Kimberly-Clark, maker of the iconic Kleenex tissues and Huggies diapers (or nappies – depending on where you’re reading from), reported earnings for the final quarter of 2018 yesterday. The result was weak, and we weren’t surprised. But it was the devil in the detail that sparked a lively conversation here in our New York office. In this piece I want to share two examples of “misperceptions” that sparked the interest of Amit, our Senior Research Analyst, and myself.
Another branded household goods company remains challenged
Montaka investors and followers of our memos and missives will know that we have been short several branded consumer and household goods companies for some time now. Our team published a whitepaper in July last year which described the challenges that the broader industry is facing, and the pressure this is creating on the top-lines and profitability of the owners of many iconic brands. You can find a copy of that publication here: https://montaka.com/whitepaper-how-to-profit-from-market-myths/ . Kimberly-Clark is one such business.
So, when Kimberly-Clark reported that sales in the fourth quarter of last year had declined (again) by 1% compared to the same period the year before, and that operating profits were down by 23%, we weren’t exactly surprised. Chief Executive Officer Mark Hsu explained that a “challenging macro environment” weighed on sales, and profit margins were driven down by “significant commodity inflation and currency volatility”. We had suspected these challenges, combined with persistent soft category sales trends and heightened competition – from the formidable Procter & Gamble, as well as private label – would make life difficult for Kimberly-Clark for the foreseeable future. This was always key to our short thesis.
However, there was more to the result that meets the eye. As we followed the earnings release, we noticed management’s interesting presentation of two significant financial items: cost-savings related to a restructuring program, and organic sales. Let’s take a look at each in turn.
Misperceived benefits of a restructuring program
In January 2018, Kimberly-Clark embarked on a restructuring program (aptly named the “2018 Global Restructuring Program”) with the aim of reducing the company’s cost base and improving the ability to invest in its brands and products. To implement the program management estimated that the company would incur charges of US$1.7 to US$1.9 billion through the end of 2020. That’s a lot of money, representing almost a full year of operating profits for Kimberly-Clark, but management expect the program will reduce annual running costs by US$500 to US$550 million. Put simply the spend on the program has a pay-back period of less than four years, after which Kimberly-Clark shareholders will be better off by half a billion US dollars every year for the rest of time. Sounds good, right? Not so fast.
The problem we have with this presentation is that it creates a misperception that the restructuring program should be wildly valuable for equity owners. However, it fails to provide an estimation for the reinvestment, or reallocation of costs, required by the business. In fact, the company announcement explicitly referred to the program freeing up money for additional spend elsewhere. The question for management is how much of the saved costs fall through to the bottom line?
Given the intensity of competition and the slow industry growth we think there is a high likelihood that all or more of these cost saves need to go back into the business. And rather than generating additional sales, they will be needed just to have a chance at maintaining the existing level of business. If this is indeed the case the cost of the restructuring program needs to be recognised as a capital outlay with almost no return, or an expense. Said another way, Kimberly-Clark shareholders need to pay up US$2 billion just to stay in the game, without necessarily improving profits or increasing sales. It gets a bit worse.
Recurring non-recurring items
When management presents its financial accounts, the earnings are presented on a GAAP (generally accepted accounting principles) basis which includes a charge for the costs incurred as part of the restructuring program. Fine. However, this statement of accounts is a few pages back in the press release. Less fine. And it’s the “adjusted” earnings, which exclude any cost associated with the restructuring program (US$180 million in the fourth quarter, for what it’s worth), that are found in the bullet points of the Executive Summary. Not fine.
Then, whenever the GAAP operating profits are mentioned they are always qualified by an immediate presentation of the equivalent measure excluding restructuring costs. As if they are one-off in nature. This may be the case. But there is a strong chance that in a couple years another restructuring program is required to find costs that can be eliminated, to fund “investments” that probably won’t lead to higher sales or profits. In that case the restructuring charges would paradoxically have become “recurring non-recurring” charges. And any add backs to the GAAP accounts miss these real and ongoing economic charges – which could account for several hundred million dollars in this case and a meaningful percentage of earnings and value.
Montaka’s short book seeks to gain from businesses that are challenged, overvalued and misperceived. It’s often easy to see why we think a stock is structurally weak or trading at a high price in the market, but accounting misperceptions by their nature aren’t so obvious, even if they do represent a meaningful reduction in shareholder value.
Christopher Demasi is a Portfolio Manager with Montaka Global Investments.
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