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Morningstar | Kimberly-Clark Falls Victim to Tepid Sales, Languishing Profits; Shares Still a Touch Undervalued

Competition and intensifying inflationary headwinds hampered Kimberly-Clark’s second-quarter results, which included flat organic sales and a 270-basis-point erosion in adjusted gross margins to 33.4%. While lackluster sales trends have plagued firms across the industry the past several quarters, the rise in input costs (namely pulp), which are now expected to be around $675 million-$775 million versus $400 million-$550 million most recently and $300 million-$400 million initially, was more pronounced than expected. As a result, Kimberly lowered its full-year earnings per share outlook to $6.60-$6.80 on an adjusted basis from $6.90-$7.20 prior. We intend to update our assumptions to account for these near-term challenges and will probably reduce our $118 fair value estimate by a low- to mid-single-digit percentage. However, we don’t anticipate materially altering our long-term outlook for low-single-digit annual sales growth and high teens operating margins over our explicit forecast.

The downdraft in sales was felt in personal care (nearly half of consolidated sales) and consumer tissue (about one third), each down 1%. We attribute this performance to innovation that has failed to hit the mark with consumers, a challenge given the intensely competitive landscape, particularly in China, where personal care sales were off 10% on an organic basis. While we don’t think consumer product manufacturers should ratchet back spending to drive growth, we view Kimberly’s efforts to rightsize its employee base and manufacturing footprint (as a means to free up around $500 million-$550 million annually by 2021) as prudent, primarily because we don’t think the bulk of these savings will merely aid profits. Rather, we expect the firm will direct a portion of any savings toward research and development and marketing to support the intangible asset source of its narrow moat, particularly its entrenched retail relationships.

The notable weak spot was developing and emerging markets (around 30% of total sales), where organic sales ticked up just 1%. Performance was mixed across geographies, with market share gains in Brazil, Argentina, and Eastern Europe but down in China. Given elevated promotional activity from other nationally branded operators, local foes, and private-label alternatives, we think Kimberly-Clark could be challenged to prop up near-term sales, especially if it opts to raise prices to offset recent cost pressures, absent new product wins. Despite this, we expect favorable demographic and disposable income trends and a younger consumer base (which offers the potential for a lifetime of transactions) to prop up category sales longer term. For one, we think Kimberly is poised to benefit from greater diaper usage in many emerging markets as income levels rise, allowing 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) and ultimately an expansion of the category. 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 share 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.

Although management didn’t entertain questions about intentions for its European consumer tissue business, we would not be surprised if it continued down the path of parting ways with less profitable areas of its mix (similar to actions to shed the bulk of its Western and Central European diaper business, some of its lower-margin consumer tissue operations, and the spin-off of its healthcare business) to focus on its core iconic brands and ultimately free up resources to support its competitive edge. We’ve long held the firm to be an exemplary steward of shareholder capital and suspect that at the right price (north of 1 times sales, or $1 billion, by our estimates) it could jump on the chance to slim down, using the proceeds to reinvest in the business and return excess cash to shareholders as opposed to acting as a consolidator in the space. Inflationary headwinds are an outsize challenge for this segment (as evidenced by the 240-basis-point decline in operating margins this quarter to 14.1%), given the vulnerability to private-label competition, and we don’t expect these challenges to subside.