Description

RB is a world-class consumer staples business with an extensive history of value creation. Its management has long been regarded as the best team in the sector. They are proven brand builders while simultaneously widely seen as second only to AB Inbev in terms of cost-savings delivery. RB’s performance driven culture has been consistent since it was set out by Peter Harf and Bart Becht in the early 1990s and is underpinned by an incentive and compensation structure that is designed to drive long-term growth, tight cost management and high cash flow conversion with a major emphasis on long term share ownership.

¾ of RB’s profits are generated from its consumer health business which includes market leading brands such as Durex, Nurofen, Mucinex, Strepsils, Gaviscon, Dettol, Scholl, MegaRed and many others. Last year, this list has been supplemented with infant nutrition brands, Enfamil and Nutramigen, which were added via the acquisition of Mead Johnson. One of the unique characteristics of the consumer health category is that distribution channels span across the entire spectrum of consumer staples and pharma and dedicated shelf space is often limited. Therefore, managing a successful consumer health business requires the skill set of consumer branding and distribution in combination with pharma/health capabilities. As a result, key brands often have dominant market shares in local markets. In addition, barriers to entry are generally higher than in other parts of consumer staples because in addition to customer loyalty derived from brand recognition, there is a level of trust in the safety and an expected tangible benefit from consumption of the product that significantly increase brand equity and make the product less prone to switching and bargain hunting. There is a far lower propensity of consumers to try untested brands in their moment of need. Regulatory barriers are also higher. These factors make the product more resilient against disruption over the long term as it satisfies a primary need that is not determined by fashion or aspirations.

Long term growth for consumer health is driven by an aging population in developed markets with a propensity to spend more on health and wellbeing combined with continuous growth in middle-income families in emerging markets as rising disposable incomes lead to higher expenditures on health and wellbeing. In addition, the growing public healthcare cost burden means governments increasingly want the population to self-medicate and push for a more proactive health management lifestyle to cure episodic issues and take preventative measures to reduce future disease treatment costs to the national system. These core drivers are the reason why the consumer healthcare category is experiencing the fastest rate of growth among the core consumer staples categories. In addition, thanks to the quality of its brands and management’s focus on innovation, RB’s Health segment has significantly outperformed its peers over the past few years, continuously gaining market share.

The remaining c.25% of RB’s profits are generated from its Home Hygiene segment. This segment includes global #1 brands such as Vanish, Lysol and Finish and #2 brands such as Air Wick, Mortein and Harpic. In aggregate, 80% of this segment’s revenue is generated from brands that are #1 or #2 in their categories. In this segment, RB has underperformed its potential in recent years as LFL growth over the past 5 years has been around 1% vs long-term category growth of 2-3%. The new business structure put in place late last year, with a full management roster dedicated exclusively to this segment, is designed to reinvigorate growth and margin expansion for RB Hygiene Home.

The above mentioned qualities have historically been well reflected in RB’s share price performance and its relative valuation. Since merger of Reckitt and Benckiser at the end of 1999 until the 3^rd quarter of 2016, RB shares have significantly outperformed global peers as well as the major indices over almost any multi-year period and the shares traded at premium multiples to the staples group for most of the period.

This outperformance stagnated in the latter half of 2016. Since then, RB shares have significantly underperformed the European consumer staples group. On P/E ratio basis, the company reversed from a c.10% premium to a c.20% discount relative to its peer group.

This was caused by several consecutive events that negatively impacted the market’s confidence in RB’s management and the overall prospects for its business:

