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Morningstar | Rising Input Costs, Competitive Pressure, and Customers Tension Plague Asaleo, FVE Cut to AUD 0.65. See Updated Analyst Note from 19 Jul 2018

While we had expected Asaleo Care to face challenges including aggressive competition and rising costs, these challenges have proven more severe than we previously expected. We downgrade our fair value estimate for Asaleo Care to AUD 0.65 per share, from AUD 1.20 per share. Despite the share price tumbling, the company now looks overvalued relative to our reassessment of the company's future cash flow potential. Our fair value reduction reflects several more-negative outlooks than we previously forecast. These include: higher input costs, which the firm is unable to pass through; an intensifying competitive environment and price battles; rebasing of our volume assumptions; and further pressure from supermarket customers, who haven proven ruthless when negotiating with suppliers (especially those lacking brand power).

We have cut our EPS projections by around 43% during the next three years to AUD 6 cents per share on average. 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, which we believe will result in EPS falling by almost 50% to AUD 6 cents per share.

Additionally, we have concerns about the company's balance sheet health, which we believe will require a suspension of dividend payments. 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 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. Accordingly, we have cut our fiscal 2018 dividend forecast to zero, from AUD 10 cents per share. We assume the company resumes paying dividends in fiscal 2019, albeit at a 50% payout ratio, compared with the recent 95% payout ratio.

Despite cutting our dividend forecasts, we still expect net debt to remain above the comfort level of 2.5 times EBITDA for the next few years. For the company to return to within the comfort zone immediately, they would need to raise approximately AUD 70 million equity, equivalent to around 17% of the firm's current market value. Nonetheless, if the company raises equity at an approximate 20% discount to the current AUD 0.78 per share market price, the issue price would be only marginally below our fair value estimate, hence the impact on our fair value would be neutral.

In our opinion, this recent profit warning highlights the firm's lack of pricing power and reinforces our no-moat rating. We believe each of these challenging factors will keep Asaleo's returns on invested capital capped at its 8% cost of capital for the foreseeable future, near our estimated cost of capital.

The tissue segment has been hit the hardest, with EBITDA falling by almost 40% in the first half of fiscal 2018, a consequence of the spike in pulp prices, the primary input cost. The company has attempted to recover some of this cost by raising prices, however the competitors have not followed suit, maintaining their prices and consequently taken market share. While we believe the higher pulp prices are cyclical, the fact competitors can accept a lower margin to win market share forces us to rethink our long-term margin assumptions. Accordingly, we’ve lowered our midcycle tissue EBITDA margin forecasts to 12%, below our prior forecast of 16% and only slightly above the current 10%. In the event pulp prices fall, we believe competitors will likely cut their prices to continue building share, ultimately limiting Asaleo’s scope to grow margins.

The company has commenced a strategic review (details of which will be provided later in the year) which we believe is focused on cost cuts. The quantum of available savings is unclear, nonetheless, we now believe over the long term, any efficiency gains will be eroded through competitive pressure, less favourable terms with supermarkets, or a combination of both, driving returns down to the cost of capital. The consumer tissue business lost substantial volume during protracted customer negotiations, which were further exasperated by the competitive intensity. While management has decided to invest in additional trade spend on an ongoing basis, we believe the cost of doing so is likely to offset any market share gains. On balance we expect revenue will remain muted.

We expect the challenges in feminine care will persist, with competitors continuing to discount aggressively. The firm's market share in feminine care started to improve after leaving every day pricing, however, the competition has slowed this recovery. Similar to the tissue segment, the company is ramping up trade spend to support market share, although in our opinion, this demonstrates the negotiating power of the supermarkets, and Asaleo Care's lack of brand equity. Meanwhile, unrelenting pressure from Kimberly Clark is likely to keep Asaleo's revenue in check. While we expect personal care can grow revenue at a modest low-single-digit pace annually, we don't think it will return to fiscal 2014 highs within the next five years. In both the feminine care and tissue segments, the company must choose whether to cut prices to win back market share, and wear the margin pressure, or continue trying to defend margins at the expense of market share. It cannot have both.