Reckitt Benckiser still has a lot to prove

Consumer staples companies have long been firm favourites with investors. First and foremost they are very easy to understand as they sell brands that millions of consumers are familiar with and buy regularly. This has created very stable and predictable businesses that have historically been able to grow steadily but modestly and reward shareholders with very reasonable returns.

Life has become much tougher for them in recent years. Consumer preferences have been changing, not only in the brands that they buy but how and where they buy them. Competition has increased and the big consumer staples companies have been slow to innovate and adapt to a changing marketplace.

The dependable bond-like characteristics of their revenues and cash flows have been valued more highly by the stock market as interest rates have fallen since the global financial crisis, but that benefit now looks all but played out. Further increases in share prices will have to come more from growing revenues and profits, and this is not going to be an easy task once the boost from Covid-19 has worn off.

Reckitt Benckiser has laid out a plan to do this with a new chief executive. However, it seems that investors are not willing to price much in the way of benefits from it into the shares. Having seen a very strong upwards move from its March 2020 lows as the popularity of its health and hygiene products soared as the Covid-19 pandemic hit home, the shares have underperformed significantly since the summer as inventors rightly look forward and ponder what will happen to the company once things get back to normal.

Can Reckitt Benckiser become a more valuable business by upping its sustainable rate of growth?

The business

Reckitt Benckiser can trace its roots back to the early 19th century. Benckiser was founded in Pforzheim in Germany in 1823 as an industrial chemicals business. Reckitt and Sons set up a starch flour mill in Hull in 1840 before branching out into selling household products. Over the years, the business has grown largely by buying up some of the world's most established and strongest consumer hygiene and healthcare brands. Reckitt and Benckiser merged in 1999.

It is now home to an impressive portfolio of leading global health and hygiene brands including: Nurofen painkillers, Gaviscon heartburn remedies, Dettol and Lysol disinfectants, Finish dishwasher products, Mucinex and Strepsils cough and cold medicines, Durex condoms, Scholl foot products, Harpic cleaning products, Vanish stain removers and Air Wick air fresheners. In 2017, it bought infant nutrition business Mead Johnson, which brought the Enfamil and Nutramigen brands into the company.

The company has a significant global presence and seems well placed to benefit from the growth in consumer affluence in developing markets. 

The three main businesses are very profitable and earn high operating margins. Over 80 per cent of annual profits comes from the Health and Hygiene divisions.

Overall, the business has consistently produced highly sought-after financial performance characteristics such as high returns on operating capital employed (ROOCE) and free cash flow generation. The acquisition of Mead Johnson in 2017 has significantly reduced RB’s ROCE. The deal, which looked very expensive at the time based on the profits being acquired, has proved the sceptics right and over £5bn of goodwill attached to the transaction has been written off – a glaring admission that the company significantly overpaid for it.

The key issue for this company has not been the level of profitability, but the growth of it. 2020 has seen a windfall in terms of revenues and profits as customers have stocked up on Dettol and Lysol disinfectants, Nurofen, Finish dishwasher tablets and cleaners and Air Wick air fresheners in large amounts in response to Covid-19. When the company reports its 2020 full-year results next month they are going to look very good – but it’s what happens next that matters.

Laxman Narasimhan took over as chief executive in September 2019 and used his honeymoon period to state what he thought was wrong with the company and how he was going to go about putting it right.

He rightly pointed out that RB was an underperforming business that was not fully engaged with its customers and who were not receiving a good enough service. Like many of its peers, it had not invested enough in innovative new products while its existing ones were implicitly acknowledged to be too expensive. The end result was that the company was not selling enough and had many of the hallmarks of a good but stagnating business.

The current plan is to reinvest £2.2bn into the business by cutting prices and investing in new products and capacity, Two-thirds of this cost will be paid for through cost-cutting and efficiency gains. Short-term profit margins were expected to fall by up to 300 basis points before recovering. If all goes well, then RB will get to the mid 2020s with the following characteristics:

• Annual mid-single-digit percentage revenue growth.
• Mid 20 per cent operating margins.
• Annual earnings per share (EPS) growth of 7-9 per cent.

The hope is that the increased price competitiveness and quality of products will drive an uplift in sales volumes which will leverage the significant fixed cost base of the business and cause profits and profit margins to increase.

The big boost in like-for-like sales in 2020 has given a nice flow of cash to reinvest, while £300m of cost savings have already been achieved. However, it is far too early to tell if the strategy will be successful. That said, it is possible to see how the company is facing up to some of the ongoing challenges it faces. Here there are some grounds for optimism, but there are still some big risks.

Price perception of its products and the competitive threat of private label 

Brands have always been able to command higher selling prices than private-labe products. They are selling trust and dependability that has often been built up over decades and also come with higher marketing costs that need to be recovered. 

However, the size of the price premium can get too big. As many private-label products have been improving in quality and essentially do the same job as many branded equivalents this is something that branded consumer staples companies need to be mindful of. Comparing some of RB’s leading branded products with Tesco’s own-label equivalent shows the kind of price differential that exists. In short, the differences look big.

