Kimberly-Clark Corp (KMB) — Q3 2017 Earnings Call Transcript

Thank you, and good morning, everyone, welcome to Kimberly-Clark's Third Quarter Earnings Conference Call. With us today are Tom Falk, Chairman and CEO; Mike Hsu, President and Chief Operating Officer; and Maria Henry, our CFO. Here's the agenda for our call. Maria will start with a review of third quarter results. Tom will then provide his perspectives on our results and the outlook for the full year. And we'll finish with Q&A. As usual, we have a presentation of today's materials in the Investors section of our website. As a reminder, we will be making forward-looking statements today. Please see the Risk Factors section of our latest annual report on Form 10-K for further information. And lastly, we'll be comparing our 2017 results to 2016 adjusted results, which exclude certain items described in this morning's news release. And now I'll turn it over to Maria.

Thanks, Paul. Good morning, everyone, thanks for joining the call today. Let me start with the headlines for the third quarter. We continue to deliver earnings growth and returned to positive sales growth territory in a challenging environment. We achieved excellent cost savings and reduced our discretionary spending, and we returned significant cash to shareholders. Now let's look at the details, starting with sales. Our third quarter net sales were $4.6 billion, up 1% year-on-year. Organic sales rose slightly, and Tom will provide more color on our top line in just a few minutes. On profitability, third quarter gross margin was 35.8%, that's down 60 basis points as input cost inflation and lower pricing more than offset our strong cost savings. Commodities were a $115 million drag in the quarter, and we now expect full year inflation will be slightly above our previous estimate of $200 million to $300 million. This outlook includes somewhat higher cost estimates for pulp and polymer resin. Helping to offset that inflation, our teams continue to deliver significant FORCE cost savings, with third quarter savings of $125 million. Moving down the P&L. Between-the-lines spending was down 60 basis points year-on-year. As we mentioned on our earnings call in July, we're tightly managing overhead and discretionary spending in this environment. Our third quarter operating margin was 18.4%, up 20 basis points year-on-year. I'm encouraged with the margin improvements we achieved in our Personal Care and K-C Professional business segments and in the developing and emerging markets overall. On the bottom line, third quarter earnings per share was $1.60, up 5% year-on-year. Lower equity income reduced earnings by about $0.03 per share, offset by a slightly better effective tax rate worth about the same amount. Now let's turn to cash flow. Cash provided by operations in the third quarter was $805 million and in line with our expectations. Cash flow in the year-ago quarter was $948 million and included very strong working capital improvements. Our third quarter 2017 working capital cash conversion cycle was down 6 days compared to full year 2016. I'm pleased that our teams continue to make good progress in this important area. We're also managing capital spending even more tightly in this environment, and we expect that full year spending will be slightly below our $850 million to $950 million target range. On capital allocation, third quarter dividend payment and share repurchases totaled more than $500 million. We expect that the full year dividends and share repurchases will total $2.3 billion. That number includes $900 million of expected share repurchases. Looking at the segment results. In Personal Care, organic sales fell approximately 2%. Organic sales were up 3% in developing and emerging markets but down elsewhere. Personal Care operating margins were 20.8% and up 100 basis points. The improvement was driven by cost savings and reduced between-the-lines spending. In consumer tissue, organic sales were up 2%, driven by North America. Consumer tissue operating margins were solid at 17.1%, although down 100 basis points. The results were impacted by higher input costs, mostly in pulp. In K-C Professional, organic sales in the quarter were up 2%, with gains in all major geographies. K-C Professional operating margins were strong at 20.9%, up 130 basis points. That comparison included benefits from both sales growth and cost savings. In summary, we continue to grow earnings in a difficult environment, we are tightly managing costs, working capital and capital spending and we continue to allocate capital in shareholder-friendly ways. I'll now pass the call over to Tom.

