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Morningstar | Cost Pressure Weighs on Asaleo's Earnings, While Balance Sheet Pressure See Dividends Suspended

Fiscal 2018 is shaping up to be a challenging year for Asaleo Care, with interim net profit tumbling by almost 40% to AUD 18 million. While the result is soft, at the current pace, the firm is tracking broadly in line with guidance and our full-year expectations. The primary headwinds the company is facing are the higher pulp and energy costs (two of its major expense lines), along with market share losses in feminine care, baby care, and consumer tissue. While Asaleo achieved price increases, passing through the higher input costs, its competitors have not followed suit, and consequently the company has ceded substantial market share in the consumer tissue category.

We maintain our AUD 0.65 per share fair value estimate and our no-moat rating. Despite the recent share price drop, we see further downside risk at the current market quote. In our opinion, the cost pressures, intensive competitive pressure, and constant battles with key customers are likely to persist for the foreseeable future. Additionally, the board did not declare an interim dividend, which is consistent with our expectations, and we believe will be unlikely to pay a final dividend either, given the current state of the balance sheet.

Most recently, the tissue segment has been the main source of pain, with revenue declining by 9% and EBITDA margin contracting to 11% from 16%. If we were to separate out the impact of higher pulp and energy prices, which were partially offset by favourable currency movements, we estimate the segment's EBITDA margin would've been broadly flat on the previous corresponding period, or pcp. Our main concern is the company attempted to pass through these higher costs, whereas competitors held their pricing steady which contributed to the volume and revenue revenue pressure. If competitors are happy to accept a lower margin to capture market share, we don't envisage a scenario where Asaleo's tissue margins can return to prior levels, even if pulp and electricity prices decline. We do expect tissue revenue to stabilise from fiscal 2019 onwards as a new private label contract offsets a lost private label contract, and volume which was lost during protracted price negotiations with customers.

We expect tissue EBITDA margins can recover to around 12% within the next five years, substantially lower than recent levels, on the back of cost savings and reinvestment into business-to-business manufacturing efficiency. However, we believe the additional trade and competitive pressure spend are likely to limit margin upside. We believe this lack of pricing power will prevent the company from sustaining excess returns on invested capital and is a key contributor to our no-moat rating. Within the tissue segment, the professional hygiene section performed better, growing revenue by a modest 1%, although this was not enough to offset the pressure in consumer tissue.

Despite being the home of some of Asaleo Care's most reputable brands, namely Libra and Treasures, the personal care segment continues to suffer, on track for its fifth consecutive year of declining earnings. Revenue and EBITDA fell by 10% and 7%, respectively, in the first half of fiscal 2018. Aggressive competition in the feminine care space has been the main challenge, and rival Kimberly Clark is showing no signs of backing off. Until recently, the company was somewhat bound by every day pricing, or EDP, and unable to match its rivals which have been heavily discounting and stealing market share. However, since moving off EDP and resuming promotional pricing, the company's share of volume has stabilised, although in our opinion, this undermines any argument for brand power. We expect the company to recover modest share in personal care, and the segment's revenue should grow at a low-single-digit pace (with the exception of fiscal 2018). However, we believe margins will be constrained at around the current 30% on average due to increased trade spend and lower selling prices.

While we believe the suspension of dividends is the right decision, we remain concerned about the company's balance sheet health. Covenants have not yet been breached, but we believe this is a material risk, as debt levels now exceed the company's target comfort range of between 1.5 and 2.5 times EBITDA. Based on our estimate, net debt is likely to exceed 3 times fiscal 2018 EBITDA, which exceeds comfortable levels. The company is undertaking a strategic review (the details of which will be provided in the last quarter of 2018), and we believe raising equity is a possibility, although we have not factored this into our assumptions.

The company incurred AUD 149 million of nonrecurring charges during the first half, reflecting an impairment and write down of the tissue Australia and New Zealand personal care business, along with restructuring charges. This resulted in a statutory loss after tax of AUD 102 million, compared with an AUD 28 million net profit in the pcp.