Church & Dwight Co., Inc. (CHD) Earnings Call Transcript & Summary

Good morning, everyone. I'm Dara Mohsenian, Morgan Stanley's Household Products and Beverage Analyst. Just before we begin, a quick disclosure, please see the Morgan Stanley research website at www.morganstanley.com for our research disclosures, and contact your Morgan Stanley representative with any questions. With that, I'm very pleased to welcome Church & Dwight here to this fireside chat today, including Matt Farrell, Chairman and CEO; and Rick Dierker, CFO. Church is a fabulous track record of driving shareholder value, really, over the last decade and beyond. But it certainly experienced some of the CPG industry volatility we've seen recently and has had some different performance by the product category. So it's a great time to have the team here with us today to get an update. So thanks for being here, guys.

And I thought, first, we'd start with some of those different pieces of the portfolio. Obviously, the majority of the portfolio has remained strong recently, but there are a few places where you've had some challenges more recently. So first, maybe on WATERPIK and FLAWLESS, can you detail how much of the weakness has been driven more by underlying consumer demand versus retailer inventory cuts. How you think about that going forward? I would assume maybe the inventory piece of it isn't as bad as we move into next year versus the back half of this year. And just give us an update on what's occurring there? And then on the vitamin side, a bit of a different situation where there's been a drop off in category growth post-COVID. You've had some supply constraints. It does look like trends are getting better in the scanner data. So a bit of an update on the vitamin side also would be helpful.

Okay. That's plenty. All right. The way to think about it is 80% of our business is doing extremely well. We have the 20% is our problem. And the 20% I'm referring to is WATERPIK, FLAWLESS and Vitamins, is what Dara is bringing those 3 up. And certainly, WATERPIK and FLAWLESS we did have issues with respect to retailer adjustments to inventory in -- particularly in the third quarter. But those adjustments, both Q2 and Q3 are largely behind us for those 2 brands. The issue with WATERPIK and FLAWLESS is that they're devices. So WATERPIK is something you'll buy every 3 to 5 years. 60% of the purchases are based on a recommendation of a dentist or hygienist. So long term, it's a great business to be in. We bought it in 2017. And every year since 2017, up until '22. The business grew high single digits. So we got really slammed to this past year. And we do attribute it to the fact that it's a discretionary purchase. And that's true for both WATERPIK and FLAWLESS. What we have found for WATERPIK year-to-date is that our units actually are kind of flat year-over-year. And that's because within the brand, people are trading down from the high-priced items, which can be anywhere from $100, $150 to the lower-priced items, which would be say, $50. So lower sales, lower profits, but flattish units year-over-year. I do think we have a few more quarters of year-over-year negative growth. We don't think that's going to start recovering until the second half of next year for WATERPIK. I think the same is true for FLAWLESS. Now as far as vitamins go, so vitamin is not a device. So when you think about that 20%, right? 10% is going to be WATERPIK or FLAWLESS. So over 10% is going to be vitamins. And the issue with vitamins is like you have a lot of people exiting the category. And so if you look at the third quarter of this past year, consumption of Gummy Vitamins was down 8%, but it's getting better. In the -- in October, it was down 4%. And in November, the Gummy category is flat year-over-year sale. So that's a good thing. We -- that's good with one exception is that we have lost share in the category for a couple of reasons. And one is our fill rate. So we've had difficulty with fill rates all year long and even today. So that is a big one. And the second is the promotional activity by a lot of our competitors in the category. So we've got to get our fill rates right in the vitamin category, and then we got to deal with the promotional activity. But just kind of sum up here. Vitamins and WATERPIK Water Flossers is a good business, it's going to be long term. FLAWLESS is, if you think of all the acquisitions that we've done, I think that's the one would give us a black eye. Because it hasn't really grown since we acquired it. So we do have plans to turn that around in the next year to 18 months.