Thanks, Maria, and good morning, everyone. I'll give you some more detail on our top line sales and market conditions, and then I'll address our outlook for the balance of the year. Looking at the third quarter, our organic sales were up slightly year-on-year after being down about 1% in the first half of the year. Volumes in the third quarter increased more than 1%, while net selling prices fell about 1%. But overall, it's challenging to find growth right now in several of our large markets. So looking at some of those key markets. In North America, conditions remain relatively difficult, including elevated competitive activity. In the consumer categories that we compete in, the total market did grow by about 1% in the third quarter, and that's 1 point better than that same category grew in the first half of the year. In our consumer businesses in North America, organic sales were similar year-on-year after being down 3% in the first half of the year. Volumes rose 1%, led by our consumer tissue and adult care brands. On the other hand, net selling prices fell 1% as a result of competitive activity and some of the fine-tuning of our promotion strategies that we mentioned on our earnings call in July. Looking at our individual businesses in North America. Personal care volumes were off 1%. In the infant and child care mega category, our volumes were down mid-single digits in a continued challenging environment. Now we expect better performance in the fourth quarter as comparisons ease and we have more promotion and other brand activities planned. Volumes increased high single-digits in adult care in the third quarter. Our Poise and Depend brands benefited from category growth, increased marketing and promotion support, and innovations that we've launched behind these 2 brands over the last 12 months. Consumer tissue volumes in North America increased by 5% and rebounded nicely following a difficult first half of the year. We benefited from a stronger promotional calendar, good merchandising execution and our comparison to a soft performance in the year-ago period. Turning now to our K-C Professional business in North America. Organic sales rose 2% in the quarter. That was driven by volume growth of 3%. Volumes were up in all major product categories as our team is executing its growth strategies well in a relatively sluggish market. Switching to developed markets outside of North America. Organic sales were down 3% in the third quarter. All of that decline was driven by South Korea, including in diapers, where category conditions are challenging as a result of a significant decline in the birthrate in that country. Moving to developing and emerging markets. Organic sales were up 3% in the third quarter, including volume growth of 4%. Looking at some of our key markets there. In Brazil, organic sales in personal care were similar year-on-year. Our volumes continue to grow with benefits from innovation across the portfolio. Selling prices came down, though, as we adjusted to the stronger Brazilian real and competitive activity. In China, organic sales in personal care were up mid-single digits with strong double-digit growth in feminine care. Our Kotex brand in China is benefiting from product innovation and our focus on the premium end of the market. Organic sales in diapers in China were similar year-on-year. Product mix improved while volumes and selling prices were down as comparisons were impacted by very strong growth last year and competitive activity this year. Diaper pricing continues to be less negative this year than it was last year. And going forward, we will continue to focus on driving winning product solutions on Huggies in China. In Argentina, organic sales in personal care were up strong double digits, driven by higher selling prices. Huggies diapers volumes continue to grow somewhat even though the category demand in Argentina is still down. And then lastly, in Eastern Europe, organic sales in personal care increased high single digits. Our volume momentum continues in this part of the world as we achieved another double-digit increase this quarter on both Huggies and Kotex. Selling prices declined in Russia and Eastern Europe, mostly reflecting price rollbacks following the strengthening of the Russian ruble. I'd also like to mention at the end of the third quarter, we purchased the remaining 50% of our joint venture in India. Although the categories in India are small today, we're optimistic about the long-term growth potential in this country. And then finally, I'll briefly build on Maria's financial review to say that I'm encouraged with our team's accomplishments on our FORCE cost-savings program, the way we've managed our overhead spending this year, especially in the third quarter, and then our working capital and capital allocation. Now I'll turn and cover our outlook for the balance of 2017. As we mentioned in this morning's news release, we're confirming our previous full year 2017 targets. We continue to expect that sales will be similar or up slightly year-on-year. Given results through 9 months, it's more likely that organic sales will be similar for the full year. On the bottom line, we continue to expect that earnings per share will be at the low end of the $6.20 to $6.35 range. As Maria noted, our commodity inflation estimate has increased somewhat from 3 months ago. On the other hand, we've reduced our discretionary spending plans for the year. In addition, our outlook for currency rates and the effective tax rate has improved slightly. So in summary, we're focused on competing effectively in the near term, we're executing our Global Business Plan strategies for long-term success and we're optimistic about our opportunities to deliver attractive returns to shareholders. That wraps up our prepared remarks, and now we'll begin to take your questions.

