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Even as Relentless Cost Pressures Stifle Kimberly-Clark's Profits, Continued Brand Spending a PlusEven as Relentless Cost Pressures Stifle Kimberly-Clark's Profits, Continued Brand Spending a Plus Erin Lash Sector Director Business Strategy and Outlook | by Erin Lash Updated Apr 26, 2022 From our vantage point, narrow-moat Kimberly-Clark continues to struggle navigating a volatile demand environment and pronounced cost pressures. While we didn't anticipate the significant level of consumer stock-ups realized since the onset of coronavirus would persist (particularly as mobility restrictions ease), commodity cost inflation outpaced our expectations (serving as a 900-basis-point drag to gross margins in the first quarter--the highest level it has ever seen), and these pressures are unlikely to abate. In this context, Kimberly expects inflation in the range of $1.1 billion to $1.3 billion in fiscal 2022, on top of the $1.5 billion in incremental costs incurred in fiscal 2021. However, we don’t surmise Kimberly is sitting still. Rather, we believe it's employing a judicious, multipronged course to blunt the impact of these challenges. For one, Kimberly has been raising prices (a 6% benefit to sales in the first three months of fiscal 2022), and while early, we're encouraged management cites minimal volume retraction over the past few quarters. Despite this, we anticipate additional price hikes are on the cards, as inflationary headwinds remain, which could utlimately weigh on volumes, as consumers trade down to lower-priced alternatives. Beyond this, we posit its stringent cost focus has been accentuated, with the firm committed to extracting $300 million-$350 million in inefficiencies this year, a low-single-digit percent of costs, which we view as prudent. Not only should this dull the inflationary impact, but it should also serve to fuel spending on research, development, and marketing. In this context, we're encouraged that enhancing its value proposition and leveraging consumer insights across geographies and categories has been an area of focus for product development. We forecast it will direct an average of 6% of sales annually, or $1.4 billion to research, development, and marketing, which we view as critical to solidifying its relationships with retail partners and its brands in the eyes of consumers. Further, we think this holds even more weight in the longer term given the lack of switching costs in the consumer products sector. Economic Moat | by Erin Lash Updated Apr 26, 2022 We believe Kimberly-Clark has a narrow economic moat based on intangible assets, reflecting the entrenched retailer relationships it has built as well as its portfolio of brands that span multiple aisles of the store, such as diapers and wipes, feminine care, incontinence, and consumer tissue (consisting of toilet paper, facial tissue, paper towels, and napkins). The strength of its portfolio is evident in that five brands generate sales over $1 billion: Huggies, Scott, Kleenex, Cottonelle, and Kotex. We think it's these brands and the resources the firm maintains to support its intangible assets (as it relates to research, development, and marketing, spending nearly 6% of sales, or $1.1 billion, annually on average the past five years, and we don't think it will pull back on these investments) that should enable it to secure shelf space even in a consolidating retail landscape. As evidence of its competitive edge, Kimberly has generated returns on invested capital, including goodwill, that have averaged about 23% annually the past five years. We expect the company to continue earning excess economic profits for the next 10 years, supporting our narrow economic moat rating. Our explicit forecast calls for ROICs, including goodwill, to average a similar level over the next five years, more than 3 times our 7% estimate of the firm’s weighted average cost of capital. We believe one of the biggest challenges for consumer product firms is securing shelf space at retail outlets (particularly brick-and-mortar stores). While the base of retailers through which it sells has consolidated over the past several years, Kimberly-Clark remains a leading player in the global tissue and hygiene market, a low-teens share of the market (a touch behind the 14% share held by wide-moat Procter & Gamble), including nearly 60% share in Mexico, almost one quarter in the U.S., 17% in Brazil, and 18% in the United Kingdom. Digging deeper, Kimberly controls 17% of the global baby wipes market and just shy of 20% of worldwide nappies/diapers/pants space, versus low-double-digit and 23% respective levels for P&G. The rate of births around the world (in both developed and emerging markets) has continued to languish, falling from 4.5 births per woman in the early 1970s to less than 2.5 births per woman more recently, but we surmise that Kimberly’s position as a leading manufacturer combined with its commitment to invest behind product innovation aligned with consumer trends should ensure its competitive edge persists. In addition, while switching costs are negligible in consumer products, we view baby care (and diapers, in particular) as a category that has evidenced a bit of loyalty to the extent that parents are less willing to abandon a particular offering that works for their child. The company also owns the Depend brand, which is the dominant product in the growing adult incontinence category, with around one quarter of the market in the U.S. (where annual usage is around 5 times the level in emerging regions such as Eastern Europe, Latin America, and Asia). However, we believe consumer adoption of the offerings in this category is only beginning (as usage has been hindered by the