Earnings Roundup: Unilever, Procter & Gamble, Kimberly-Clark
publication date: Oct 23, 2017
author/source: Brian Nelson, CFA
We love the business models of consumer staples, but recent fundamental performance hasn’t been great, and valuations are a bit stretched. Unilever is blaming natural disasters in the US for its underlying sales growth shortfalls, Procter & Gamble has to deliver now that it defeated Nelson Peltz, and Kimberly-Clark’s meager top-line expansion may not support its valuation. A good business does not always make a good stock.
By Brian Nelson, CFA
Consumer staples stocks (VDC, FSTA, XLP) are fundamentally-sound entities that sell everyday items that consumers need regardless of the ups and downs of the economic cycle. That makes their business models quite resilient through thick and thin, but it also means that many are household companies that everybody knows about, making investment opportunities (stock mis-pricings) in them quite rare. Many, however, boast dividend yields in excess of the 10-year Treasury rate (the foundation to price many debt instruments), meaning that certain members in the group can often provide satisfactory income, especially considering that bank instruments--as in savings, checking, or certificates of deposit--are yielding practically nothing this day and age.
Our biggest concern with consumer staples stocks hasn’t been their business models or the name-brand products they sell that boast tremendous pricing power, but rather the valuations of the group. When it comes to stock picking, what you pay for something is often different than what it is worth. Said differently, the price of a stock on the stock exchange is what you pay for it, but the value of the stock is based on the present value of all future free cash flows (including balance-sheet considerations) that it will eventually pay to shareholders. Price and value are seldom the same. At the time of this writing, according to Factset, the average consumer staples stock is trading at over 19 times its forward 12-month earnings, above its 10-year average of 16.3 times, meaning the consumer staples sector as a whole is likely as much as 20% overvalued, if not more – and that’s if stocks don’t overshoot to the downside (in the event of a bear market).
There are three consumer staples equities that reported earnings recently that may help set the fundamental backdrop of the group. You’ve probably heard of them and use a lot of their products, too: Unilever (UN, UL), Procter & Gamble (PG), and Kimberly-Clark (KMB). Unliver’s brands include Dove, Hellman’s, Knorr, Lipton and many others like Ben & Jerry’s and Country Crock. Procter & Gamble’s include Charmin, Tide, Crest, Old Spice, and Febreze, among others like Head & Shoulders and Mr. Clean. Kimberly-Clark is probably best known for its Huggies, Kleenex, Cottonelle, Scott, and Kotex brands. These companies are three of the biggest players in the consumer staples sector. Walking through their respective calendar third-quarter results will offer perspective on the operating environment of late.
Unilever Says Turnover (Sales) Impacted by US Storms
M&A talk involving Unilever has been quite abuzz of late. Kraft Heinz (KHC) recently shot down the idea of making a second bid to acquire Unilever in September, according to the New York Post. If Unilever doesn’t want to be taken over, Warren Buffett, who owns more than a quarter of Kraft Heinz, will have none of it. He is not one to make hostile overtures. Something tells us that Unilever may be more open to talks once this bull market ends, the timing of which is the only uncertainty from where we stand. Unilever has also been talked about as an acquirer, with Estee Lauder (EL) potentially identified as a good fit and even Colgate-Palmolive being talked about as of interest. Something on the M&A front is going to happen with respect to Unilever in the coming years, in our view, so stay tuned.
The company’s ‘Trading Statement Third Quarter 2017,’ released October 19, showed some trends to keep an eye on. Turnover decreased by 1.6% in the third quarter, as currency headwinds of 5.1 percentage points tore into the top line performance. Management noted that “conditions in…developed markets remain challenging,” and while it pointed to “poorer weather in Europe compared with last year and natural disasters in the Americas” as temporary reasons for the weak growth in the period, we’ll have to wait and see whether something more concerning is brewing.
In any case, for the full-year, Unilever continues to expect underlying sales growth within the 3-5% range on improving underlying operating margins of 100 basis points (underlying sales growth was 2.6% in the third quarter, below the yearly target). Many have been taken aback by Unilver’s recent three-second diversity video ad (#BoycottDove), and while we think the Dove brand will eventually recover, the brand may feel some impact in the last quarter of 2017. Unilever’s next quarterly dividend is payable in December 2017 (€0.3585 per Unilver N.V. share and £ 0.3199 per Unilver PLC share; US$ 0.4217). We maintain our view that shares of Unilever are overpriced on the basis of our fair value estimate.
Procter & Gamble Holds the Line
We continue to like the fundamental business model of Dividend Growth Newsletter portfolio idea Procter & Gamble, but as with many of its consumer staples brethren, shares are a bit pricey. Here’s what we said about P&G last August, “Procter & Gamble Is No Gamble:”
In the past, we were worried about Procter and Gamble’s business transformation where it shed many well-known brands rather quickly, but we think our worries were overblown--if the company’s share-price performance is any indication. The company wrapped up fiscal 2017 results July 27, and frankly, the results were solid. Both the top line and operating income advanced over fiscal 2016 results, and net earnings from continuing operations approached levels that were once were a function of higher revenue performance.