I have a few questions. One is if you can talk about kind of the recent top line organic results you delivered in the context of the longer-term 3% to 5% organic range, and what you see is the gaps, whether it be particular geographies or particular business units that you need to close and, I guess, your comfort with that. That's the first question.

Yes, sure. I think a couple of comments, first on overall category growth. When you've got the birthrate going negative in big markets like the U.S. and major negative in South Korea, we'd guess the birthrate's down 7% to 9% year-to-date in Korea, which we have a hard time explaining to be honest, and don't think that's sustainable. On the other hand, it is what it is and those babies aren't born this year and they won't be in the category next year or the year after that. So category weakness is certainly there in a couple of big markets. And then we had negative 1 price, which is pretty similar in the first half and the third quarter as you had pricing that went in as a result of currency in some places like Russia and Brazil last year that's coming out as those currencies have turned around and a generally more competitive price environment, even in markets like the U.S., as the same number of competitors are chasing lower growth or lower category. So we still think the 3% to 5% is the right long-term growth opportunity. We've got good growth as emerging markets develop. But I'd say, certainly this year, that has been tough to go find.

Considering all the factors at play, do you believe they will improve in 2018, or do you have no clarity on that? It seems quite challenging to approach the 3% to 5% growth range, even for next year.

Yes, we will provide our 2018 guidance in January. However, I agree with your intuition that we are not expecting a quick recovery. The babies not born this year will not contribute to the diaper market next year either. Additionally, it seems that millennials are having children later, which may be impacting this situation. We are also considering other factors in Korea that might be affecting it and thinking about the future recovery path. Overall, I anticipate that 2018 will be another challenging year for growth, and that's what we are currently preparing for.

And then just if I may, just the last question. Given what we're seeing on private-label trends, what's your stance on manufacturing private label for other retailers than Costco? For example, Amazon.

Yes, we do, do private label for a number of retailers and across several categories and have for a long, long time. We don't usually talk about it very much, and it is a very small part of our business. It's less than 5% of our overall sales.

And nothing in particular about the e-commerce channel in regards to private label?

I think there isn't much private label in e-commerce today. Therefore, we are really concentrating on developing our branded business and e-commerce across our categories, especially in key markets around the world like China and Korea, where it has experienced significant growth. That’s where much of the category activity is occurring.

Can you discuss your decision to aggressively reduce spending? While it's commendable that you've maintained your profit margins in a challenging environment, I assume there are some drawbacks to operating leverage and that costs are rising. When you mention cutting discretionary spending, how much more can you afford to cut? Additionally, could you address the idea that if you spent less, would it potentially enhance your organic top line growth? Please share your thoughts on this, considering the difficulties many markets are currently facing.

Let me provide you with a few key points before Maria shares more details. Firstly, there has been a shift away from advertising and digital couponing that might not be immediately visible to you. The value of digital coupons reduces gross sales to arrive at net sales, which impacts our price calculations in the analysis of sales changes. Therefore, part of the negative impact on price is due to increased digital coupon usage and a slight decrease in our advertising spend. Additionally, with low birthrates in markets like the U.S. and Korea, simply increasing advertising might not effectively stimulate demand in the category. While it could help in gaining market share, in the current environment we recognize the necessity of being competitive on price, leading us to invest a bit more in that area. The cost-cutting measures we are implementing are typical belt-tightening actions during a challenging year, but I'll let Maria elaborate further on our approach to this matter.

Yes, I just follow on Tom's comments that on the growth-oriented investments that we make, we pay a lot of attention to what the ROI is on those investments. And we continually monitor that to see, are we getting what we're expecting? And then we shift our investment dollars to the highest and best use, where the strongest ROI is, given the competitive environment and the category dynamics. On the overhead spending, that is an area where you always have room on discretionary expenditures. And when the top line is where it is and as we face inflationary pressures, it just makes sense to tighten our belt on discretionary items. And while we hope that all of our spending contributes value, there's a rank order of higher-value activities and lower-value activities. And we just pull back and eliminate the areas that, again, have a lower return to the overall profitability and success of the company. And so it's regular belt-tightening below the line and a really hard look at ROIs on the growth-oriented investments.