stigma associated with a product that essentially resembles an adult diaper). This potential for growth is further supported by the fact that adults 60 years of age and older now account for more than 13% of the world’s population (22% in North America alone), levels that could double over the next 20-30 years. Further, on its home turf, Kimberly controls more than 20% of pantyliner and shields, just behind the 31% held by P&G, but outpacing the 13% share held by lower-priced private-label fare. While not to the same extent as in the adult incontinence realm, we also believe that feminine care is a space that has been constrained from a usage perspective by a degree of stigma, causing girls in underprivileged regions domestically and internationally to refrain from activities (such as going to school or even leaving their home) when they are menstruating. With category growth rates in the mid- to high-single-digits around the world and stemming from its position as a leading player in each of these categories, we think Kimberly should remain a valued partner for retailers, aiding in its efforts to drive traffic into stores. Beyond its current set of offerings, we view Kimberly's strategic emphasis over the past several years to actively manage its portfolio of businesses (shuttering its less profitable operations, including the bulk of its Western and Central European diaper business, some of its lower-margin consumer tissue operations, and the spinoff of its healthcare business) to focus on its core mix of iconic brands as favorable, supporting the intangible asset source of the firm's narrow moat. However, not all of the firm's categories maintain as much prowess, so we lack confidence that its returns on invested capital will continue to exceed our cost of capital estimate for the next two decades (as required to assign a wide moat rating). For one, consumer tissue, which accounts for around one third of the firm's consolidated sales base, tends to be a category where purchase decisions are driven by price rather than brand, given the more commodity-like nature of the product. As such, we believe these offerings lack much in the way of pricing power. This is reflected in the market share erosion of the firm's offerings in the global tissue products space, which is down 260 basis points (on a value basis) since 2012 to just 11.7% as of the end of 2021, versus the more than 21% share private label controls (the leading seller in the category). Further, this lack of pricing power is evident in the low-double-digit operating margins that tend to characterize sales in the tissue category, which materially lag the high-teens to low- to mid-20s margins other subsegments of the household and personal-care space boast. Based on these factors, we don't believe this category holds the same clout with retailers as other areas within the firm's mix (including feminine care, adult incontinence, and baby care to name a few). Further, we don't believe the firm's competitive edge is based on any other moat source. Its operating margins (which have historically hovered in the mid- to high-teens) generally lag the low- to mid-20s its peers tout, failing to suggest it has amassed a cost advantage. When taken together, we lack conviction that it will generate economic profits over a 20-year horizon, which would be necessary for a wide-moat rating. Fair Value and Profit Drivers | by Erin Lash Updated Apr 26, 2022 We're edging up our fair value estimate for Kimberly-Clark to $126 per share from $125, due to time value. However, we expect inflationary headwinds and supply constraints will continue, even as the firm works to offset a portion of this angst through higher prices on the shelf. When taken together, this prompted management to tick up its fiscal 2022 sales target to 2%-4% growth (versus 1%-2% prior) but to hold the line on its adjusted EPS guidance in the range of $5.60-$6.00, which squares our outlook (2.6% organic sales growth and adjusted EPS of $5.82). Our revised valuation implies 2022 enterprise value/adjusted EBITDA multiple of 14. In light of recent cost pressures, which management now pegs at $1.1 billion to $1.3 billion in fiscal 2022, on top of $1.5 billion last year, Kimberly raised prices across its mix at mid- to high-single-digit rates beginning in late June (and has suggested additional increases could be in the cards). But we don’t believe Kimberly is merely relying on price hikes to offset these cost headwinds. Rather, Kimberly also targets extracting up to $300-$350 million in costs this year. This builds on recent efforts, whereby the firm had rationalized its workforce and shuttered or sold manufacturing facilities. Beyond helping defray inflationary headwinds, we suspect a portion of any savings realized may also serve to bolster its brand spend. This is reflected in our forecast, which calls for 6% of sales (about $1.4 billion) to be directed to research, development, and marketing in aggregate annually the next 10 years. As a result of these factors, we think Kimberly's operating margins are poised to return to the high teens over time. And despite these challenges, Kimberly had been on a course to improve its sales trajectory before the pandemic by elevating brand spending and enhancing its prospects in emerging markets and online since CEO Michael Hsu took the helm in January 2019. Longer term, we still think organic sales growth will be roughly split between higher prices and increased volume. We expect gains will be driven by personal care (more than half of sales), as volumes are propped up by an increase in adult incontinence products and greater usage of diapers in China and other emerging markets, which underlies our more than 3% average segment sales growth