Okay. And then just one quick follow-up on WATERPIK and FLAWLESS. Is it reasonable to think some of the retailer inventory cuts dissipate as we move into the first half of next year, maybe sequentially, trends are a little bit better, understanding it's really the back half when you see a big recovery? And then, on the other 80% of the portfolio that's doing well, you mentioned the fill rates in vitamins. There have been issues in other pieces of the portfolio. So it looks like next year should be a pretty robust year on that other 80%, when you consider net your portfolio benefits from trade down, your back-end supply. How do you sort of think through that other 80% conceptually as you look out a bit particularly keeping in mind some of the supply constraints for this year?

Yes. Look, the other 80% is doing extremely well, just from a consumption standpoint and a share standpoint. The -- notably some of the businesses that are really racking our [indiscernible] with the dry shampoo. We just can't make it fast enough. The -- I would say that if you think about -- because probably what just trying to get at is what's 2023 going to look like. And we think that 80% of the business is going to do extremely well. WATERPIK is probably going to need to stabilize in the first half of the year, WATERPIK and FLAWLESS. And but we do think that it's going to be a good year from an organic standpoint. But if you want to talk about the entire P&L, which I'm sure you want to get to at some point, there's pluses and minuses for next year. And we're not going to call a number today with respect to organic or EPS. But the pluses for next year is certainly trade down. And we've been hitting all-time highs with ARM & HAMMER liquid laundry detergent and also been doing well in Cat Litter. Many of you may know, we have both the premium cat litter and a value cat litter, which is the orange box. And the orange box is growing far faster than in the category right now. So trade down is going to be a real plus for us next year. We do think that those businesses that I mentioned before are going to stabilize, the 80% of the business is certainly going to be -- continue to carry out. And we do think our share performance is going to improve as well next year. So it's -- so I gave you some of the pluses. Of course, the minuses for next year ago, currency is going to be an issue for us as well as interest rates because a portion of our debt is variable. And a couple of other things are going to be headwinds for us. One is marketing. So marketing as a percentage of sales is going to end this year around 10% of sales. And historically, we're 11% or better. So we do think we're going to be making a step change next year to have higher marketing as a percentage of sales. We won't get all the way to 11%, but it will be a meaningful move up from 10%. And the other headwind for next year is incentive comp. Many of you know, we have 4 metrics. We got sales, gross margin, EPS and cash flow. And we're all in a donut on 2 of those. That's for cash flow and EPS and not hitting the numbers for sales and for gross margin. So that's about a $30 million headwind next year for a normalized incentive comp in '23 versus '22. So there's definitely a bunch of pluses, including fill rate getting better, but we have the minuses as well. So kind of I'm sure that's what's on most people's minds today. So I think that's the best way to frame it.

Okay. That's very helpful. And as you think about gross margins, obviously, some pretty big pullbacks in spot commodities here that takes some time to flow through. And I plan to ask some questions on pricing going forward. But just given all the volatility we've seen in the last few years and maybe volatility would have been a good thing. But the downside in the last few years with the cost structure being so much higher, how do you think about the gross margin side going forward from here? How do you think about the timing of when costs flow through and that gap in terms of gross margin realization from pricing versus cost, just conceptually, how should we think about it?

Yes. I could take a swing at that or [ reckon ] I have my finance guy here.

Yes, I'll take a swing at it. So look, gross margin, we said in the last call for 2023 that we also think is going to be a tailwind next year. And basically, we've had now $0.5 billion of inflation over the last 2 years. And do we think we're going to have deflation next year? No. Do we think we're going to have inflation? Yes, we do. Not to the same extent that we've seen over these last couple of years. We'll have carryover pricing. We'll have pack size changes. We'll have fill rates, especially for our personal care business that are kind of back to normal, which always helps from a mix perspective. And then for the first time in 3 years, we believe we'll have productivity outrunning inflation, which is a great thing and kind of back to normal. So I mean those are some of the reasons we believe that we're going to have gross margin expansion. I think as we exit even Q4, previously, we had thought we were going to inflect positively. That's what we had said maybe 2 quarters ago. It's -- I think we're still going to be down in Q4, but we're starting to see the step changes happen. From a commodity perspective, usually, we're 65%, 70% hedged in any given year as we go into the next year, and we're probably closer to the 20s, 30s these days because we still believe that there's more room for commodities to come down. But it does take a while for that to go through the supply chain.