Got it. Okay. And then my second question, if I can, is just on China. Because we heard a lot from Procter on Friday about their initiatives in the diaper category, how much they're investing there. Can you just remind us where exactly you are positioned, your portfolio? Are you in the superpremium end? How big is your share maybe in the pants area? I'm trying to assess how much of a threat their renewed focus in that market is on your business specifically.

Yes, Wendy, it's Mike. We're generally balanced, but the premium segment of our business is the one that's growing the most. We have a strong presence in Tier 3, as well as in Tier 4 and 5. The growth primarily comes from the premium side of our operations, which is where we are focusing our efforts. This quarter, our performance in China, as Tom mentioned, was similar to last year. However, we are very confident in our long-term prospects there, as it is the world's largest diaper market. We have an excellent team with advanced technology, and we are pleased with our standing in that market.

Clearly, this is shaping up to be a pretty tough year for you guys, as I think you've conceded, Tom. What I'm trying to do is wrap my head around, parse out, what may be sort of transitory pressure and what may have some more enduring headwinds. I mean, birthrates in the U.S. look like, at some point, they should come back. Input costs obviously ebb and flow, and right now, it's flowing against you. But what stands out in results is really the combination of pricing and cost. I think I've got to take my model back to 2004 to find an environment or a year where you were poised to deliver negative price with cost inflation. And Ali asked the question on private label. We see in the data, it's got momentum and you're flagging competitive intensity just around so many markets, driving some negative price. So my core question is that. Is that here to stay? And if not, why not? Why should we believe that pricing pressure won't be more enduring? And if it is, what are the implications for the margin profile of your business overall?

Those are insightful philosophical questions. I would mention that the Nielsen data may overestimate the private label segment because it does not account for expanding areas of the market, especially e-commerce, where private label presence is minimal at this stage, particularly in the U.S. We did notice a slight increase in private label during the quarter in certain markets, likely related to hurricane relief efforts. For instance, people may choose to buy private-label diapers for donation purposes. However, we will see how this develops as the quarter progresses. In response to your broader question, we believe it is essential to have both successful products and competitive pricing moving forward, and this is unlikely to change. We anticipate significant local and global competition leading to a price-competitive environment, meaning annual price increases may not occur consistently. Mike, do you have anything to add to that?

No, no, I think it is an interesting observation you make, Jason, though, that with the cost inflation, seeing the pricing pressure in some of the markets isn't what you normally see. And so again, I think we're preparing ourselves to operate effectively in that environment and be able to grow profitably in that kind of a marketplace. But obviously, that's not our preference.

Some of the pulp price increase, honestly, if you look at a supply and demand model, you wouldn't have predicted it would be as high as it is. Another forecast suggested that it's going to be higher in 2018. Yet, it is hard to believe that under the supply and demand fundamentals, it will reach that level. It's more challenging to set prices if you're uncertain whether the commodity increase is real and lasting.

First question for Tom and Mike. I wanted to come back to personal care, which came in a little bit shorter than expectations, I think, broadly in the quarter, and just understand what the surprises were to the downside. Because, Tom, I think you talked about birthrates in North America and South Korea, which were already sort of understood going into the quarter, year-over-year comparisons also understood. So was it just the competitive environment that was worse than expectations that drove some of the downside? And if so, why does that necessarily get better in Q4 or even into next year? I'd just like to try to better understand that. And then I have a follow-up.

Yes, I believe the competitive environment has played a significant role. The decline in birthrates, especially in the U.S. and South Korea, has been anticipated for some time and may have turned out to be more pronounced than we initially predicted. The competitive landscape remains quite active, particularly in North America. However, we expect our performance to improve as we approach the end of the year, especially in the U.S. and North America, driven by our revised promotional strategies. We're starting to see some positive changes on the shelves and are hopeful for better results moving forward.

