Description

Personal Care and Consumer Tissue are the main revenue & profit drivers. Key brands in no particular order include Huggies, Pull Ups, Depend, Scotts, Cottonelle, Viva, Kleenex, and Kotex.

KMB’s strongest positions and “good” business lines include diapers, training pants, incontinence products, and tissue (only good in developing markets). Kotex is weak in the US but has been very successful in South Korea (55% share) and KMB plans to use that success to launch into China & North Asia.

KMB’s trouble areas include tissue/paper products (North America & Weston Europe) and all Western European products (Western Europe is a tough market for all personal care & food companies).

KMB has a very high exposure to raw material/energy costs which represent 55% of revenue. Increasing raw material costs have been a major headwind for KMB in 2006-2008 but due to the dramatic reversal in the global economy this headwind is now becoming a strong tailwind for 2009. 

KMB raw material costs in 2008 include the following: $2.16bn in pulp, $290mm in wastepaper, $630mm in oil & derivatives, $150mm in natural gas & derivatives, and $440mm on polymers.

KMB is estimated to generate 55% of 2009 earnings from the United States. KMB’s 2009 geographic revenue split is estimated follows: 57% North America, 16% Western Europe,13% Latin America, 8% Asia/ROW, 5% Australia/New Zealand, 1% Eastern Europe. Key specific countries include: US 56%, Brazil 8.1%, South Korea 4.8%, and UK 5.7%. 

Developing & Emerging markets (D&E) represent 26.6% of sales with the “BRICIT” countries (Brazil, Russia, India, China, Indonesia, and Turkey) representing 11.1% of sales. D&E have been growing 2x the overall growth rate with “BRICIT” at 4x.

Thesis

KMB is an attractive defensive stock for those who want to keep defensive exposure in their portfolio. In my opinion, it is the most attractive HPC (household & personal care) or food stock right now. KMB is particularly attractive because it stands to benefit a tremendous amount of the abrupt recent reversal in raw material costs (oil, nat gas, resin, and pulp). 

KMB has been pummeled by raw material cost inflation over the past few years. Cost inflation was particularly acute in 2008 and KMB has suffered downward revisions of 2008 & 2009 EPS all through the past year. This has resulted in poor absolute performance and multiple compression compared to historical norms.

Input costs recently started dropping very dramatically, but there is 1-2 quarter lag from when spot prices drop and when KMB’s actual costs drop. Associated with improving costs has also been a dramatically strengthening dollar. The recent strengthening of the dollar has had an immediate negative impact on KMB while the benefits of lower raw material costs are going to come with a lag. This dynamic caused KMB to lower Q408 guidance when they reported Q308 results and was a minor disappointment. I believe this timing dislocation has created the opportunity to buy KMB at an attractive price just before the benefits of lower costs will start to flow through (and generate upward EPS revisions and good momentum for the stock).

KMB trades at the low end of its historical absolute valuation range (currently trading at 12.5x 09 EPS). KMB has a solid ROIC (~20%) and has shown strong capital management with close to 100% NI to FCF conversion. KMB has historically returned all FCF to shareholders in the form of dividends (4% yield) and stock buyback (3%+/year). My DCF analysis of KMB’s long-term cash generating potential suggests a 1-year fair value target of ~$71. KMB has historically traded at >15x fwd EPS multiple, so a return to historical absolute valuation would also support a $72+ 1year target.

Two challenges with buying consumer staples as defensive stocks right now is that 1) while they are attractive on an absolute PE basis they are much less attractive on a relative PE basis, 2) many consumer staples generate a substantial percentage of profits ex-US and are going to face downward EPS revisions from the stronger dollar. While KMB’s 2009 PE is high relative to the group, it is much more attractive than the PE for other HPC and food peers. 

Other positives to the KMB story include: 1) the company has shown positive momentum in recent Nielsen US retail takeaway data suggesting nice price elasticity dynamics and the potential to pocket the gains from recent price actions and improving raw material costs.

Positive Change / Shareholder Value Management

·        Raw material costs have suddenly changed from being a material headwind to being a material tailwind; current expectations do not fully incorporate this benefit

·        Company generates strong FCF (due to its decent ROIC) and returns FCF to shareholders in the form of dividends and buyback. KMB repurchased 7.5% of shares outstanding in 2007 and 2-3% in 2008.

Other Positives

·        KMB is viewed as a well-run company with strong brands and rational competition.

·        KMB offers “necessities” such as diapers, paper towels, and facial tissue which should hold up well in a though environment (with private label and price elasticity being the key risks)

·        The diaper business is a great business; the tissue business is less attractive but should have a huge boost from the recent roll-over in paper and energy costs

·        KMB has a lower ratio of debt to market cap than many other peers which makes it’s PE discount all that more attractive on an unlevered basis

·        D&E exposure is a long-term positive for secular growth (but creates short term FX and organic deceleration risk)

·Risks / Negatives

·        Francois Trahan at ISI recently made an interesting argument that the equity ‘safety shelter’ of buying consumer stables is getting crowded. He believes that an overweight position in staples is the equivalent of making a bearish market call. He showed some charts showing that relative performance recently hooked upwards but this uptick tends to be coincidental with upticks in volatility, higher credit spreads, and lower treasury yields. He also points out the relative valuations are at peak 20-year levels. He argues you should only own consumer staples if you think things are going to continue to get even worse. I think is argument has some merits and that most consumer staple stocks are not that interesting on an absolute valuation basis and even less interesting on a relative basis. I find KMB much more interesting than most other large cap HPC and food companies. 

