Kimberly-Clark Looks Way Too Expensive For What It Is

By Stephen D. Simpson, CFA | April 22, 2013 AAA

Investors can certainly make good money investing in well-run personal care companies with solid brands. Along those lines, names like Procter & Gamble (NYSE:PG), Colgate-Palmolive (NYSE:CL), Unilever (NYSE:UN), and Kimberly-Clark (NYSE:KMB) have all delivered very strong capital gains over the past year. In the case of Kimberly-Clark in particular, though, I do worry that this consumer staples melt-up has gone a little too far. I do like the company's growth potential in emerging markets, but commodity inflation could threaten further margin improvements and I believe the stock is too expensive relative to its growth prospects.

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On-Target Growth And Strong Margins In The First Quarter
Kimberly-Clark helped its case with a strong first quarter result. Revenue rose less than 2% on a reported basis, but organic revenue growth was in excess of 3% despite a challenging year-ago comps. Growth was led by the consumer tissue business (a lucrative cold/flu season) which rose nearly 4%, while the personal care business was up more than 2%. KC Professional revenue was up slightly, while organic health care revenue was down 2%.

As mentioned, margins were surprisingly strong this quarter. Adjusted gross margin improved about 140bp and beat the sell-side average by about 80bp. Likewise, adjusted operating income was considerably stronger than expected, as it increased 16% and beat expectations by about 8%. All told, about half of the company's beat relative to the average EPS estimate can be tied to operating outperformance.

SEE: Understanding The Income Statement

Brand Strength Versus Pricing Pressure
One of the curious things about the recent strength in consumer stocks is that it is coming in the face of relatively weak pricing and volume trends. Consumers tend to be pretty loyal when it comes to products like toilet tissue and facial tissue, but private label brands (particularly at retailers like Walmart (NYSE:WMT) have been picking up quite a bit of share over the past couple of years.

Now maybe the Street believes that these companies are past the worst of that share loss to private label, and that enhanced promotional activities will restore share growth. I'm not so sure. Between Nielsen data and consumer surveys, it sounds like shoppers are increasingly price conscious and that could become a larger problem for Kimberly-Clark if and when input costs start to rise again.

In the meantime, it will be interesting to see how rivals like Procter & Gamble and Johnson & Johnson (NYSE:JNJ) choose to compete against Kimberly-Clark. Nobody seems eager to surrender any margin and there hasn't been much price competition among the major branded players โ€“ something that could arguably play into the hands of the private label manufacturers.

International Is Still A Bullish Story
A big part of the bullish thesis on Kimberly-Clark has been its above-average growth potential in emerging markets. Few personal care companies have a larger emerging markets business than Kimberly-Clark (Colgate would be one of the exceptions), and the company has definitely benefited from the growth in consumer demand for products like disposable diapers, facial tissue, and toilet tissue.

Still, these products aren't so entrenched that constant sales growth is a given. Against some difficult year-ago comps, Kimberly-Clark saw international sales up just 4% in consumer tissue (in constant currency) and 6% in personal care โ€“ not bad, I'll grant, but certainly weaker than the year-ago levels. I suspect that one of the challenges for Kimberly-Clark in the future will be in maintaining brand value โ€“ local production will certainly help the cost structure, but I do believe the company will eventually have to convince local shoppers that there's a good reason to pay premiums for Huggies and Kleenex.

The Bottom Line
Kimberly-Clark has an excellent dividend history, both in terms of the consistency and the growth of the payout. Likewise, this is a company with strong brands and solid consumer loyalty. What is not as consistent, though, is the history of operating income growth and margins. The company has done a good job of improving its manufacturing process and reducing waste, but input costs like fiber, energy, and packaging are still meaningful.

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I am looking for Kimberly-Clark to continue growing its free cash flow at a low-to-mid single-digit rate. In fact, I'm looking for the company to post stronger growth over the next decade than it has over the past ten years. Even with that growth, though, the shares do not look cheap. Whether you consider discounted free cash flow, EV/EBITDA, or P/E, Kimberly-Clark shares seem to be sporting a significant premium, and I don't see the growth or earnings consistency here to pay such a high multiple today.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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