Sure. In terms of our commodity purchases, what we say is that, generally, commodities- and energy-related spend is just under 50% of our cost of goods sold. And then within that, our largest single commodity buy is pulp, which is about 1/3 of that number. That will get you to about our pulp spend for the company. In terms of the inflationary pressures that we see, as I think Tom commented, it is stronger inflation than we were expecting. When you look at the fundamentals of demand and where we are in the cycle, we wouldn't expect it to be as high as it is. There are some supply constraints that seem to be in play here, so we'll have to work through that. The higher inflation is one of the drivers of getting even more aggressive on the overhead cost that we've been talking about in the third quarter. We're fortunate to have very strong performance on our FORCE cost savings delivering $125 million of savings against $115 million of inflation that we saw in the quarter. The teams have done a great job on the FORCE cost savings. We're now at about 4.1% of our cost of goods sold in savings delivery. And that has been up year-on-year for the last couple of years. And the teams continue to expand the lens that they look at to continue to drive productivity in our supply chain. In terms of the exact numbers and expectations on where we think the commodities are going, I'm going to ask Paul to kind of run you through.

Yes, I believe that for the next 12 months, particularly for 2018, we will provide our planning assumptions in detail when we reach January. Additionally, as mentioned, current market forecasts indicate that we should expect inflation again next year.

At some point, if you consider commodity inflation within a range, if it increases sufficiently, we anticipate being able to implement some pricing strategies in response. However, given our current situation regarding inflation and its volatility, it is somewhat challenging to set prices. Historically, after reaching a certain point of inflation, we typically have the ability to adjust prices in the market.

Thanks for that. Just to drill down without asking you guys to put numbers on it. For Maria and Paul, is it fair to say at this point, based on what you know and where spot prices are, that you feel comfortable that the FORCE savings can cover your input cost inflation over the next 12 months?

Well again, I don't want to give a specific number on the outlook. I think our FORCE cost savings, we're in good shape to deliver the guidance that we gave for this year when you look at where we are on a year-to-date basis. I think broadly, we continue to believe we've got room to go on that program as we look forward. So when we come back in January, we will give you our perspective on what we think on the cost savings versus the inflation estimate.

I have a couple of questions. First, I wanted to ask about China. I thought you mentioned that diaper volume there was down this quarter, which I don't recall hearing before. My understanding was that the trend was strong volume with negative pricing, but now you've indicated that pricing has improved. Can you explain the dynamics behind the declining volumes in the diaper segment in China and your outlook going forward? That's my first question.

Yes, volume was down in China, especially in diapers. The mix was favorable. The pricing environment seems to have stabilized compared to the second quarter, aligning with our initial annual assumptions. The decline in volume may be attributed to increased competition in the world's largest market, along with a stronger presence from local Chinese competitors in recent quarters. We likely lost some volume in our mid-tier business compared to our premium offerings. While we are aware of P&G's competitive launch, it hasn't significantly impacted our business at this stage; rather, it's been more about local players gaining traction.

Looking at the situation, our most significant comparison for this year in China volume is against the strong growth we experienced in the third quarter last year. Despite this tough benchmark, we are making progress. The competition remains challenging, but we are pleased with our current activities. Our femcare business in China has seen substantial growth, achieving strong double-digit increases and helping to balance our performance this quarter.

I guess the question, we've been hearing a theme emerging over the past few quarters, at least on all the conference calls, about the local players you mentioned in some of your remarks about China and some things you're seeing in Tier 3 cities. But if you kind of, like, think about the entire world, in Latin America and what these local players are doing, what is different, number one? And why are they gaining share? And number two is how do you address it? I mean, are there organizational design changes you might need to make in order to better address the local consumer?

I’ll start and then let Mike elaborate. In China, when we refer to Tier 3, we're talking about the middle of the category in mid-priced performance, rather than low-end products. A lot of this is driven by e-commerce, which makes it easier to feature products prominently. If consumers try the product, there’s potential to gain market share. We’re seeing more local entrepreneurs offering competitively performing diapers through e-commerce, which helps them gain visibility and initial trials. It’s still early to evaluate repeat purchases. In other markets, we haven't observed as significant a trend. There are emerging local players like CMPC in Latin America, but China has seen a notable increase in smaller local companies this year.

Yes, Nik. I don't believe I have any groundbreaking insights on how to address this. However, I think it all comes down to the fundamentals of how we operate our business, which includes better innovation. We're focusing on customizing our innovations to ensure we perform and compete effectively against all competitors across all levels. We have several initiatives in mind to enhance our product performance and are also planning to invest more in our brands. We believe Huggies is very well positioned in all markets, especially in China. We are pleased with our standing there and will increase our investment in the Huggies brand to grow that business.