• South Korea Humidifier Sanitizer (HS) Scandal: In June 2016, RB was forced to issue a public apology and set aside a (small) provision to compensate victims of negative health effects caused by an HS product that was discontinued several years ago by a company that RB acquired. There was a major backlash against RB’s products in the country leading to a full boycott. Korea accounted for 1.5% of RB’s sales so the company’s LFL growth was immediately reduced by 1.5%
• Scholl Innovation Flop: Around the same time as the Korea issue surfaced, RB’s footcare business took a nosedive as its latest innovation in the space failed to gain market traction (likely due to the high price-point) which led to major destocking in the retail channel, hurting Scholl sales. This reduced RB’s LFL growth by 2-3%.
• India, Russia, Brazil: As seen across the peer group, RB also faced a tough macro backdrop in in India due to demonetization and the introduction of a goods and sales tax (GST), in Russia as the sanctions started to bite and in Brazil due to tough comps following Zika in 2015
• Cyber Attack: As if all the above wasn’t enough, in June 2017 RB’s systems suffered a major cyber-attack. The effect of the attack on RB’s inventory systems resulted in a temporary mismatch between supply and demand of certain products as the system downtime caused a backlog in RB’s health factories where they operate a finely balanced supply chain and disrupted the company at a time when key promotional slots were being finalised for the 2^nd half of the year. This reduced RB’s LFL growth by 2%
• US OTC Healthcare market slowdown: Due to significant destocking at several large retailers the overall OTC market in the US slowed 
• Mead Johnson (MJN) Acquisition: MJN’s weak sales and margin collapse combined with a seeming lack of product overlap led investors to question management’s decision to acquire it 
• Pfizer Consumer Health Auction: investors had significant concerns that RB would overpay for this asset and be forced to issue equity in the process given its limited debt capacity following the MJN acquisition

·        Even the decades of value creation did not provide RB’s management with sufficient credibility to withstand so many issues/market concerns in such a short period of time.

Taking a step back, there are 3 categories of issues here:

1.  One-time rebasing of the sales base: this applies to Korea, Scholl, the 3 emerging markets and perhaps the effect from the cyber attack
2. Overall industry growth slowdown
3. Concerns around M&A and capital allocation decisions

Regarding the first category, these issues are now history and the rebasing is fully done so there shouldn’t be any incremental headwinds. It is worthwhile noting that on an underlying basis, backing out these effects from RB’s reported numbers, the company has continued to outperform peers throughout the period. In addition, as these issues have abated in recent quarters we are already seeing a recovering trajectory in LFL growth reported so far this year.

To address the 2^nd category, it is important to note that the ‘Health Relief’ segment which includes the OTC brands that many bears are focused on (Mucinex, Nurofen, etc) accounts for just c.15% of RB’s sales. So even if it were true that this segment is structurally challenged, its impact on the overall business would be relatively muted. However, that is not at all the case. In H1, RB’s OTC sales increased 6% on top of 4% growth in the FY17. There will be fluctuations in the growth rates due to the severity of the flu season and the trade-off between private label competition and the level of success from the innovations pipeline, but over time this continues to be an attractive growth category where RB is strongly positioned.

Finally, on M&A we believe they are doing an excellent job. A thorough analysis of the Mead Johnson acquisition reveals that it is a perfect fit with RB’s long-term M&A strategy. MJN is a phenomenal asset that was terribly managed. We are convinced that under RB’s ownership, the business will thrive and the deal will add significant value for shareholders over time.  In the 12 months that RB has owned MJN there have already been some significant enhancements to the product range, packaging formats and distribution channels which are showing early results as MJN’s LFL sales growth trajectory has turned positive, its margins have stabilised and market share in the crucial Chinese premium infant formula market has started to improve.      

The company’s announcement on March 21^st that it pulled out of the Pfizer consumer health auction removed the risk of a large equity issuance alleviating market fears and further demonstrating the company’s discipline on M&A and capital allocation.    

Looking forward, we expect accelerating LFL growth as RB Heath continues to accelerate and laps very easy comps, Mead Johnson continues to recover and margins expand as cost synergies are realized and the company’s balance sheet delevers rapidly. Delivering on the above alone, will result in 2020 EPS (at current FX rates) of at least £4.4. Applying the peer average multiple (22x P/E) to this 2 years from now we derive an expected IRR of 25% including dividends. Further upside exists if RB returns to market share gains in Health and the restructuring of RB Hygiene Home proves successful in reigniting growth for this segment (so far in the 6 months since the separation of the business units HyHo growth has accelerated to 4% LFL) . Conversely, considering current market expectations around growth and the valuation discount, we believe downside risks are very limited.

Catalyst

• Accelerating LFL growth
• Imporving margins
• Value creative M&A (following some initial deleveraging of the MJN debt)