Okay. And is there a pretty big difference in terms of cost year-over-year first half versus second half? How do you think about that just from a timing standpoint? Obviously, things can change in the spot market here. But when should we think about some of the more moderate cost starting to flow through or less pressure at least?

Yes. I'd probably defer that question to February when we give our outlook and some of that details on quarters and stuff like that.

Okay, okay. Fair enough. And just on supply chain and the lower fill rates this year, any repercussions in terms of shelf space, retailer relationships as you look at the business. It sounds like a pretty big marketing increase next year is going to drive some enthusiasm, I'm sure externally as well as internally. But any thoughts on that front. And as you've sort of reoriented the supply chain a bit, any longer-term cost that you'll now have to accrue in the business? Or is it more just sort of reworking contracts in terms of third parties as opposed to significantly higher spending in supply chain.

Yes. The relationship with the retailers is good. And one thing we've learned over the past year to 2 years is that transparency with respect to your difficulties, fill rates are so important. And also your forecasting process and working with the retailer. So I think oddly, our relationships with many retailers have improved because we've had to work more closely with them about what we can and cannot ship next year. Is that where you're going?

Yes. Yes. And I would probably just add to that, our ACV numbers are at or above where we were prepandemic, and in some cases, like THERABREATH and some of those newer acquisitions are just growing by leaps and bounds. So no issues in terms of shelf sets or SKU facings or anything like that.

Yes. The issue with fill rates is retailer fines. And just to give dimensionalize that for everybody. Our fill rates in the third quarter finally got to 90% to 91%. And you might think that's pretty good, but it's lousy. Normally, it's 98.5% to 99%. So when your fill rates are 90%, 91%, you leave money on the table, and you're also experiencing fines not only in the U.S. but also internationally. So that also is a real benefit going forward to the extent we can get the fill rates back up to the high 90s.

Yes. And your second question was really on the supply chain. Like do we have a systemic issue now that we have a different supply chain, a higher cost perhaps. I would say it's -- we also don't look at it like that. We've added more resiliency to the supply chain. So now we have a backup to the backup supplier in some cases. We've moved some volume to other suppliers so that we have more flexibility in-house, outside. So we've added probably almost 100 additional suppliers or third-party manufacturers, and that's going to be fantastic on a go-forward basis. So what that also does over time as you're doing your RFPs now that you have all these people qualify because that's what takes a long time, especially in regulatory -- regulated personal care areas is to get it qualified -- regulated is, all of a sudden, we have more competition there to produce. And so that will help, I think, over time as we have an RFP process.

Great. We had a lot of suppliers who are sole suppliers going into COVID. So we've been scrambling for the last couple of years to put a lot of other -- stand up a lot of suppliers and co-mans. And that's largely complete right now. So ready for the next black swan.

Right. okay. Maybe we could turn to pricing. It's been such an important part of driving top line growth in the industry the last 1.5 years. A, as you look out going forward, is most of the pricing in place that you have planned a lot of what's to come is more sort of carryover pricing from what's been implemented? Or is there a lot more pricing going in? How do you think about the consumer demand elasticity to pricing? Has that changed at all? Are you comfortable with the price gaps out there. And there have been some press around greater retailer pushback? Recently, have you seen any of that? So is there more pricing consumer -- competitive retailer reaction to pricing?

Yes. Well, I'm sure many of you know, we priced up 80% of our portfolio over the last couple of years. And in some cases, we priced up twice, like in laundry and litter. And if you look at the price gaps for most of the categories right now because the whole category was moving up. They're pretty much similar to where they were pre-COVID. So that's a good thing. As far as going forward goes, yes, we are looking at our pricing in some smaller categories, both U.S. and international. But the reception part of retailers is going to be very chilly as far as raising prices going forward. So I think that will be tough sledding. And that's ahead of us, but I wouldn't say that's a early needle-mover for us in '23. It's more lots of clean up. And the consumer is squeezed right now. So if you look at like what's working on shelf. It's really 2 things. It's the best price per ounce, whatever the product happens to be. So that's often going to be the larger sizes or extra-large sizes. And then the absolute price point, the smaller bottles or cartons whatever you happen to be selling are popular right now. And the other -- looking forward beyond absolute list price changes, the other avenue is, of course, the pack size changes. So -- and obviously, you have to be very careful with pack size changes as far as your shelf impression. But that's the other area that you can push through a price increase, but it is still a price increase and the retailers know when you do a pack size change.

