How Will A Recession in Brazil Impact Colgate-Palmolive?

Brazil is currently going through its worst economic crises in over a decade. Recently released macroeconomic data on retail sales ^[1] and inflation ^[2] has raised widespread concerns that the country is on the brink of a recession. Following the release of the inflation data, Brazil’s central bank decided to stick to its pace of tightening the money supply and raised the target lending rate by another 50 basis points. ^[3] While this move may potentially bring inflation under control, it will undoubtedly hurt consumer confidence and spending. The overall economic uncertainty and bleak outlook is reflected in the weakened Brazilian Real, which fell past 3 per dollar for the first time since 2004.

These factors are likely to have set alarm bells tolling at oral care major Colgate-Palmolive (NYSE: CL), which derives over a quarter of its revenues from Latin America and has significant operations in Brazil. The current economic scenario deals multiple blows to global personal care companies like Colgate-Palmolive. Plummeting retails sales indicate weakening volumes, while inflation puts pressure on margins through higher commodity costs. On the other hand, a weak local currency results in conversion losses and higher import costs, thus impacting the top line as well as the bottom line.

In this report, we look into how a recession in Brazil will impact Colgate-Palmolive.

We have a price estimate of $56 for Colgate-Palmolive, which is around 20% lower than its current market price.

See our complete analysis of Colgate-Palmolive here

Brazil’s Revenue Share is Significant Enough to Move the Needle

In fiscal 2014, Colgate-Palmolive derived 26% of its total revenues from Latin America. ^[4] The company does not report revenue share by country, so share of Brazil in Colgate-Palmolive’s total revenue is not clear. However, Brazil is one of the biggest countries in Latin America and accounted for nearly 40% of the total GDP of Latin America in 2013. ^[5] Therefore, we have assumed that Brazil accounts for 40% of Colgate-Palmolive’s revenues from Latin America. Based on this assumption, Colgate-Palmolive derives 10.4% of its total revenue from Brazil. It should be noted that the actual share of Brazil is likely to be higher as Colgate-Palmolive does not operate throughout Latin America, and operations are concentrated in major countries like Brazil, Venezuela, Argentina and Mexico.

This establishes that Brazil’s revenue share is substantial enough for a major economic crises in the country to have a notable impact on Colgate-Palmolive’s overall performance. In fact, the company attributed low volume growth in Latin America in 2014 to volume declines in Brazil. ^[4]

Volumes and Margins Likely to Tumble, Counter-Measures Limited

Brazil is currently facing the unenviable combination of plunging consumer spending and high inflation. Sales of consumer products have been falling for some time, which forced Colgate-Palmolive to carry out destocking measures in the country. This destocking was expected to be over by the fourth quarter of 2014 but is still ongoing. ^[6] Now that the economic scenario has worsened even further, Colgate-Palmolive may decide to extend its destocking due to low demand. The prospect certainly seems highly probably, given that disposable income is not expected to keep pace with rising prices. ^[7] The extent of the fall in demand will be determined by the magnitude of the recession, which is widely feared to be imminent. ^[8] Unless the economic scenario in Brazil improves, there is little that Colgate-Palmolive can do to prevent a fall in volumes.

Similarly, margins are bound to be hit by the runaway inflation and weakening Real. Colgate-Palmolive has so far resorted to price hikes and cost savings to protect its bottom lines, but these measures have limited application. Cost savings are not specific to Brazil, and thus have not been considered for the purpose of this analysis.

On the other hand, the company has extensively used price hikes to protect its margins in the past and will continue to do so. However, a bulk of the benefits of higher prices may be wiped out by rampant commodity cost inflation. Also, Colgate-Palmolive is likely to avoid increasing prices indiscriminately, as too high prices may push consumers away from its products to lower priced substitutes offered by local competitors.

Weakening of the Brazilian Real to Further Compound Troubles

In 2014, adverse foreign exchange movements were the single biggest factor that pulled down revenue growth and margins. In Latin America alone currency headwinds depressed revenues by as much as 14.5 percentage points, spurred on by the currency crises in Venezuela.

Now, the Brazilian Real has weakened to historically low levels below 3 per dollar. If the Real fails to recover or achieves an inconsequential recovery, it will wipe out the impact of price hikes and volume expansion, improbable as the latter may be. Sustained weakening of the Real may force Colgate-Palmolive to incur a charge on the value of its Brazilian assets, which will further depress its GAAP profits.

In light of the above, we estimate that there may be a 7% downside to our current price estimate of $56, if its market share and margins decelerate slightly in the short term instead of our existing growth assumptions. It should be noted that most of the deceleration is expected to occur in the oral care business, since the company primarily operates in the oral care segment in Latin America. Also, since oral care accounts for 46% of the company’s total revenues, the impact of a recession in Brazil on the personal care and home care segments would be inconsequential.

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1. Brazil retail sales post sharpest drop on record in December, Reuters, February 11, 2015 [↩]
2. Brazil Posts Fastest Annual Inflation in Almost a Decade, Bloomberg, March 6, 2015 [↩]
3. Brazilian Real Weakens to 3 Per Dollar for First Time Since 2004, Bloomberg, March 5, 2015 [↩]
4. Colgate-Palmolive 2014 10-K [↩] [↩]
5. World Bank: Latin America | Brazil [↩]
6. Colgate-Palmolive 2014 Fourth Quarter Earnings Call Transcript, Seeking Alpha, January 29, 2015 [↩]
7. The crash of a titan, The Economist, February 28, 2015 [↩]
8. Brazil’s Real Declines as Analysts Forecast Economic Recession, Bloomberg, February 18, 2015 [↩]