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Kimberly-Clark: Great Business, Expensive Stock

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About: Kimberly-Clark Corporation (KMB)
by: Patrick Doyle
Patrick Doyle
Long/short equity, long only, Growth, momentum
Summary

I think the market for this stock is a mirror image of what it was in April 2018 when I last wrote about the shares. We're now excessively optimistic.

The shares reflect the great management and great business, and so I think investors who buy today will underperform in future.

For those who are too impatient to wait for shares to drop, I offer what I think is a win-win options trade.

Since publishing my bullish piece on Kimberly-Clark (KMB) in April of last year the shares are up about 27%, versus a 16% return for the S&P500 over the same time period. While this is gratifying on some level, I think it's worth looking in on the name to see if it's worth buying more at these levels. After all, a stock that's trading at $127 is much more risky than the same stock when it's trading at $100. For those who can stand neither the suspense nor my writing, I'll come directly to the point. I would avoid buying the shares at these levels, and will be taking profits in mine. Before offering the reasoning behind this change of heart, I think it would be enjoyable to look at Wall Street's record on this name since I wrote my bullish piece. After poking fun at Wall Street, I'll go through my reasoning for selling by looking at the financial history here and by looking at the stock as a thing distinct from the business. I'll also offer an options trade as an alternative to waiting for shares to drop. In sum, I think remains a wonderful business, with a great management team. My worry is with the valuation. In a sense, the world we now inhabit is a mirror image to the world of my first article here. The market has done a polarity shift from pessimistic to optimistic on these shares and that's troublesome in my view.

Can We Use Wall Street As a Contra Indicator?

I'm skeptical of Wall Street analysts for a host of reasons, and I think investors would be wise to compare analyst prognostications with subsequent results, in order to try to ascertain which analyst is least bad. When I examine the analyst field in this case, I'm left to wonder at why we listen to these people at all. In this section of my note, I'll examine the analyst headlines we've read about this stock since I published my bullish piece in April 2018. To summarize, of the seven analysts who commented on this name since I wrote about them, one posted a recommendation that went on to be profitable. The others either missed the boat completely (I'm looking at you, Goldman Sachs) or put on a buy so late that the shares have underperformed the S&P 500 since the change of heart. The following is the analyst walk of shame on this name.

  1. In April of 2018, shares of Kimberly Clark were under pressure because the market fretted about some pricing pressure from P&G, and Morgan Stanley downgrading Clorox (CLX). Shares of Clorox are up about 16% since the Morgan Stanley downgrade.

  2. In August of 2018, JPMorgan upgraded Kimberly Clark to neutral from sell. While they were very late to the party, and this was hardly a ringing endorsement, JPMorgan at least demonstrated the capacity to acknowledge some bright spots (in that case price increases).

  3. In October, 2018, Goldman Sachs at first "cooled" on KMB. Two days later, the firm posted a "sell" rating on the shares. The stock has rallied ~17% since then. That's a spicy meatball!

  4. In January of this year, JPMorgan turned positive, moving to an overweight rating ahead of the next earnings announcement. The shares are up 15% since then. As far as I can tell, this is the one "good" call to come out of Wall Street on this stock since April of 2018.

  5. In January of this year, BAML highlighted the "wide profit miss off weak operating income." At that point, the firm was neutral on the shares.

  6. A full year after I posted my article, both Macquarie and Argus upgraded the shares. The shares are up about 4% since, versus a 5% increase in the S&P500.

  7. Two months ago, BAML joined the party and lifted KMB to a buy from neutral. The shares are down about $11 since then.

  8. Late last month, Deutsche Bank moved from "sell" to "hold" on the shares. Perhaps we should be worried when these people start to get a bit optimistic.

Financial Snapshot

A quick review of the financial results here indicates that this is a somewhat cyclical company. Both revenue and net income have risen and fallen, but never egregiously, since 2013.

What I like most about this business is that management has a great track record of controlling what they can control to treat shareholders well. Specifically, in the teeth of these fluctuating conditions, management has returned just over $14.8 billion to shareholders since 2013. Approximately $6 billion of this was in the form of stock buybacks, and the balance was from ever rising dividend payments. I consider shareholder friendly management a necessary precondition to make an investment, and on this score, Kimberly Clark doesn't disappoint.

In my prior piece, I expressed some worry about the capital structure here, but it seems that debt is being paid down at a reasonable rate, and there's little reason to worry about a credit or solvency crisis here anytime soon.

In my view, the most interesting aspect of the financial results is a comparison of the first nine months of this year with last. Specifically, in the first nine months of 2019, "cost of product sold" dropped $324 million, and "marketing, research & general expenses" dropped $204 million. These changes caused operating profit to balloon by ~$650 million in the first nine months of 2019 relative to the same period a year ago. The company saw input cost deflation for the first time in 3 years during the quarter just ended.

