EUR 850.00 For Business Accounts Only

Morningstar | Steady Top-Line Growth Helps Essity Mitigate Cost Pressure in 2Q; Shares Fairly Valued

We don't expect to materially change our SEK 219 fair value estimate for no-moat Essity after reviewing second-quarter results. Year to date, net sales have grown 8%, tracking slightly above our 7% estimate, but margin pressures have continued to weigh on the bottom line, with adjusted EBITA margin contracting about 70 basis points to 11.2%. While we think this softness is partly attributable to Essity's presence in categories with significant competitive pressures and limited opportunities for differentiation, a key aspect underlying our view that the firm lacks a competitive edge, we expect certain cost pressures to be more short term in nature. As evidence, management claims that unfavorable raw material costs, including higher market prices for pulp (35% above the rate seen in the year prior) and oil-based materials, reduced its adjusted EBITA margin (which stood at 11.3%) by 4% during the quarter. While we may adjust our near-term outlook to incorporate these results, we plan to maintain our longer-term outlook, which calls for mid-single-digit sales growth and adjusted EBITA margin around 13% on average over the next five years (versus 12% in 2017).

We believe modest margin expansion is feasible longer term, as the firm continues to extract excess overhead costs, restructure its operations to improve supply chain efficiency, and improve pricing in certain markets. We were pleased to see price/mix improve by 130 basis points during the quarter. While adjusted operating margins faltered in consumer tissue (contracting 160 basis points to 8%) and personal care (contracting 70 basis points to 12.5%), profitability strengthened in the professional hygiene business. Adjusted operating margin in this segment (which contributes nearly one fourth of sales) expanded 90 basis points to 14% due to improved price/mix and cost savings; we expect this metric to expand to a midteens rate toward the end of our forecast.

Essity's top-line momentum in emerging markets (35% of sales) continued through the second quarter, with organic sales growing 4%. We expect these regions to drive sales across the firm's businesses over the next several years, as per capita spending on hygiene products continues to grow.