Yes, maybe the only thing organizationally is we are organized, where we're the local market leaders, own the response to any local competition. So the team running the China business, they're accountable for developing the strategies to deal with whatever kind of competition is in front of them. There's a global organization around to help them. But they're there on the front line every day and deciding what to do, what to launch, how to promote or what channels to go after it.

Welcome back, sorry.

It's okay. We're here all day.

So two questions. One is, look, FORCE, for many of us, certainly me, continues to be a little bit of an abstract concept, right? So it's broad based, you're hearing lots of things. Can you maybe just give us...

It's real cash, Ali. It's spending money.

Can you provide us with two or three specific examples of what makes up FORCE? Is it a substantial project? It would be helpful to have something concrete that translates into real revenue this year. This could assist in clarifying the concept for everyone.

The FORCE cost savings are coming from several areas. First, we are achieving savings by negotiating lower material prices with suppliers. Second, we aim to improve productivity and reduce waste in our manufacturing operations by enhancing overall equipment effectiveness and applying lean manufacturing techniques. Third, we are focused on reducing overall spending at our manufacturing facilities, minimizing unnecessary costs in addition to boosting equipment productivity. Finally, we're optimizing the cost specifications of our products, with our engineering teams constantly seeking ways to lower product costs while maintaining or improving performance and quality. We have made significant progress in these areas both this year and last year. Our global supply chain team is evaluating all these aspects, including logistics, to identify additional savings opportunities. The project list contributing to the FORCE cost savings includes hundreds of initiatives worldwide that aggregate into these savings. For example, in personal care, we've successfully implemented best practices across different manufacturing facilities, allowing us to share cost-saving strategies, such as optimizing diaper production. This collaborative effort enables us to reduce the overall cost of our products effectively.

That's very helpful. If we dive into one of them to provide a bit more detail, specifically about productivity and operating efficiency, what are your operating efficiency metrics right now on average? I'm trying to understand how much potential improvement is still available. Where do we currently stand on those metrics, for example?

It varies significantly across businesses. For instance, the OEE of our tissue machine is very high because it operates continuously, 24/7. In contrast, the OEE for a diaper machine is much lower due to frequent stops and changes in materials and grades. We measure the OEE for every diaper machine in the system, and there's a notable difference between the best and worst-performing machines. Fortunately, the improvements we are making mean that our top-performing machines are enhancing at a similar pace to our lower-performing ones. Therefore, we still see substantial opportunities for productivity gains to reach best-in-class status.

Okay, super helpful. Totally separate type of question. You mention your categories clearly are more challenged right now. We get that. But it also looks like your market shares are more challenged. And I just want to go back to this what you were just mentioning a second ago, for example in China, but more broadly, that look at reinvestment that has to be put back into the marketplace a little bit there. But not just China, in the U.S., showing less share even elsewhere. What are the things that you expect, not just from a category perspective, but from a market share perspective, you guys to be able to deliver on better results?

Yes, that's fair. We're not satisfied with our market shares this year. We're up in about 40% of the country category intersections that we track, that are the biggest ones. And our goal for the year is to be up in at least half. So we're tracking below goal. North America has probably been the one that has had the toughest hit, given the first half results that we've had. We expect them to finish a little stronger. But I don't know, Mike, if you want to give any more color on other areas you're thinking but from a market share standpoint.

No, I mean, it's a great area to pick at, Ali. It's an area that we're clearly not happy about, and that we're trying to make sure that we run the business and make sure we find the right investment behind the brands to be able to grow profitably. And we're doing that. I think we made some progress in family care. Not declaring victory because we're just taking the next step in the right direction. But we're trying to grow our shares, grow our business and then grow our profit at the same time.

Yes, if you looked at our three-month shares versus our year-to-date shares, our trend is a little better sequentially, but we're still not satisfied.

All right, well, thank you, everyone, for your questions this morning. And we'll conclude with a short comment from Tom.

Well, once again, we appreciate your support of Kimberly-Clark. And we'll continue to do everything we can to deliver good shareholder value over the long term. Thanks very much.