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Morningstar | Placing Asaleo Care Under Review. See Updated Analyst Note from 17 Jul 2018

We are placing no-moat-rated Asaleo Care under review following a severe earnings downgrade. The company has slashed fiscal 2018 EBITDA guidance by around 30% to AUD 80-85 million, representing an approximate 35% decline on the prior year. This comes as the latest in a series of earnings downgrades and management has cited significantly higher input costs (pulp and electricity), continued competitive pressure in feminine care, and market share losses in consumer tissue as the primary causes. We are likely to cut our fair value estimate substantially given the deteriorating earnings outlook and stretched balance sheet. We plan to publish an updated note and fair value estimate by Thursday July 19, 2018.

While we've long held that Asaleo's business lacks an economic moat, our bear-case scenario appears to be playing out, in which the intense competitive environment, powerful customers, and relatively commoditised product, inhibit the company's ability to pass on rising input costs. This is likely to continue weighing on both revenue and EBITDA margins, both of which declined by 9% and 24%, respectively, in the first half of fiscal 2018.

Additionally, this news raises concerns about the company's balance sheet health. As at June 30, 2018, the firm's net debt balance stood at AUD 310 million, approximately 2.8 times the trailing 12 months EBITDA. While covenants have not yet been breached, we believe this is a material risk, as debt levels now exceed the company's stated comfort range of between 1.5 and 2.5 times EBITDA. Based on our estimates, net debt is likely to exceed 3 times the guided fiscal 2018 EBITDA, which is dangerously high, in our opinion. We think the likely scenario is a suspension of dividend payments until the balance sheet is repaired, and/or potentially raising additional equity. While both scenarios are undeniably disappointing, ultimately stabilising the company's financial position should be the main priority.

The tissue segment is the most recent source of pain, with an additional AUD 24 million pulp cost expected for fiscal 2018. While the company has attempted to recover some of this cost by raising prices, the competitors have maintained their prices and consequently taken market share. We believe this inability to pass through cost inflation demonstrates the firm's lack of brand equity and the cost-conscious nature of typical consumers, which are key factors in our no-moat rating.

The challenges in the feminine care sector are also showing no signs of dissipating. The firm's move off every day pricing had shown some positive initial signs, with market share starting to improve late in fiscal 2017. However, the pace of recovery has slowed, and we believe the firm will be unlikely to recover the share it lost during fiscal 2017. As we've discussed in prior notes, we believe the company will be faced with tough competition from global giant Kimberly Clark which will keep revenue and margins under pressure for the foreseeable future.