·        Modest long-term secular growth: minimal growth in tissue; okay growth in personal care (diapers, training pants, incontinence pdts, etc). Growth has been boosted over the past few years by innovations in baby wipes and training pants but such growth-enhancing innovations may be lacking in the future. There is still tremendous room for growth from D&E markets which represent 26% of KMB’s revenue.

·        Private label is a key risk for all HPC and Food companies as it detracts from growth, puts a lid on pricing, and challenges margins and the ability to pass through cost pressures or to benefit from cost relief. I see private label as a manageable risk . From 2003 – 2007, private label has been mostly dormant in the US. However, it started to be more of a factor in 2008 and has gained over 100 bps of market share over the past year from 12.5% to 13.5%. PL hasn’t really been a factor in the diapers category where it has actually been slowing share over the past year in the US. PL is a big factor in the paper towel and tissue categories where they represent 21-23% share and have been growing 100-140 bps y/y in the past year. PL will “keep KMB honest” in these categories, but losing 1-2% of growth per year to PL is a manageable headwind. PL penetration is a cyclical phenomenon that exerts its greatest pressure in a weak environment. While a “frugal future” thesis suggests several years of consumer retrenchment, this is a manageable headwind. PL is a huge problem in Western Europe where penetration rates are much higher. There is a risk that over the long term the US evolves to be more like Europe, but I don’t see that as likely given that cultural factors and certain agents of this phenomenon (Lidl & Aldi and several other retail concepts that heavily promote PL) are unique to Europe.

·        KMB’s tough areas: Western European tissue (7% of sales), North America paper towels (5% of sales), North America feminine care (3% of sales); Western Europe is though for all pdts .

·        Branded and private label competition and/or unfavorable price elasticity responses might force KMB to pass through more of the raw material cost benefit in 2009 than I am expecting.

·        D&E exposure creates FX risk for 09 and could drive an abrupt deceleration of growth in 2009 (but D&E exposure a long-term secular positive)

·        Raw material cost pressure likely to resume in the long term: A good argument that the benefits that KMB are seeing in raw material costs are a cyclical phenomenon tied with the global downturn and that the secular pressures on oil and petrochemical costs will resume in the long term. The past few years showed KMB’s vulnerability to this pressure and inability to get full pass through of raw material costs, so the potential for this trend to resume puts a limit on long-term growth and on the valuation for this company.

·        HPC & Food companies are very difficult to model with precision due to uncertainty on raw material costs, pricing power, competitive dynamics, and pension expense (recent phenomenon due to abrupt market moves). One can approximate raw material inflation/deflation by looking at spot prices but this provides just a general proxy due to contract pricing and the use of hedging. Furthermore, even if you knew exactly how much raw material prices will go up or down in the year ahead, it is hard to know just how much of this might get passed through in the form of higher/lower prices and not make it to the bottom line. Associated with pricing changes is the impact on volume through price elasticity. In summary, predicting earnings power in a period of severe cost inflation or deflation is quite difficult. I believe this actually is what has created the unappreciated opportunity to buy KMB in the face of favorable cost tailwinds in 2009, but it is very difficult to quantify this benefit with precision.

·        KMB’s inventory levels are high after building up form Q406 to Q108 as part of restructuring and probably have to come down (they dropped in Q308) which could hurt earnings with a production downtime headwind

Analytical Detail on Key Issues

$500mm+ Raw Material Tailwind in 2009

·        Pulp $973 in 08 to $775 in 09;

·        Oil $106 in 08 to $75 in 09

·        Resin from 0.93 in 08 to .8 in 09

·        Pulp: Purchases $2.6-2.7mm tons per year. Each $10 benefit ~ $26.5mm

·        $1 oil = $5-6mm annually

·        Resin: Purchase 650mm lbs/year: each 1c benefit = $6.5mm

·        $1 nat gas = $16mm annually ($25mm globally)

·        Last guidance reduction in mid-Jul 08 was based on $140 oil, $12.50 nat gas, $900 pulp. Substantial cost relief since then, but no guidance has been given in 09 yet and relief won’t be realized until Q109

·        Cost inflation was $850mm in 08 and $500mm in 07. See room for $500mm+ reversal in 2009.

Bridge from 2008 EPS to 2009 EPS

                                                            Pre-tax            After-tax         EPS

2008 Dil EPS (ex 10c rest chg)                                                          $4.15

Raw material benefit                             $500mm           $355                0.86

1% pricing (full year 09vs. 08)                $200                $142                0.34    

-1.5% vol drag (assoc w/ above)          -$100               -71                   -0.17

Net Raw Mat/Price/Vol                                                                     $1.07

Give up 1% price/1.5% vol ben           -$100               -71                   -0.17

2% core growth                                    $50                  $35                  0.09                            

Force & Restructuring Savings                $125                $88                  0.21                

FX PBT Hit                                          -$210               -$149               -0.36

15% Eq Inc hit                                                             -$30                 -0.07

Total                                                                            $246.9mm        0.72

Pension Headwind                                                                                -0.27 (rough est)

Mfg Downtime Headwind (inv level currently high)                                -0.10 (rough est)

2.5% stock buyback                                                                             +0.10

Total EPS Delta                                                                                 0.55

2009 Dil EPS                                                                                      $4.60

Dividend                                                                                               4%

Catalyst