Reckitt Benckiser is a name which came up several times following my recent, mildly negative review of Unilever.
In many ways, Reckitt Benckiser is in the same boat as Unilever. They’re both companies which are highly valued because of their historically low risk, steady growth characteristics.
That’s why they’re sometimes referred to as “expensive defensives”.
But in recent years, Reckitt Benckiser has generated little in the way of steady growth.
To fix that, management have decided to spend more than £14 billion acquiring Mead Johnson Nutrition, a global leader in infant nutrition.
This could be a smart move, but from where I’m standing the acquisition may have turned Reckitt Benckiser into a high debt, low growth timebomb.
Reckitt Benckiser’s growth is going, going gone?
Let’s start with the reasons behind this acquisition; primarily, Reckitt Benckiser’s relatively weak growth over the last few years.
I say “relatively weak growth” because context is important here.
In the good old days of 2012, you would have seen a company riding the crest of a wave. Reckitt’s growth had averaged 17% per year over the previous decade and very steady growth it was too.
This made the company very popular with investors and their enthusiastic buying pushed the share price up from £40 to more than £80 over the last five years.
More recently though, the company has repeatedly failed to live up to the market’s expectations and the shares have fallen back below £65:
Today, Reckitt Benckiser’s ten-year growth rate is a modest 5%. Even more worrying is that growth over the last five years has virtually ground to a halt.
Yes, the 2016 results saw a decent up-tick, but that was largely to do with Brexit and the subsequent devaluation of the pound.
How so? Because more than 90% of Reckitt Benckiser’s revenues are generated outside the UK, so when the pound goes down, Reckitt Benckiser’s revenues (reported in GBP) go up.
So if we ignore Brexit then the company’s recent growth has barely kept up with inflation.
This is not good and there are myriad reasons behind these results. They range from one-off mistakes to potentially wide-ranging changes in how consumers view global premium brands (i.e. not as favourably as they once did).
I’m sure many of the institutional investors who jumped on the Reckitt Benckiser bandwagon are not especially pleased with the way things have gone these last few years.
I think it’s likely that huge amounts of pressure have been put upon management, by investors, to pull their finger out and start generating some growth, pronto.
In response, management decided that if they couldn’t generate growth organically, they’d simply go out and acquire it.
Growth by acquisition can be a dangerous game
And by “acquire” I mean big acquisitions, starting with the acquisition of Mead Johnson for a little over £14 billion.
That’s a huge acquisition, even for a £45 billion company like Reckitt Benckiser.
It is, in fact, more than seven-times Reckitt’s recent post-tax profits. And for context, I define any acquisition which exceeds a company’s recent average profits as “large”, so this acquisition is seven-times bigger than my definition of large.
There are pros and cons to an acquisition of this size, of course.
On the positive side, Reckitt Benckiser’s revenues, earnings and dividends will jump up at its next annual results.
That’s because Mead Johnson brings with it revenues of around £3 billion and post-tax profits of around £0.4 billion. These will provide a healthy boost to Reckitt Benckiser’s existing revenues and profits of almost £10 billion and £2 billion respectively.
So revenues, earnings and dividends will all increase and Reckitt Benckiser will own the world’s leading infant nutrition franchise. What’s not to like?
In a word, debt.
To afford this £14 billion acquisition, Reckitt Benckiser has increased its debts from an attractively prudent £2.4 billion in 2016 to an eye-watering £17.2 billion today.
In terms of the important debt-to-profit ratio, that increase takes Reckitt from 1.4 in 2016 (comfortably below my preferred maximum ratio for defensive companies of five) to a palpitation-inducing 9.7 today.
This is, in my humble opinion, insanely high and fortunately it seems that management agree.
To reduce debt and re-focus the business around its health and hygiene core, the food business (which includes famous brands such as French’s Mustard) has been sold.
This should raise around £3.2 billion, which will be used to reduce the company’s enormous debt-pile to about £14 billion.
And let’s not forget, the acquisition will boost profits by about 25% which will also reduce the debt-to-profit ratio.
However, even accounting for these factors, Reckitt Benckiser will still have a debt-to-profit ratio of more than six, which is comfortably above my preferred maximum for defensive companies.
A one-off unsustainable growth spurt
Another problem with debt-fuelled acquisition strategies is that they are usually unsustainable.
In this case, Reckitt Benckiser has boosted revenues, earnings and dividends by 25% or so by borrowing money to buy another company.
However, that’s a one-off event and post-acquisition growth for the combined business is expected to be low single-digit.
If management want another easy acquisition-driven growth spurt, they’ll have to take on even more debt, which will make the company even more risky than it is today.
Hopefully they won’t do this, but you never know.
Expensive defensive or high debt, low growth timebomb?
Okay, perhaps “timebomb” is an overstatement.
Reckitt Benckiser is still a defensive company selling market-leading, premium-branded health and hygiene consumer goods.
But it is a statement of fact that the company has produced very little real growth in recent years and that it is more indebted than almost any other defensive company in the FTSE All-Share.
So although Reckitt Benckiser is still defensive (i.e. not particularly affected by recessions), I don’t think it’s a low risk company. Its debts are simply too high for that description to be appropriate.
And because I don’t think it’s a low risk company, I don’t think it deserves a premium price; and yet a premium price is what it has today.
With the shares at £65.50, the dividend yield is just 2.4%. Even if we assume that next year’s dividend is 25% higher than this year’s, the yield only goes up to 3%.
That’s still below the FTSE 100’s dividend yield of 3.9%, or perhaps 3.5% or so if you buy an index tracker.
Or if you don’t trust the dividend yield as a valuation metric, you might want to look at price relative to earnings over the past decade.
And here again, Reckitt Benckiser does not exactly look cheap. PE10 (which is what I call this ratio) is about 18 for the FTSE 100 and about 28 for Reckitt (or 26 if we factor in 25% higher profits in 2017).
That’s a big difference and it underlines my feeling that Reckitt Benckiser is not only a high debt, low growth defensive stock, it’s also an expensive defensive stock.
I would buy Reckitt Benckiser if…
- Debts are reduced – Those debts would have to fall below £11 billion at least, and preferably below £10 billion (and preferably much lower than that), and
- The price is reduced – The share price would have to fall below £55. At that point the forecast yield could be as high as 3.5% and, more importantly, the company would enter the top 50 stocks on my stock screen.
However, my guess is that the debt-reduction process will take many years, so don’t expect to see Reckitt Benckiser in my portfolio anytime soon.