This has caused the company to offer upbeat guidance on the year. According to the CEO on the 3rd quarter conference call

Turning to the full year, we're raising our outlook on both the top and bottom line. Our revised organic sales growth target is 3% to 4% which compares favorably to our prior target of 3%. While we're up 4% year-to-date, the fourth quarter is our toughest quarterly comp of the year. That said, we expect a solid fourth quarter which should bring the full year well within the 3% to 4% range. On the bottom line, we're now targeting adjusted earnings per share of $6.75 to $6.90 that's $0.10 per share higher than our prior outlook.

Source: Company filings

Thus, I think investors will start seeing positive earnings surprises here, and management will continue to treat shareholders very well.

The Stock

It's obvious that I like Kimberly Clark a great deal. The problem is that investing well is about much more than simply finding a company like this and buying at any price. If you were that sort of investor, you might end up as an analyst working 18 hour days at BAML (sorry, couldn't resist). At least as important as the quality of the underlying cash flows is the price that we pay for those cash flows. An investor who buys this company at $95 will by definition enjoy a much better long term return than someone who buys at $132. For that reason, we need to look at the price we're being asked to pay and see if it's worth it or not. I particularly want to ask 'to what extent does this share price reflect excessive market optimism?'. If the market is excessively optimistic, the shares will drop when the company inevitably disappoints, and so I want to eschew optimism. I generally review optimism in a few ways. First, I look at the ratio of price to a measure of value (like earnings or free cash flow).

In my previous article I made much of (some would say "went on about") the fact that Kimberly Clark was trading at a multi year low valuation of 18 times free cash flow. I liked that valuation because I suspected that the multiple would mean revert and grow. It has since done, and is now trading near multi year highs per the graph below. This is the mirror image of what I encountered when last looking in on this name.

ChartData by YCharts

Source: Ycharts

I also track optimism by unpacking the assumptions embedded in the current stock price. I do this is to see whether the market is excessively optimistic or pessimistic about the future of a given company. Again, I want to avoid shares in companies that the market is excessively optimistic about. The way I determine the assumptions the market is acting under is by employing the methodology outlined in Professor Stephen Penman's book "Accounting for Value." In this work, Penman describes how an investor can use a standard finance formula to isolate the "g" (growth) variable and unpack what the market must believe about the future of a given company. According to this methodology at least, the market seems to be assuming that Kimberly Clark will grow at about 5.4% in perpetuity. I consider this is shade optimistic, given the history here.

Options to the Rescue

I think the shares of this great company are overvalued by about 20% at the moment. This puts investors on the horns of a dilemma. They can either wait for shares to drop to the $105-$110 range (boring!) or they can generate some option income immediately by selling puts. In my opinion, the latter is the preferred approach, given that it creates a "win-win" trade for the investor. If the shares continue to rise of flatline from these levels, the investor simply pockets the premium and moves on. This is obviously an acceptable outcome. If the shares drop to a more reasonable price, the investor is obliged to buy, but they do so at a much lower price, which is, by definition superior to simply buying today.

My current favorite short puts are the April 2020 Kimberly Clark puts with a strike of $110. They are currently bid-asked at $1.10-$1.85. If the investor simply takes the bid on these puts, and is subsequently exercised, they'll be obliged to buy the company at a net price ~17% below the current level. At this price, the dividend yield climbs to 3.78%.

Conclusion

I (still) think Kimberly Clark is a great company. The things the market was fretting about (input inflation), are starting to improve, and this is driving performance improvements like what we've seen so far in 2019. In addition, management continues to treat shareholders very well, having returned massive sums to them in the form of stock buybacks and ever growing dividend payments. In addition, the debt overhang that I fretted about in my first article is being paid down at a reasonable rate in my view. There's nothing at all wrong with this business. My problem is that the stock market has gotten wind of the improvements at Kimberly Clark and has now driven shares to unreasonable levels. I think long term returns are a function of the price you pay for a given business, and I think the long term return potential from these prices is not favorable. For that reason, I must recommend that investors take profits in this great business. Finally, just because the shares are overpriced, doesn't mean the investor need simply wait for them to return to a lower price. I think put options offer investors a "win-win" trade at these levels. If the shares continue to rally or flatline, the investor wins with premium. If the shares drop and the investor is obliged to buy, they win by buying at a price that offers a much better chance at great returns going forward.

Disclosure: I am/we are long KMB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Although I'm long the stock as of this writing, I'm about to sell the shares. Additionally, I will be selling the puts mentioned in this article.