total, which is definitely a trend that needs reversing.

Digging somewhat more under the covers, the company is geographically diverse and operates in three main regions: Africa, Asia and Europe. The mix across these regions has remained broadly static at around 42%, 20% and 38% respectively, even as the company has grown.

As for return on retained earnings, the company’s historic return on capital has been around 10%, which is quite an average rate of return.  Going forward I would assume that any future retained earnings will also achieve that sort of return.

And last but not least, another positive feature is the company’s limited financial obligations. It has borrowings of around £120 million and pension liabilities of about £280 million. Neither of those figures is much for a company worth about £1.6 billion on the stock exchange.

So with its highly defensive consumer non-durable products, international exposure and track record of success, PZ Cussons is definitely a company I would invest in at the right price.

So what is the right price for PZ Cussons’ shares?

A company with a 4% yield might be attractive, but if there is an equivalent company with a 6% yield then it is the latter which should be bought, and so one way to look at the value of a company is to compare it to its peers.

For example, at 371p, PZ Cussons has:

• A dividend yield of 2.1%,
• a PE ratio of almost 18 and
• a PE10 ratio of 26.

The FTSE 100 at 6,400, with its slower and lower quality growth, has:

• A dividend yield of 3.4%,
• a PE ratio of 13.4 and
• a PE10 ratio of 13.3.

So the large-cap index is “cheaper”, but deservedly so because future dividend growth is likely to be slower for the index than for PZ Cussons.

A more reasonable comparison might be those companies that have similarly fast and consistent growth. There are 20 companies (including PZ Cussons) listed in the All-Share index with 10-years of unbroken dividend payments, Growth Rates of between 8% and 12% and Growth Quality scores of between 80% and 90%.

As a group those companies have on average:

• A dividend yield of 3.2%,
• a PE ratio of 16 and
• a PE10 ratio of 22.

So in comparison with other companies with similar track records, PZ Cussons has a lower dividend yield and higher PE and PE10 ratios. To me that suggests it isn’t obviously cheap relative to its peers.

A more direct comparison would be with a very similar company such as Reckitt Benckiser (RB), owner of brands such as Durex, Nurofen and Vanish washing powder (an interesting combination).

RB has a Growth Rate of 15.3% and a revenue growth rate of 12%. It also has a Growth Quality score of 96% and so it has grown both more quickly and more consistently than PZ Cussons.

At 5,130p, RB has:

• A dividend yield of 2.7%,
• a PE ratio of 22 and
• a PE10 ratio of 28.5.

So RB has a higher yield than PZ Cussons but also higher PE and PE10 ratios.

That’s a conflicting set of ratios. RB has the higher dividend yield and better history of growth, which suggests that it’s cheaper, but PZ Cussons appears to be cheaper relative to past earnings.

The key difference may be the historic return on capital and retained earnings.

The importance of return on capital

PZ Cussons shares have an earnings yield of 5.7% (the inverse of its PE of 17.6), 2.1 percentage points of which are paid out as a dividend with the remainder (3.6 points) retained for use in the business. In contrast RB has an earnings yield of 4.5%, of which it pays out 2.7 percentage points as a dividend and retains just 1.8 points for future use.

PZ Cussons has a much higher earnings yield, which is why it looks more attractive on a price to earnings basis.

But RB has managed to earn a return of around 23% on its capital and retained earnings over the past few years compared to the 10% that PZ Cussons has earned.

The higher rate of return on RB’s earnings shows up in its superior growth record, despite the fact that it is retaining a smaller amount of earnings per share. So in RB’s case less earnings, retained at a higher rate of return, have resulted in more growth.

Simply buying the company with the lower PE ratios may not be the best option.

That, among many other reasons, is why I currently own Reckitt Benckiser rather than PZ Cussons.

However, I did say that I would buy PZ Cussons at the right price, so what is that price?

By fiddling with its share price on my stock screen I can see that currently the “right price” for me would be something below 275p, some 26% below its current 371p per share price tag.

If you think that such a large drop is not feasible, consider Rolls-Royce. In July I thought that a good price for Rolls-Royce shares was 800p, even though at the time they were trading 31% higher at 1,045p. Fast forward to today and RR shares are indeed at exactly 800p.

So miracles do happen, popular shares do fall out of favour, and patient investors can sometimes hoover them up at reasonable prices.