2023-06-15 07:50:39 ET
Summary
- Kimberly-Clark's disappointing performance in recent years is hardly a surprise and does not make the company a bargain.
- After years of relying on share buybacks to support its share price, KMB could no longer support these activities.
- The short-term perspective on margins remains mixed, in spite of the management's optimism.
Sometimes it's possible to justify holding a stock that has failed to deliver over a period of few years. In such cases, the business is either going through some form of restructuring and the management is making all the right steps to transform the company or simply the macroeconomic environment has been a headwind for the industry.
Unfortunately, I don't see Kimberly-Clark ( KMB ) as such case. Exactly three years ago, I wrote a thought piece on the company, explaining why weak competitive advantages are in the main reason for its poor performance.
Since then, KMB's share price has remained flat and the company's total return now stands below 5% over the past 3-year period. At the same, the S&P 500 has delivered a staggering 40% return (without accounting for dividends).
The relative performance to the consumed staples sectors has been equally disappointing with Consumer Staples Select Sector SPDR ETF ( XLP ) delivering a total return of 33%.
As a result of this poor share price performance, KMB could still appear as a bargain relatively to its peers, which are priced at significant premiums. Nevertheless, little has changed since 2020 and the business is still at the mercy of outside forces.
The Troubling Cash Flow Dynamics
Large cap consumer staple businesses are not the area of the market where one would expect high cash flow growth, however, the case of Kimberly-Clark is a stark example of a business model that fails to deliver.
For nearly 20 years now, KMB's free cash flow has remained relatively flat and is now at the same levels that it was all the way back in 2004.
During the same period, Kimberly-Clark's share price has roughly doubled which is at odds with the free cash flow dynamics we saw above.
At the same time, KMB still trades at a relatively attractive free cash flow yield of 5.1% as of today.
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The main reason for that discrepancy between free cash flow and share price performance has been the company's sizable share repurchase activities over the years.
As we see in the graph below, the amount of share buybacks has fallen sharply in 2022/23 period.
What that means is that KMB share price is no longer supported by the company's buyback activities. The more troubling development is that the annual dividend increased have now resulted in the dividend payments being almost equal to the company's free cash flow which leaves little to no cash flow available for share repurchases, debt reductions or strategic acquisitions.
The free cash flow squeeze that KMB is now experiencing is limiting the management's options as far as capital allocation is concerned. As we all know, this prompts a phenomenon known as moral hazard where the management has an incentive to take on more risks in their desperate attempts to get out of a tough spot.
The Only Hope
Given the low growth profile of KMB, the only hope for the business at this point in time is improving profitability.
During the latest earnings release, the management has indicated that gross margin is improving as input costs are stabilizing and pricing remains strong. The management also expects that gross margin would continue to improve through the rest of the year, although specifics were not provided.
During the conference call, the management even compared the current period to the 2020/21 one, when gross margin increased for a number of quarters in a row.
This marks the second quarter in a row that we expand gross margins , and by not an insignificant amount versus the prior year. And as a reminder, the last time that had happened had been eight quarters ago , if you step back in time.
Source: Kimberly-Clark Q1 2023 Earnings Transcript
Of course, however, the dynamics this time around are very different. First and foremost, during the pandemic lockdowns and in the following months KMB benefited massively from the unprecedented demand for its products. Secondly, although commodity headwinds are now dissipating the medium to long-term outlook for commodity prices is now less predictable.
The recent price increases are also expected to lap in the second half of the year which would put more pressure on year-on-year margin comparisons.
A couple of things to keep in mind are the fact that we were early in terms of pricing. So we will begin to lap some of the pricing as we go into the second half of the year . Hence, why some of the increases that we've seen in last quarter and this quarter in gross margin in terms of absolutes, we don't expect that to remain .
Source: Kimberly-Clark Q1 2023 Earnings Transcript
In terms of rising costs, wage increases are now becoming a more important factor to keep an eye on as KMB's low gross margin cannot sustain significant increases in fixed costs.
In addition to the $200 million headwind from higher wages and other manufacturing costs as stated last quarter.
Source: Kimberly-Clark Q1 2023 Earnings Transcript
Having said that, the ratio of advertising spend to sales is also increasing and is expected to normalize in 2023, after two years of relatively lower advertising costs.
As we scaled recent innovations to more markets and advance our commercial capabilities, we expect to step up brand investments in the second quarter and the rest of the year, as we said last quarter.
Source: Kimberly-Clark Q1 2023 Earnings Transcript
All that makes it highly unlikely that KMB's management would be able to sustainably improve its margins over the coming years. In spite of the misleading scaling on the graph below, so far it appears that the company is making significant progress in terms of profitability, but I remain skeptical that this trend could be sustained for long.
Conclusion
Over the coming months, Kimberly-Clark's share price will continue to depend on outside factors, such as commodity pricing and economic activity. Margins would most likely improve, but the medium to long-term sustainability remains questionable. Structural problems at the company will continue to put pressure on the management to drastically change course and take on more risk by either pursuing a large M&A deal or increasing leverage.
For further details see:
Kimberly-Clark: Short-Term Tailwinds, But Little Hope For The Long Run