P&G’s net income margin, for example, hit 15.7% in fiscal 2017, steadily increasing from 11.7% in fiscal 2015, and up from the 14.3%, 14%, and 12.1% marks set in fiscal 2014, fiscal 2013, and fiscal 2012, respectively. Clearly, we were underestimating P&G’s ability to execute its transformation plan, but we sure are happy to have still included the idea in the Dividend Growth Newsletter portfolio. Letting winners run has proven to be a fantastic component of the Valuentum approach during this prolonged, multi-year market upswing.
P&G recently beat activist investor Nelson Peltz bid for a board seat, by what appears to be less than a percentage point, and we now think the P&G executive team has its work cut out for it. Having won over the loyalty of its shareholder base, it now has to deliver in a big way. If it were us, why not give Nelson Peltz a board seat? What does P&G have to lose by receiving varying perspective and new ideas to keep the company going in the right direction? Perhaps there is more to hide than there is to gain? We, outsiders, can only wonder. P&G’s calendar third-quarter results (its fiscal first quarter) were about in line with what we were anticipating, despite operating in what management described as “a decelerating global market and against a strong base period.” The company’s outlook for fiscal 2018 was maintained:
P&G said it is maintaining its guidance for organic sales growth in the range of two to three percent for fiscal 2018. The Company estimates all-in sales growth of about three percent for fiscal 2018, which includes a neutral to half-a-percentage-point benefit to sales growth from the combined impacts of foreign exchange, acquisitions and divestitures.
The Company also maintains its expectation for core earnings per share growth of five to seven percent versus fiscal 2017 Core EPS of $3.92. P&G noted that it is maintaining estimates despite over $100 million of incremental commodity cost headwinds resulting from the hurricanes that impacted the Gulf Coast in September. All-in GAAP earnings per share are expected to decrease 26% to 28% versus fiscal year 2017 GAAP EPS of $5.59, which included a significant benefit from the Beauty Brands transaction that was completed in October 2016. The fiscal 2018 GAAP EPS estimate includes approximately $0.10 per share of non-core restructuring costs.
We continue to include Procter & Gamble as an idea in the Dividend Growth Newsletter portfolio on the basis of its strong brand, healthy free cash flow generation, and solid dividend. However, as with most of its consumer staples peers and many in this frothy US stock market, P&G’s shares aren’t really a bargain--and there's not much of a catalyst for shares on the horizon (given the Peltz defeat). P&G remains a potential source of cash in the Dividend Growth Newsletter portfolio.
Kimberly-Clark’s Valuation Is Stretched
We talked a lot about our concerns about consumer staples stock valuations in our August piece titled “Coca-Cola, Pepsi, Kimberly-Clark: Great Businesses But Lofty Earnings Multiples and Net Debt Positions,” and not much has changed given the recent move in the stock market higher since then. The crux of the piece is that the top line of many consumer staples equities just isn’t growing fast enough to justify the earnings multiples they are being given, particularly as much of their bottom-line enhancement is being driven by lower-quality and largely unsustainable cost cuts (a company can’t cut costs forever). We saw the paltry top line performance in Kimberly-Clark’s third quarter report, released October 23, with sales basically rising “slightly,” which we estimate at less than 1%.
As with Unilever and Procter & Gamble, Kimberly-Clark also said that it is operating in a “challenging environment.” Given the many years of the current economic expansion and where consumer wealth levels are as a result of the stock market rise, the times today may be the best these consumer staples entities may see for some time. We’re just having a hard time believing that the current market environment is “challenging” or “difficult.” Nelson Peltz and his bid for a board seat at Procter & Gamble likely reveals the disgust many investors are feeling, if they aren’t talking about it. Kimberly-Clark’s outlook is essentially in-line with what we’re modeling:
The company continues to expect that full-year 2017 net sales and organic sales will be similar, or up slightly, year-on-year. The company also continues to anticipate that full-year 2017 earnings per share will be at the low end of its target range of $6.20 to $6.35.
With Kimberly-Clark’s shares trading at 18 times current year earnings at the low end of the guided range, it’s hard to say the company’s equity is a bargain. We have no qualms with the health of the dividends of Unilever, Procter & Gamble, and Kimberly-Clark, but the valuations of all three remain stretched, in our view. Investor caution is always warranted, stocks don’t always go up forever, and valuation matters. The bull market is hiding a lot of weak fundamentals, in our view, and it may not be long before investors start paying more attention to the price-to-fair value equation, especially if interest rates hit the all-important inflection point, which we estimate near 4% on the 10-year. It may be some time yet, however.