Portfolio shares: Will my patience pay off at PZ Cussons?

There aren't many family-controlled businesses in the FTSE 250. But consumer goods group PZ Cussons (LON: PZC) will be the second such company I've looked at in two weeks.

(The first was homewares retailer Dunelm – check out that piece here if you missed it.)

This business can trace its roots back 135 years to Sierra Leone, where founders George Paterson and George Zochonis (PZ) began trading commodities with the UK.

In 1975 PZ acquired Cussons, creating the current business. Today the company operates in four main markets; the UK, Nigeria, Indonesia and Australia. Key brands include Imperial Leather, Carex, Cussons and Original Source.

The Zochonis family remain dominant shareholders and control approximately 30% of the stock, although a good chunk of this is held by the Zochonis Charitable Trust. According to the company, around 13% of PZ Cussons dividends go to the Trust each year.

In a similar vein, PZ Cussons is working to become a B-Corp, underwriting its commitment to sustainable principles.

Unfortunately, PZ Cussons has not enjoyed the same run of success as Dunelm in recent years. Both sales and profits have fallen steadily since 2014, reversing a two-decade run of growth:

This venerable business has faced a range of problems over the last five years. These have included allegations of financial misconduct by a former chief executive, slowing sales in Nigeria and a lack of strategic focus that's led to a general decline.

Fortunately, newish chief executive Jonathan Myers is making good progress resolving these problems, in my view. Since taking charge in March 2020 he's refocused the business on a core portfolio of 'Must Win' brands in hygiene, baby and beauty segments, and has disposed of various non-core assets.

My impression is that the focus and performance of the business is already visibly improved. But this progress has yet to be reflected in the company's share price, which is still dominated by the impact of the pandemic:

What happened was that Covid-19 triggered a massive surge in sales of Carex sanitiser and other hygiene products. This distorted the group's FY21 results, but has now largely reversed, as expected.

I held PZ Cussons shares before the pandemic and before I launched this model portfolio. I think that this share price action simply reflects a return to fair value after the sentiment-driven distortion of Covid-19. For this reason, I'm not concerned by the share price slump over the last year.

Indeed, I'd suggest that the chart above illustrates the truth of value investing pioneer Benjamin Graham's famous quotation:

"In the short run, the market is a voting machine but in the long run it is a weighing machine."

Recent trading: I covered PZ Cussons' third-quarter trading update in my April monthly review (the company has a 31 May year end).

I won't repeat the details here, but the short version is that full-year guidance was maintained. That appears to mean like-for-like revenue growth and adjusted pre-tax profit "within the range of current expectations".

SharePad shows a consensus pre-tax profit estimate of £65.8m for FY22, which would compare to a figure of £68.6m in last year's results. So we'll have to see what adjustments are applied and where the final figure drops out. I'm not too concerned, as this has been a transitional year following the pandemic.

In the remainder of this review, I'll step through the different stages in my dividend screening system and explain why I've chosen PZ Cussons to be one of my model portfolio stocks.

Unless specified otherwise, the financial data I use in this process is drawn from SharePad.

Disclosure: Roland owns shares of PZ Cussons.

PZ Cussons: crunching the numbers

Description: Family-controlled consumer goods group with a focus on hygiene brands, such as Carex and Imperial Leather. Click here for an archive of past posts.

Latest accounts: half-year report for the six months to 30 November 2021

Dividend culture: excellent

Family ownership is often a good leading indicator for reliable dividends, in my experience.

One of the things that first attracted me to PZ Cussons was the company's long dividend history. The payout has only been cut once since 1993, according to SharePad:

My screen scores stocks for dividend culture based on the number of years of consecutive payouts. PZ Cussons achieves a rare perfect score, signifying more than 25 years of unbroken dividends.

PZ Cussons scores 5/5 for dividend culture in my screening system.

Dividend safety: reasonable

Unfortunately the single cut I highlighted above occurred quite recently, in 2020. Should I be worried about the sustainability of this payout?

On balance, I don't think so. Since the 2009 financial crisis, PZ Cussons' dividend cover has averaged around 2x, while free cash flow dividend cover has averaged around 1.5x.

For another dividend cut to be necessary, I would suggest that CEO Myers' turnaround would have to have been completely derailed. I think this is unlikely and believe the current payout looks quite safe.

PZ Cussons scores 3.6/5 for dividend safety in my screening system.

Dividend growth: not recently

I score shares for dividend growth by looking at the follow metrics:

• 5yr average dividend growth
• 5yr average free cash flow growth
• 5yr average net asset value per share growth (for an explanation of this recent addition, see last week's piece)

PZ Cusson's dividend was cut two years ago and the payout remains below its pre-cut level. This means the five-year average growth rate is negative. So is five-year free cash flow growth.

This stock was never likely to score well for dividend growth, but I can accept this weakness in this scenario.

The dividend cut is known and understood. I don't expect another cut.

The lumpiness in PZ Cussons' free cash flow is more complex, but I think it reflects the company's pre-Myers problems, followed by the impact of the pandemic on factors such as working capital.

I'm hoping for a more consistent cash performance in the future – a view that's supported by current broker forecasts.

However, PZ Cussons scores badly here and its recent track record does not demonstrate the quality dividend growth I believe this business can deliver.

For now, I'm happy to accept this and remain patient, but I'd hope to see some improvement over the next 12-18 months.