Great. And it'd be helpful to get an update on what you're seeing in terms of the U.S. consumer, you're fairly unique and that you have more of a value orientation than most public companies, but you also have a premium end of the business, too. So what are you seeing in terms of trade down in your portfolio? And when you look at the consumer, it would be helpful to hear about differences in the lower income versus higher income consumer. We just talked about package shift a bit, but channel shift, all those dynamics, it would be helpful to get an update on what you guys are seeing in the U.S.

Yes, I'm sure we don't have anything original to say here. Everybody knows what's going on with inflation. And particularly on the food side, gasoline prices have come down, but energy is high and expected to be high in this winter. We do think that the European consumer is going to be really squeezed because of energy in the next 3 to 6 months. But I would say, as far as the consumer goes, it's what you would expect to happen is happening, and it's happening during the last great recession, and that is trade down to value. And 40% of our portfolio is value. So we stand to benefit, and we are benefiting. It is masked by the fact that -- we've got WATERPIK and FLAWLESS and vitamins going the other way. But it's a big tailwind for us today and going into next year. But I wouldn't say there's any unique behavior on the part of the consumer. I mean you think about what's the median household income in the United States, it's like high $68,000. And so that is the -- that's the consumer that we're marketing to. Yes, there are higher-end consumers. The club shoppers generally higher-end consumer, but that's just -- just a small part of our total portfolio.

Okay. Great. And can you help us understand the promotional environment? It seems like things are moving back towards normal, but maybe not all the way there yet. Obviously, it will be different category by category. But as you think about the overall promotional environment in the U.S., where do things stand today using your crystal ball, where do you see them moving going forward?

Yes. Well, look, the promotion -- when people talk about promotional environment for a CPG company, you're generally focused on household products. The household products is where you have a lot of trade promotion, less so on the personal care side. And household for us is laundry and litter. And if you look at what the sold-on deal percentages are for laundry and litter, they are low in comparison to historical levels. The levels for litter around 11% and normally, they are high teens. And in the third quarter, the sold-on deal for our liquid laundry detergent was around 31%. It's normally mid-30s. So it's not where it has been historically. What typically happens in a recession is that you do have an increase in promotional spend. So that would be kind of a logical expectation over time, but I don't expect that it's going to be a light switch. It's suddenly there's going to be a ton of spend. But it could start to creep up over the next 4 or 5 quarters.

Okay. And has the build back up been slower than you expected? And how would you sort of categorize that? And what's driving it...

It's been low for a while. It's not just a recent phenomenon for 2022. You saw it was true in '20 and '21. And that was largely because of difficulty, and you don't want to be promoting to empty shelves and lots of people in CPG had difficulties with out of stocks. But that's largely behind everyone right now. I said, even our fill rate is in the low 90s. So I do think that it potentially could get back to where it was pre-COVID and may be getting there faster than we would have expected because of the recession. When you have that behavior for almost 2 or 3 years with lower sold-on deal, that could become permanent. That's like the new normal. But because of the -- what we expect this to be an upcoming recession. We do think that it could heat up in the next year, and we have to watch.

Right. Okay. And then I'd love to spend a little time on marketing and your thought process going forward. You mentioned earlier that you look to rebuild marketing levels as a percentage of sales. Just conceptually, how important is that as an organization. If we look at your track record over the last decade, Church has been a company that sort of delivered algorithm year after year after year. Obviously, with some of the industry pressures and some of the isolated businesses this year hasn't happened. Is the mindset sort of, look, this year is an aberration, and we look to sort of return going forward? Or is it more, hey, we've got some ability to really drive the top line next year through all the pieces we talked about and we've got a heavy emphasis on marketing as an organization. Just sort of conceptually, how do you think through that when you think about resource allocation and the external environment, we're in?

