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Morningstar | Cost Headwinds Erode Essity's Profits in 3Q Despite Improving Mix; Shares Fairly Valued

Cost pressures continued to weigh on no-moat Essity's third-quarter results, as higher raw material and energy costs led adjusted operating margin to contact 250 basis points to 9.5%, despite continued improvements in pricing and product mix (2.6% contribution to net sales) and ongoing efforts to extract costs. Weakened profits were largely driven by the consumer tissue segment (37% of sales), where higher pulp prices (management estimates the market price for pulp is 30% higher than the prior-year period) led adjusted operating margin to fall 440 basis points to 5.8%, despite a 4.4% improvement in price/mix. While we expect the lack of differentiation and subsequent price elasticity in the tissue category limits the potential for material pricing power over the long run, price increases for certain contracts were implemented following the end of the quarter and negotiations for further price increases may benefit 2019 results; we expect tissue segment adjusted operating margin to return to a low-double-digit level longer term (comparable with its roughly 10% three-year historical average). The company also launched an additional cost savings program during the quarter (now targeting SEK 900 million annually, or roughly 1% of costs of goods sold and operating expenses, excluding amortization) that should help alleviate these profit headwinds.

Despite these lackluster bottom-line results, we were pleased to see Essity's top line track ahead of our expectations (with sales up 8.4% in the first nine months, or 90 basis points above our full-year outlook), as performance in emerging markets (35% of sales) remained healthy. We plan to adjust our near-term outlook to incorporate these results but expect higher sales and weaker margins to largely offset one another. As such, we don't expect a material change to our SEK 222 fair value estimate and are maintaining our outlook for 4% sales growth and low-double-digit operating margin on average over the next five years.

Organic sales in emerging markets grew 4.3% in the third quarter versus a 0.1% decrease in mature markets, including 12% organic emerging market growth in the professional hygiene segment (25% of sales). We expect these markets will continue to be a key determinant of Essity's growth in the years ahead, as per capita hygiene spending in these regions continues to grow. For example, management estimates that per capita tissue consumption in Eastern Europe is only one third of that in Western Europe, and that per capita use of incontinence products and baby care in Asia is less than one fourth of that in North America.