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Colgate reported a top-line miss, but met EPS expectations of $0.70, for 2Q13 this morning and revised earnings guidance lower by 1% to 4.5-5.5% for the year. There were some reservations ahead of the quarter, on our part, about the difficult sales growth compare but strong volume growth, offset by FX headwinds, impressed versus expectations. Despite strong organic growth and operational performance, we would not own the stock at 21x forward earnings. Importantly, #RatesRising, one of Hedgeye’s 3Q Macro Theme, is a key risk for the broader Staples sector and we believe that the associated strength in the USD would be a negative for CL.

North America: The North America division delivered 5% organic sales growth (6% volume, -1% price) as Colgate continues to grow its dominant share of the oral care category. A strong new product pipeline is continuing to support robust revenue growth in this division, which represents roughly 18% of company sales.  EBIT margins in North America grew 2.8% year-over-year to 29.8%. This may be unsustainable, but a “benign cost environment” and continuing sales growth implies additional strong EBIT margin results going forward.

Europe South Pacific: Management cited sluggish economic growth as a headwind to sales growth after announcing organic sales declines of -2% versus 2Q12 (1% volume, -3% price). Despite the slowing environment, the company is growing its share in toothpaste, toothbrushes, mouthwash, and fabric softener.

LatAm: The Company’s largest region, by revenue, delivered 7% organic growth in the second quarter (2.5% volume, 4.5% price) and grew market share in many categories and markets. FX was an 8% drag on the top line, driving the entire -1.5% decline in net sales growth. EBIT margins contracted in Latin America for the third successive quarter although, again in 2Q if the impact of Venezuela’s currency devaluation were excluded, LatAm margins would have been up year-over-year.

Greater Asia/Africa: GAA delivered 9.5% organic sales growth (0% price) as toothpaste market share increases in India, China, Russia, and other markets. China and India are growing at double-digit organic growth rates. Growth potential remains promising in this segment as the company improves its distribution into new cities and rural areas.

Hill’s Pet Nutrition: Hill’s net sales surprised to the upside, with unit volume of 2.5% and pricing of 3% resulting in 5.5% of organic sales growth. While the volume growth was unexpected, “one quarter ahead of schedule”, according to management, it seems to have come at the expense of some margin. In 2Q, Hill’s EBIT margin contracted by 250 basis points to 24.8%.

Guidance:

  • Management revised FY13 EPS guidance to +4.5-5.5% growth versus +5.5-6.5% prior. This downward revision was entirely due to
  • Reaffirmed organic growth rate guidance of 6-7% for FY13
  • Reaffirmed gross margin expansion guidance of 30-70 bps

What we liked

  • EPS met consensus expectations
  • Consolidated organic sales growth came in at 5.5% vs. a difficult comp (comps ease over 2H13)
  • Gross margin expansion accelerated in 2Q13 despite sequentially tougher comparison (chart below)
  • EBIT margin year-over-year growth was 3.1% versus sales growth of 1.9%
  • FCF flat vs. year ago despite 57% ramp in capex
  • Easing comparisons in 2H12
  • FY13 gross margin guidance likely to be met

What we didn’t like

  • FX continues to be a big drag
  • Earnings multiple implied by the stock price seems full at 21x
  • Margin weakness in Latin America

CL ORGANIC GROWTH IMPRESSIVE - cl gross margin chart 7.25.13png

Rory Green

Senior Analyst