Yes, if you look at the trend in marketing as a percentage of sales. So it was unusually low for us in Q1 and Q2 of '22. So if we use a round number that was 8%. So 8% Q1, 8% Q2. Now Q3, round number is 11%; in Q4, 13%. So we're averaging 12% in the second half. And as I said earlier, what you want to get -- what we want to get back to is around 11% as percentage of sales. So we are committed to increasing it to be higher than 10% in 2022. And the reason why it was low is obvious because of the fill rate issues. So it was lower in the first half of this year low and during the COVID period, but particularly the first 2 quarters of this year. So it needs to normalize. We need to get back to where a CPG company and marketing matters. So we got to get somewhere between 10% and 11% next year.

Yes. And I would just add to that. If we look at our track record over a long time, and we're in great categories, right? Categories are growing 3% plus for a long time because we're picky about what categories we've gotten into. And then we've grown share more often than not. If you look at the scorecard, 75% of the time over the last 5 or 6 years, we've gained share. And why have we gained share? Well, a big reason is because we typically overinvest versus the peer set on marketing spend, we do innovation, of course, and everything else. But really, marketing spend is important for the brand. And so just to make sure that we are putting that investment first is critical. So that's kind of the backdrop.

Okay. That's helpful. And then, Rick, we talked about the supply chain side. Just as you think about core SG&A, maybe ex that marketing going forward, you guys are at a pretty efficient level relative to the peer set. Are there opportunities to improve that going forward? Is there inefficiencies that build up there in COVID? How do you think about that? Is that a line item as a percent of sales, not marketing, SG&A? Were there some room for further improvement? Or are you pretty lean at this point already?

Yes. Well, I mean, the comment that Matt made about restoring incentive comp to normalized levels is over here. But beyond that, our evergreen model is we want to expand or leverage SG&A by 25 basis points a year, and we think we can do that. We can get halfway there just by growing the top line and then growing the dollars at half the rate. So that typically happens day in and day out. And then we have a couple of things going for us. Unlike many of our larger competitors, we are fortunate to have a North American instance of SAP as an example, right? We can really leverage systems more than most because of our footprint and how we're organized. So leverage and systems, we have a big focus internally on analytics and robotic process automation, which just takes thousands of hours out of the network. So those things are always helpful in SG&A. And the good news is internationally, I think we said this publicly maybe 2 years ago, we had finally reached critical mass, right? We're $800 million on the way to $1 billion for our international subs. And so those operating margins each and every year are now expanding because we actually have the footprint. And we don't have to add all the infrastructure as we grow those businesses.

Okay. Great. And can we talk a little bit about the innovation pipeline going forward? Obviously, COVID caused a lot of volatility. So just sort of checking in on your perspective for forward contribution from innovation over the next couple of years relative to the last couple of years, when you consider all that volatility and how you think about that?

Yes. Generally, if you think about our evergreen model, we're 3% organic growth and you look back historically, generally 1% to 1.5% of our top line growth is driven by new products. And that's been consistent. Even in 2022, it's about -- it's 1.3%. So I look at that a few days ago. So yes, we're still delivering on -- as far as what the new products scale. Of course, that's been masked by all our problems with the fill rates and our discretionary products is overwhelming that, which is fine. But I wouldn't comment yet on what we're launching in 2023, but I would expect that the contribution of our new products in 2023 is just as robust as it was in 2022.

Okay. And another area maybe that's harder for us to have insight in externally is the specialty business, macros are potentially a bigger impact on that business. Just how do you think about it going forward? Obviously, the attrition in the chemical side of it. But how do you think about that business over the next 18 months here?

Yes, that's a business that doesn't get a lot of anchor, a lot of interest, but it's the original business of Church & Dwight, which is bulk sodium bicarbonate. We also have an animal productivity business. So think of it as a $300 million business, $100 million spoke slightly by carbonate, the other $200 million is the animal productivity business. And historically, the way that business performed was it would be up 1 year, and it would be down year 2 and 3, up year 4, down year 5 and 6. Why is that? It's because the business was largely a dairy business. Now that's changed over the past few years. We've made some acquisitions and we've grown those a bit. So we don't have that same cyclicality. In fact, 2022 is the third year in a row now where that business actually has delivered organic growth. So I do expect that to continue in the future. We have 4 years in a row where specialty products business is going to grow. As far as the end markets go, they are healthy. If you think on the dairy side, which is dairy, but also cows and poultry. And we've also started focusing more on international and because it's been largely a U.S. business. So that business is expected to grow as well. And I think that's where the future is for that business is international.

