Did Goldman Sachs Flub Its Kimberly-Clark Rating?

 |  Includes: GS, KMB
by: Low Sweat Investing

I found a bottle with a message in it once. It washed up on a beach where I was walking. I opened the bottle. There was a piece of notepaper inside, with scribbling.

It read:

“Disregard last message”

That also seems to be the theme of Goldman Sachs’ (NYSE:GS) bobbing research notes about Kimberly-Clark (NYSE:KMB).

Last month, GS cut KMB to a sell rating, with a price target of $60. After the downgrade, KMB slipped about a buck to just under that magic number. Getting their sea legs, GS promptly scrawled a new note, sinking KMB all the way to a “Conviction Sell” (whatever that is) and dropping the price target to $57.

So KMB promptly went up a couple of bucks.

Fun to watch, sure, but more fun still is the story behind the shifting sell ratings and springtime stock squiggles.

It turns out the GS broadsides are mostly a tangled debate about how KMB’s earnings might be affected by the price of pulp, a crucial and costly commodity for paper product manufacturers.

Here’s the tale, told from the beginning, with a twist at the end. Because maybe the coming tide is set to carry KMB’s stock even higher, not lower as GS suggests.

In January, KMB said “input costs,” including pulp, would show “significant” inflation this year. The company figured this into its outlook, saying it believed rising pulp prices would be offset by other cost cuts and by cash flow increases.

Based on all this, KMB’s 2010 earnings guidance was $4.80 to $5.00 per share, up 6% to 11%, equaling or exceeding the company’s long-term growth target.

Sounds good, especially because Aristocrat KMB likes to raise its hefty dividend right alongside earnings.

But in early March, GS declared pulp prices were headed higher than KMB thought. So GS cut its estimate by a whole penny, to $4.89, and issued the initial “sell,” apparently calculating the stock might drop all the way to where it already was. About $60. (Or maybe it just wasn’t supposed to go up.)

Anyway, after that things really got goofy.

KMB was scheduled to update analysts on earnings, costs and pulp pronouncements in late March, about three weeks after that initial GS sell rating.

So just before that scheduled KMB update, GS peered into its pulp price crystal ball again, saw even worse numbers and scribbled their “Conviction Sell,” reckoning KMB was about to tell analysts that pulp would pummel earnings.

So guess what KMB said in their update?

You got it. Yes, pulp prices were going to be higher than first estimated. (Score one for GS.) But other cost cuts would offset them. (Oops.) And earnings guidance was not changing. (“Conviction Oops.”)

In a follow-up interview, KMB’s CEO said pulp’s new price jump was partly caused by a temporary supply interruption from the Chile earthquake, though if pulp continued its upward price trend, KMB would have to consider passing along the costs to consumers.

People who know me best know I could talk about Wall Street and pulp all day long.

But let’s take a break and move on to some KMB valuation, growth and dividend numbers instead, just to be conversational. Because I think those numbers might tell long-haul investors this stock is more likely to go up than down.

First, KMB valuations are still low compared to their historical levels, so there aren’t a lot of expectations built into the price.

And KMB still anticipates sales growth of 3% to 5% and middle-to-high single-digit earnings growth, through 2015.

The stock yields about 4.2%, and KMB reiterated it will increase its dividend with earnings growth, and it is generating the cash flow to do it.

So here’s the twist, with no crystal ball or market moving pulp prediction.

If KMB’s stock stays stuck where it is or drops, dividend bumps will keep lifting its yield further and further above 4%.

But KMB’s business is growing, its payout ratio is about 54% and Morningstar grades the company ‘A’ on both Financial Health and Profitability. Its return on equity is 35%. And going into the 2008-2009 downturn, KMB’s dividend yield was typically around 3%.

So it seems to me KMB dividend increases might begin hoisting the stock price upward, pushing the yield back down to a more ‘normal’ level. KMB is too good a business for its dividend increases to balloon the yield to abnormal levels.

That said, the stock certainly isn’t for every investor, and I take the point the GS pulp masters are making. Costs matter. And slow growers who need to cut costs to boost profits are vulnerable if costs spike.

Overall, KMB is indeed a slow growing steady-eddie cost cutter, not a skyrocket. Total returns averaged something like 4% annually over the past 10 years (the S&P 500 was negative). So pulp paranoids and those investors looking for capital growth in a budding economic recovery should look somewhere else.

But what about long-term investors looking for a solid business with a growing dividend, and who can find other things to worry about besides the price of pulp? Those investors might check out KMB. Just don’t tell GS I said so.

For investors who prefer ETFs to individual stocks, several dividend ETFs include KMB in their top 25 holdings. These include the SPDR S&P Dividend ETF (NYSEARCA:SDY), a portfolio of high-yielding Dividend Aristocrats, and the lower-yielding Vanguard Dividend Appreciation ETF (NYSEARCA:VIG), a subset of Dividend Achievers screened for high quality businesses.

Finally, for a stock with a more moderate yield than KMB, but more growth potential, check out my Seeking Alpha article, “Darden Restaurants: Sweet Growth, Tasty Dividend” (NYSE:DRI).

References and Links

Seeking Alpha, “Kimberly-Clark Corporation Q4 2009 Earnings Call Transcript,” January 22, 2010.

The Street, “Sell Kimberly-Clark Stock: Goldman Sachs,” March 2, 2010

StreetInsider.com, “Goldman Sachs Added Kimberly-Clark (KMB) to their Conviction Sell List,” March 16, 2010.

Press Release, “Kimberly-Clark Reviews Global Business Plan Progress and Long-Term Objectives Through 2015 at Investor Meeting,” March 22, 2010

CNBC, “Mover Of The Day: Kimberly-Clark, Interview with CEO Thomas Falk,” March 22, 2010.

Morningstar, “Kimberly-Clark Quote Page,” March 2010.

Disclosure: Long DRI, KMB