Kimberly-Clark Stock: Volumes Remain Weak, Cost Structure Now Higher (NYSE:KMB)

Summary

Following my coverage of Kimberly-Clark Corporation (NYSE:KMB) on 31^st October 2023, for which I recommended a hold rating (stock price has remained flat since then) as I expect that KMB would not be able to sustain the same pricing power it had enjoyed previously, this post is to provide an update on my thoughts on the business and stock. I reiterate my hold rating for KMB as volumes remain weak on a 4-year stack basis, and I expect it to continue facing cost pressure, putting a lid on its ability to expand gross margin.

Investment thesis

KMB reported 4Q23 on 24^th January 2024, where its organic sales growth of 3%, driven by 2% price, 1% mix, and flat volume. By region, organic sales in North America grew 3%, developing and emerging markets were up 5%, and other developed markets were up 1%. By segment, personal care grew 6%, consumer tissue was flat, and KCP was down 1%. Gross margins were a surprise, as they did better than expected, coming in at 34.9% due to commodity cost tailwinds and price growth of 2%. That said, OPEX grew 16.6%, negating the positive gross margin trend, leading to EBIT being down 6%. All in all, KMB reported an adjusted EPS of $0.51. On a full year basis, revenue was up 1.3%, gross margin was up 370bps, EBIT margin was up 150bps, and EPS saw $6.57. However, the key metric, overall volume was down 250bps.

One of the key metrics that has been tracked by many investors is volume growth for KMB. On the surface, it appears that volume growth is gradually trending back to positive territory. However, I don’t think a y/y comparison makes sense for KMB volume performance over the past 2 years, which has been heavily impacted by the pandemic. As such, it makes more sense to look at the business over a longer time frame. Given that COVID happened in FY20, a 4-year growth stack will be a more reliable indicator of growth. On a 4-year stack basis, there were no signs of volume recovery at all.

With volume showing no signs of recovery yet, the only factors that can drive top-line growth are pricing and mix. With regards to pricing, while KMB realized 2% pricing growth in 4Q23, I remind readers that the pricing growth was largely contributed by hyperinflationary economies like Argentina and Turkey. From a math standpoint, given that the contribution from these countries is less than 40% (KMB reported 47% outside of North America—this includes large economies like Europe and Asia), For these hyperinflationary countries to move the needle to the consolidated level, the price increase must have been extremely huge. Although management expects this tailwind to continue for FY24, my opinion is that this pricing growth is going to come at a high price. This is a very negative combination for KMB, as the main demand comes from local consumers. Take Argentina, for example; the country is facing more than 200% inflation. KMB can raise prices to meet cost inflation, but consumers are unlikely to continue catching up with this inflation as wages are not growing as fast. This is a net negative for volume growth in these countries. The other consequence of this hyperinflation is that it translates to huge FX headwinds for KMB. The longer this situation persists, the worse it gets for KMB, as I expect volume and FX headwinds to increasingly outweigh price growth. Mix is unlikely to move the needle as pricing is growing at a significant level.

Once again, the government is offering an increase that is below inflation, leaving the poorest sectors of society unprotected. Courthouse News from Buenos Aires

The above points make me feel uncertain whether KMB is able to expand gross margin. Management noted that cost environment is going to stabilized at higher levels, which suggest a structurally higher cost level. Gross margin is unlikely to see a normalization benefit (i.e., gross margin not going to see any major step up again). Near term, management has also noted that rising distribution and labor costs, as well as foreign exchange headwinds on imported materials affecting emerging and hyperinflationary markets, will more than make up for any tailwinds from easing commodity prices. Although management has stated their plans to implement a productivity initiative over several years and can see the big picture for gross productivity for the next three, I don’t believe investors will put much stock in this story until they observe better trends in volume (4-year stack basis) and less foreign exchange headwinds.

Valuation

My outlook for KMB remains negative for the near term. Accordingly, I made adjustments to my model (FY25 growth has been revised from 2% to 1% and net margins revised down from 10.9/11.5% to 8.6%/9% in FY24/25 respectively). I believe the negative headwinds from weak volume will continue in the near term as there are no signs of recovery yet, and the FX headwind will become a bigger headwind as the hyperinflation economy sees their currency weaken against the USD. As a result, I have also toned down my margin expansion expectations as the cost structure is now structurally higher than pre-covid, and KMB continues to see cost inflation pressure. As such, I don’t see any near-term catalyst that will drive the valuation up from where it is trading today—17x forward PE. All in all, my target price has been revised from $123 to $93. While there is downside to the stock, I am not recommending to sell because there is a possibility for KMB to achieve success in its productivity program.

Risk

The upside risk is if KMB is able to expand margins by achieving early success in its productivity pipeline (plans to drive volume upwards). This could be a major catalyst to drive valuation upwards; however, as this management just announced this, my expectations are that it will not have any near-term impact. The way to monitor this risk is by tracking every quarter’s volume growth to see if there is any positive inflection.

Conclusion

I reiterate my hold rating on KMB as the company faces persistent challenges in volume growth and a higher cost structure. While 4Q23 organic sales showed positive aspects, including price growth and gross margin performance, the lack of volume recovery over a 4-year stack basis raises concerns. The reliance on hyperinflationary economies for pricing growth, coupled with the impact on local consumers and significant FX headwinds, contributes to uncertainties in KMB’s ability to expand gross margins.