outlook. Conversely, we see low-single-digit marks on average each year within the consumer tissue and professional arms. Risk and Uncertainty | by Erin Lash Updated Apr 26, 2022 Competition in the consumer products sector is intense and unlikely to subside, particularly if online purchasing in Kimberly’s categories levels the playing field with less-proven manufacturers. Further, switching costs are nonexistent, so Kimberly must invest to ensure that it brings products to market that resonate with consumers' evolving preferences, as it goes to bat against nationally branded peers as well as lower-price private-label competitors and small, niche operators, which have illustrated agility in responding to evolving consumer trends. From an environmental, social, and governance perspective, Kimberly has also been subject to allegations of price fixing in the past (most recently in May 2018). And while we surmise it has instilled processes to prevent such behavior, increased regulatory pressures could again arise. Kimberly is not immune to volatile economic conditions and turbulent political environments around the globe (with roughly half of its sales overseas). Further, while raw material costs had been favorable in recent years, we believe an extended period with a more inflationary climate could hinder margin expansion or compress volume if Kimberly opts to raise prices and consumers balk. And with its production (particularly for consumer tissue) occurring in regions where water is a scarce resource, Kimberly may also be challenged by impediments to its production process over time. However, given its vast manufacturing network, we don't anticipate this would serve as a meaningful constraint on the business. Against a weak macroeconomic backdrop, it's not uncommon to see financial strain manifest in consumers using less of the essential fare that Kimberly sells. For example, when Brazil's macroeconomic environment deteriorated over the recent past, consumers traded down and pulled back on product usage--which resulted in using fewer diapers per day--to rein in spending. We expect these pressures could manifest against a similar backdrop. Capital Allocation | by Erin Lash Updated Apr 26, 2022 We assign an Exemplary capital allocation rating to Kimberly-Clark, reflecting its sound balance sheet, a fair investment strategy, and appropriate shareholder distributions. Kimberly's business has historically not been subject to massive swings in sales and profitability. When combined with its low leverage levels (net debt/EBITDA averaged 2.1 times the past three years, not too far off our 1.8 times forecast over the next five years), we see little to suggest that Kimberly will be limited in its ability to reinvest in its operations while also bolstering shareholder returns. Prior to embarking on its current course (centered on reigniting its top line while keeping a stringent eye on costs), the company implemented strategic moves away from more commodified businesses (such as its pulp and paper operations) as a means to free up capital to invest in growth opportunities, particularly in emerging markets, which we viewed as prudent. In addition, Kimberly exited the diaper market (which accounted for roughly half a billion dollars in sales but generated negligible profit) throughout most of Western and Central Europe in 2012 and spun off its healthcare division in 2014. And although management hasn't entertained 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 to focus on its core iconic brands and ultimately free up resources to support its competitive edge over time. Management's disciplined, focused execution has enabled it to generate returns on invested capital of 21% on average over the past decade (25% excluding goodwill), about 3 times our 7% weighted average cost of capital estimate. Moreover, we don't see management overreaching for growth by entering categories it shouldn't or making unwise acquisitions. Despite this, we wouldn’t be surprised if Kimberly ultimately opted to pursue acquisitions (at the right price) occasionally to enhance its technological capabilities, product/category exposure, and geographic reach, though we surmise its interests would center on a smaller target that would be unlikely to alter its financial prospects, similar to its $1.2 billion tie-up with Softex Indonesia (a leading personal care operator) in late 2020. The price tag struck us as reasonable, at a less than 3 times multiple of fiscal 2019 sales, particularly in light of the strategic merits. For one, the acquisition affords Kimberly a more meaningful presence in Indonesia, where it has maintained limited reach. In addition, the portfolio composition complements Kimberly’s know-how, as Softex maintains leading positions in diapers (the number two player), feminine care (the number three player), and adult care (the number two player)--categories which in combination already account for about half of Kimberly’s consolidated sales. As such, we believe this was an opportunity to expand its global footprint, as opposed to signaling a paradigm shift in its strategic intent. But these pursuits haven't compromised its desire and ability to return cash to shareholders. It has raised its dividend consistently for around 50 years, and it has repurchased more than 2% of shares outstanding per year over the past decade (which we view as prudent when shares trade at a discount to our assessment of intrinsic value). And we don’t expect it intends to abandon its commitment to returning excess cash to shareholders, with our long-term outlook calling for mid-single-digit annual dividend growth and repurchases amounting to a low-single-digit level of shares outstanding. |
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