EUR 850.00 For Business Accounts Only

Morningstar | Inflation Eats Into Profitability; Kimberly Ekes out a Modest Sales Gain in 3Q; Shares Not a Bargain

We don’t expect to change our $112 fair value estimate for narrow-moat Kimberly-Clark following third-quarter results that leave the firm tracking in line with our full-year outlook, outside of incorporating the impact of the time value of money (which should add $1-$2 per share to our valuation). Organic sales ticked up 1% in the quarter, reflecting a 2% benefit from higher prices and improved mix that was only partially offset by a 1% reduction in volumes. However, margins eroded (adjusted gross margins contracted 250 basis points to 33.2%, while adjusted operating margins fell 120 basis points to 17.4%) as the firm was unable to offset inflationary headwinds (both raw materials and transportation), which are plaguing operators across the consumer product landscape.

But beyond its financial performance, the firm also announced that on Jan. 1, 2019, current CEO and chairman Tom Falk is poised to pass the reins to current COO Michael Hsu. From an internal perspective, Hsu struck us as the heir apparent, given he has held roles of increased responsibilities across the firm’s operations since joining the organization in 2012. We are of the opinion that Hsu has worked in tandem with Falk to lay out the firm’s current strategic course (reigniting its top line while maintaining a stringent eye on costs), and as such, we don’t view this transition as likely to result in a material shift in the firm’s direction. To further ensure a smooth transition, Falk, who joined the firm in 1983 and has held the top spot since 2002, will continue to serve as executive chairman. As a result of these factors, we see little to warrant altering our Exemplary stewardship rating at this juncture. Following a low- to mid-single-digit downdraft, shares trade at a modest discount to our valuation but we’d suggest investors await a slightly larger margin of safety before building a position, and would suggest wide-moat Procter & Gamble as a more attractive option.

From a category perspective, sales growth was modestly positive in personal care (nearly half of consolidated sales, up 2% on an organic basis), while consumer tissue (about one third) remained challenged, down 1%. Despite the firm’s efforts over the past few years to pivot from more commoditized offerings in the tissue aisle, it remains a space where consumers tend to consider price rather than brand when making purchase decisions. Further, Kimberly faces competitive pressures from the likes of other branded operators, local peers, and lower-priced private-label fare. As such, we expect that much attention will continue to center around the receptivity of retailers and consumers to the higher prices that Kimberly and its peer set intend to bring to market over the course of the next few quarters to offset a portion of these higher costs and the resulting impact to volumes. While we surmise consumers may initially balk at higher prices at the shelf, if these actions prove broad-based across the industry (as we intend), we don’t think the impact will be lasting, particularly if accompanied by value-added innovation.

However, we don’t portend that Kimberly merely intends to rely on higher prices to negate the impact of commodity inflation. Rather, we're encouraged Kimberly has opted to rightsize its employee base and manufacturing footprint (with savings of around $500 million-$550 million annually targeted by 2021), which we view as prudent means to withstand inflationary headwinds while also freeing up funds to invest in research, development, and advertising (which we think stands to support the brand intangible asset, particularly the entrenched retail relationships, that underpins our narrow moat rating) to the tune of just more than 5% of sales or about $1.1 billion annually over the next decade.

Despite current challenges we haven't wavered in our expectations that favorable demographic and disposable income trends combined with a younger consumer base, which offers the potential for a lifetime of transactions, should aid sales growth over the longer term. In this context, we think Kimberly is poised to benefit from greater diaper usage in many emerging markets as income levels rise, allowing for greater consumption per child (from the one diaper used per day on average, which pales relative to the five consumed by developed-market consumers daily), facilitating category growth. We also believe Kimberly stands to benefit from an aging global population base and the potential for increased demand for its adult incontinence fare, a category where Kimberly already controls more than half the market on its home turf. As such, we maintain our expectations for a modest acceleration in personal care segment sales to around 3% growth annually longer term.