Okay. Maybe that's a good segue into broader international. Obviously, a lot of volatility in terms of the consumer, right? There'll be some pricing that's necessitated by the FX pressure. So an update on prospects for that business, particularly given the success you've had in the last few years and maybe a bit of insight in the ability to supply internationally also would be helpful.

Yes. Well, the way to think about international is keep it simple. So it's about a $1 billion business. And 2/3 of it is the subsidiaries that we have. We have subsidiaries in the U.K., France, Germany, Canada, Mexico and Australia. And the subsidiaries have been performing well, particularly in 2022. Our issue in international is the Global Markets Group. That's the 1/3 that's remaining. And the Global Markets Group ships our products to about 80 countries around the world. And that business is going to have 0 organic growth in 2022. And if you went back each of the last 5 years, it's averaged around 15% growth. So that is -- that was a real problem for us in 2022. So we have to get that going again. Now you say, well, why did that happen? We had difficulty in filling orders for Global Markets Group and also delivering orders to all those countries just from a transportation standpoint. So we think we've got those behind us now. We think that, that is going to return to growth next year. But that is really the thing to watch for us is the Global Markets Group because it's been such a catalyst for the international business growth for the past 5 to 8 years.

Yes. And beyond supply, the other issue on the GMG group was really are the Asia, China lockdown. And as we move through that, that will also be a tailwind on a go forward basis.

Yes. And then the lockdowns in China affect not only the -- our shipments to consumers but also sourcing because we do source from China as well. So that's bringing some intermittent problems in some of the ingredients or components or finished products that we get from China.

Great. Great. That's helpful. And maybe we can touch on the M&A environment a bit. Obviously, in theory, prices have come down in the industry and there might be more availability at reasonable prices. But maybe that sentiment hasn't changed as much from a seller standpoint. So, a, just thoughts on sort of the pipeline out there in general; b, how you think about -- how you think through M&A in terms of maybe areas that could add value to your business. You've been very clear around the financial criteria historically, but a bit of an update on the strategic criteria and how you think about that in this environment?

Yes. We'll start with the strategic criteria. So we've had a pretty strict criteria for many, many years, #1 or #2 brands. Need to be able to grow at or above our 3% organic growth target. We need to have gross margins at or above the company's gross margin level. And that needs to be asset light. And then the last thing is that need to have a sustainable competitive advantage. Think about what we bought over the last couple of years in December of 2020, we bought ZICAM December 22, we bought THERABREATH, which is the fastest-growing mouthwash in the U.S. And most recently, we acquired a Hero, which is a super fast-growing brand in acne category. And think about prices, yes, because of interest rates, certainly, private equity won't be a factor and any auctions, at least for the foreseeable future. And yes, typically, prices have come down with higher interest rates. Now the way we look at businesses, too, is we don't look at it from an EPS accretion standpoint. Our focus is on how much cash earnings it's going to generate for the business. And obviously, the cash earnings that is burdened by a higher interest rate. So that affects you're thinking about the attractiveness of the business. But insurance rates are also transitory. So I said they're up right now, but will they stay up forever? So if a business came for sale, we thought it was in a good category, good prospects, we'd be interested in it regardless of the interest rate environment today.

Yes. I think Hero is a good example of that. We're super excited about the growth profile of that business, about putting that into our international footprint, expanding that business. The acne category was a sleepy category for a long time. And a couple of hundred million dollars of growth was all because of the form. And we think that's going to replicate in a lot of different places.

Yes. And that's when we'll be able to take internationally as well. So a lot of excitement around the Hero acquisition.

Okay. Great. Well, with that, we're exactly out of time. So good timing. Thanks so much for being here. I appreciate it.

So good bye. Okay. Okay, Thanks, Dara. Thank you.