The Good, The Bad, and The Ugly: Kimberly Clark

March 26, 2005 - Minyanville.com The Good:

• Sales were up 6% (excluding sales from Neenah paper which was spun off recently), on constant currency sales that were up 3%.
• Days sales outstanding is down to 2 days due to an investment in SAP software – that will help cash flows.
• KMB returned back $500 mm to shareholders: $301 through share buy- back, and $200 in the form of dividends. In addition, the company raised its dividend 13% this year.
• Sales in emerging markets are growing at a double digit rate. Emerging markets are about 23-24% of total sales. At some point, they will be providing the bulk of KMB’s growth (more on this later).
• KMB maintained its sales guidance of 3-6% (constant dollar) for the year, management stated that sequential quarter performance showed signs of improvement. Sales in healthcare (8% of total sales) showed very respectable growth in the mid single digits.

The Bad:

• Operating margins were under pressure from higher material costs, $100mm in the quarter, though partially offset by cost cutting ($45mm)
• Higher commodity prices trimmed operating earnings growth by 4.3% (my estimates).
• Gross profit grew 4.1% - impacted by the aforementioned reason.
• Operating profit grew just 2.3% - due to higher promotional spending.
• Personal care’s constant currency sales growth was very disappointing. That being said, things are likely to improve going forward.

Price increases - Following Proctor & Gamble (PG) and the lead of generic manufacturers, KMB instituted commensurate price increases across all product lines, passing the cost of commodities onto consumers. The fact that KMB is following P&G’s lead, takes out the risk that price increases would have be retracted (if P&G did not follow).

This is a very positive development. However, it will take time before price increases will trickle down to KMB’s bottom line, as inventory has to be worked out and contracts have to be re-written. Thus, next quarter numbers are unlikely to benefit from price increases, which will partially show up in the third quarter numbers.

On the tissue front, KMB figured a tricky way to raise prices and increase consumption at the same time. KMB is raising tissue count per box in their Kleenex product line. The cost per box and per sheet should increase as well. KMB feels this will drive sales as consumers will increase Kleenex inventory at home, which in turn will lead to higher consumption (this may actually work).

The Ugly:

Competition intensified in Europe, as sales were down 4% (despite a 6% benefit from a weaker dollar). In other words, constant dollar sales in Europe were down 10%. KMB is working on a turnaround of its European operations. Europe in general is a very tough market due to very little population growth. However, KMB has a product that will probably have a strong appeal to an ever-aging population (i.e. Depends - diapers for elders). The incontinence market is a faster growing market that should benefit from these demographic trends.

In developed countries, the diaper business is mainly driven by population growth. The tissue business is impacted somewhat by the severity of a flu season. However, sales in emerging markets are driven by the gradual rise in economic affluence. In emerging markets, or less affluent societies, diapers and Kleenexes are not staple items. Those markets are roughly in the same stage where the United States was thirty years ago. Folks in those countries are washing their handkerchiefs and cloth diapers.

The good news is that it will not take thirty years for consumers in emerging markets to become westernized - as a very contagious western influence spreads at the speed of light through the internet and TV screens. Though gradually, but not in the so-distant future, today’s highly discretionary products will become societal staples. As that happens, growth in consumption of those products will accelerate as population growth in emerging countries is growing at a much faster rate than the western world. A note of caution: primarily discretionary income has to grow for this transformation to take place.

As unexciting as the numbers above appear, KMB stock still has some juice in it (not intended as investment advice).

• KMB generates enormous free cash flows (operating cash flows – capital expenditures) of $2.1 billion.
• Pays a very decent dividend, yielding about 2.9%
• Very strong balance sheet, it can payoff all of its debt from operating cash flows in less than 2 years.

Overall it has very strong brands, resulting in nice margins of 12% and healthy return on capital of 22%

In the long run, it has all the ingredients to produce a stable 6-8% earnings growth rate. Between the sales growth and cost cutting, KMB should see margins expand 40-50 basis points a year for at least couple years.

KMB is buying back its stock like it is going out of style, purchasing close to 10% of its shares back in the last five years. KMB said they’ll buy back $1 billion (with a B) of their stock this year. At current valuation levels - that makes a lot of sense in my view. Stock buy backs will be accomplished from free cash flows, not from leveraging up the company.

Thus, let’s go through the composition of long-term EPS growth: Sales growth 3-5% + margin expansion 1% + share buy-back: 2-3% = EPS growth 6-9% + 3% dividend = 9-12% total return

There is some risk to the assumption that margins will expand, and though it's probable that they will, there is the risk that any improvement in margins will be competed away. In the worst case, in the absence of margin expansion, KMB total returns will range 8-11% range. KMB’s P/E (17 times 2005 estimates) has some room for expansion, but the margin of safety is not spectacular. My discounted cash flow model seconds that observation. It is hard to get excited about KMB after a quarter like this. However, it deserves a place in our portfolio as a defensive stock (not a recommendation), especially in the absence of other defensive plays at reasonable valuations. If another consumer staple comes along that has the quality of KMB, with faster growth and a lower valuation, we may re-think our position in KMB.

Vitaliy N. Katsenelson, CFA Copyright Minyanville.com