It’s not really surprising that private labels have seen significant growth in recent years, but the experience of Covid-19 has seen consumers flock back to trusted brands. According to Procter & Gamble on its investor conference call last week, private label has not increased its market share in its products in the US and Europe for the past 12 months. RB has been holding or gaining market share with most of its key products.

It would not be surprising if RB made price cuts – as the price differentials are still big – to improve its competitive positioning when more normal trading conditions come back. The big risk is that price cuts do not lead to an increase in sales volumes and profits end up being lower rather than higher than before. Its competitors are also unlikely not to respond by cutting their own prices.

Product innovation

RB and the consumer staples sector in general have not been good at introducing innovative new products for consumers in recent years. At the same time, smaller companies have brought new brands and leveraged them very effectively through internet advertising and customer engagement on social media platforms.

The sector spends very little – as a percentage of its revenues – on research and development. RB has been increasing its spend both in absolute terms and as a percentage of revenues, but still arguably needs to do more. Investment in R&D is considerably lower than you will find at engineering companies where 5 per cent of revenues is commonplace and new product development is often better as a result.

RB has had some successes with products such as Lysol and Dettol laundry sanitiser, Finish Quantum Ultimate, Neuriva (a supplement that claims to improve brain function) as well as new launches in Mucinex, Durex and Gaviscon. However, these have yet to make a significant contribution to the group as a whole and change its growth potential. I see this as its biggest weakness and biggest challenge going forward.

The changing world of retail

RB sells a large chunk of its products through supermarkets where the landscape has changed rapidly. Not only are supermarkets putting more money behind private label because there is more profit in it for them, but they are also stocking fewer products (shopkeeping units or SKUs). 

Discounters pursue a very lean stock policy and concentrate their buying into a lot fewer SKUs than the big supermarkets. However, this is slowly changing as the big chains realise that this is a smart strategy in staying price competitive.

What this means or will mean is that not all brands are guaranteed shelf space. Customer relationships and product availability are therefore key and RB has perhaps not been as good as it could have been in this areas in recent years. The company is addressing this by significantly increasing the number of selling agents into bricks-and-mortar stores. It has also invested significantly in production capacity and has done well with product availability during the pandemic.

The other big development is the growth of direct-to-consumer selling over the internet. RB has done well here and has been building up its internet sales and looks to be in a good position relative to most of its peers. The company has built up sales across global ecommerce sites such as Amazon, Alibaba and JD.com and also has a stake in Pharmapack, one of the largest marketplace sellers of pharmacy products on Amazon.

Product portfolio

RB arguably has to address some of the brands in its portfolio to see if they are doing more harm than good. There have been rumours that brands such as Scholl and Clearasil, which have underperformed in recent years, could be sold. However, the big problem business is its infant formula and child nutrition (IFCN) business.

The problem started immediately after it bought it because RB paid too much for it. Since then, growth has been weak, particularly in China, which is a big market for the business. Here competition has increased and there has been a decline in the birth rate. Prices have recently been cut and margins sacrificed in an attempt to get sales growing again. While the business has performed satisfactorily in North America it is offsetting some of the progress elsewhere. The newish chief executive might have to decide to end this expensive mistake and sell the business if things do not improve.

What happens after the Covid-19 boost wears off?

Surging sales of Dettol and Lysol produced great results for RB in 2020 and have helped the company create a platform for future growth. It has more than doubled the production capacity of its disinfectants in many markets and took Dettol and Lysol into 19 different markets last year. Dettol wipes and sanitisers have been introduced into 20 and 13 new markets, respectively.

This is undoubtedly positive and the extra cash flow means that RB is confident of achieving its strategy goals earlier than expected, but the strong performance of 2020 is going to make it difficult to grow in 2021.

I don’t disagree with the views of RB and Procter & Gamble that there is likely to be a permanent change in disinfecting activity, but that does not necessarily mean that consumers will buy more in the future than they have in the past year.

Destocking by retailers is possible and is likely to see sales volumes fall. The other thing to be mindful of is the level of promotional activity, which was a lot lower by historical standards in 2020. The sector can typically get around a third of its sales on promotion in normal times and a rise in promotions could further weaken sales and gross margins compared with last year.

Looking further out, ageing populations and an increase in self care driven by the internet and education campaigns are positive for industry growth. How much of that RB can benefit from remains to be seen.

Its strategy looks sensible and goes a long way to address some of the things it has not been good at in recent years. 

Current analysts’ forecasts look realistic, although expectations for sales growth in 2022 are not particularly bullish or indicative of a strategy that is gaining serious traction. It could be that despite RB’s best efforts, growth may not accelerate unless it can sufficiently differentiate its products from the competition.

The silver lining for investors in consumer staples right now is that valuations do not seem excessive if you believe that interest rates will stay low. But that is not likely to help share prices go up. RB needs meaningful and sustainable growth to increase returns to shareholders and on this issue it still has a lot to prove.