PZ Cussons scores -0.7/5 for dividend growth in my screening system.

Dividend yield: middling

PZ Cussons  stock currently offers a forecast yield of 3.3%, putting it broadly in line with the FTSE 250 average yield. That's nothing to write home about in an income portfolio, but my hope is that this payout will prove to be more durable and steady growing than average.

After all, only 32 members of the FTSE 250 can boast unbroken dividend records of 25 years or more. Even fewer of these offer dividend yields over 3%.

The chart below shows that PZ Cussons' current dividend yield is higher than at most times over the last decade, barring the period immediately before the payout was cut in 2020.

Based on dividend yield, my feeling is that these shares are probably reasonably valued at current levels.

PZ Cussons scores 2/5 for dividend yield in my screening system.

Valuation: fair value?

My dividend stock scoring system isn't cast in stone. One area I'm questioning at the moment is whether I should apply greater weighting to valuation.

There's a Warren Buffett quote for this, of course:

"For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments."

I haven't made any changes yet. But I may.

The two metrics I use to score a stock for valuation are EBIT yield (EBIT/EV) and free cash flow yield (FCF/EV).

As we can see from the usual SharePad chart, PZ Cussons currently has an EBIT yield of around 8%. I see 8% as a general threshold for good value, so I'm happy with this.

As I've discussed already, PZ Cussons free cash flow has been somewhat lumpy in recent years. To try and tease out the underlying trend, I've plotted two-year average free cash flow alongside EBIT yield on the chart below.

The result suggests to me that PZC's cash generation has recovered nicely since 2019, although it's too soon to be sure if this trend will be maintained.

Last year's drop in free cash flow last year has capped PZ Cussons' valuation score. But on balance, I think the shares look reasonably value at current levels.

PZ Cussons scores 3/5 for valuation in my screening system.

Profitability: better than it looks

My profitability score was one of two areas where I modified my screen last week to include net asset value per share growth. I explained my thinking on this change in my recent review of Dunelm.

Unfortunately for PZ Cussons' score, this change comes at a time when the stock's net asset value has been falling for several years.

Most recently, I think this has been due to brand impairments and disposals as part of Mr Myers' turnaround. Prior to Myers' arrival, various factors affected NAV, including significant currency losses in FY17, when the Nigerian currency was devalued.

Return on capital employed has also fallen in recent years, but last year's results showed a return to growth. I'm hopeful ROCE will eventually return to the low/mid teens level seen in the past.

PZ Cussons scores quite poorly for profitability, but I'm happy to give the company the benefit of the doubt given early signs of improvement.

PZ Cussons scores 1.8/5 for profitability in my screening system.

Fundamental health: strong

I'm much more likely to give a company the benefit of the doubt in a turnaround situation if it has a strong balance sheet.

Having financial breathing room de-risks almost any situation and gives a business the chance to deliver its potential without excessive debt costs or the risk of equity dilution.

PZ Cussons scores well in this regard – rather better than its larger rival Unilever (disc: I hold).

• PZ Cussons net debt/5yr net profit: 0.8x
• Unilever net debt/5yr net profit: 4.0x

Unilever's leverage is at the top end of what I'm willing to accept, while PZ Cussons' does not concern me at all.

Taking a longer look at the company's history, we can see that the business has gone through cycles of net debt and net cash in the past.

The balance sheet looks pretty safe to me at the moment and contributes to a very strong fundamental health score.

PZ Cussons scores 4.4/5 for fundamental health in my screening system.

Conclusion: promising

In recent comments, Mr Myers admitted that:

"the external environment is amongst the most challenging many of us have ever seen".

Cost inflation is continuing. With household budgets increasingly stretched, I expect branded consumer goods face stronger competition from cheaper own-brand rivals, especially in western markets.

What we don't yet know is how persistent inflation will prove to be. However, many of PZ Cussons' core brands have stood the test of time and are deeply embedded in consumer purchasing habits. I'm confident they're likely to remain popular.

Current broker forecasts suggest PZ Cussons will eke out sales and profit growth of around 5% in FY23. I would consider that a good result, if it's achieved, but it's far too soon to be sure.

The next update from the company should be a trading update in July, followed by full-year results in September.

My view: In scoring terms, PZ Cussons is one of the weaker holdings in my model portfolio.

However, this is a proven long-term business with more than a century of successful trading behind it. I don't see any reason why this success can't be repeated in the future.

I'm encouraged by Mr Myers' progress so far in difficult circumstances. For now, I'm quite happy to remain patient and continue holding PZ Cussons in the quality dividend model portfolio and my own holdings.

My quality dividend screening system awards PZ Cussons an overall score of 55/100 at the time of writing (June 2022).

I'll be adding a comment facility to this site in the future; I look forward to your feedback over the coming months. In the meantime, you can always reach me on Twitter @rolandhead or by email.

Disclaimer: This is a personal blog and I am not a financial adviser. The information provided is for information and interest. Nothing I say should be construed as investing advice or recommendations. The investing approach I discuss relates to the system I use to manage my personal portfolio. It is not intended to be suitable for anyone else.

You should carry out your own research and make your own investing decisions. Investors who are not able to do this should seek qualified financial advice. Reasonable efforts are made to ensure that information provided is correct at the time of publication, but no guarantee is implied or provided. Information can change at any time and past articles are not updated.