Share prices of Clorox (CLX -0.43%) fell over 14% in pre-market trading on Friday after the company reported lower-than-expected second-quarter fiscal year 2022 (FY22) results and slashed its full-year guidance.
This is yet another quarter when Clorox has disappointed investors, making its banner year in FY20 disappear further in the rearview.
Here's what's driving Clorox stock lower and how to approach investing in the business given what we've just learned.
Some context
Clorox's business was firing on all cylinders in FY20, which ended June 30, 2020. Clorox's FY20 included its highest revenue, net income, free cash flow (FCF), and gross profit margin in 10 years. Clorox followed up the performance by posting 9% year-over-year revenue growth in FY21. But its other metrics were on the decline, and the cracks in its business would only widen from there.
CLX Revenue (Annual) data by YCharts.
Clorox market penetration comes at a cost
Clorox CEO Linda Rendle took over in September 2020 and put forth a campaign centered around growing Clorox's brands and taking market share from its competitors. To a certain extent, her strategy has worked.
In its Q2 FY22 prepared remarks, Clorox mentioned that 75% of its brands are "a superior value" as measured by the company's consumer value metric. Put another way, customers rate Clorox's brands as the best in their category 75% of the time -- a record high. On the surface, it looks like the consumer staple company should be proud of its growing market share. But dig deeper, and you find that the growth came at a steep price.
Rendle's campaign came at the expense of much higher advertising spending. During the height of the pandemic, Rendle repeatedly said that Clorox was going to bet on a permanent consumer shift toward improving hygiene and cleanliness by promoting its brands. The best example of Clorox's newfound advertising appetite is through its NBA promotion.
If you've tuned into the NBA recently, you've probably noticed a new format at All-Star weekend called 2022 Clorox Rising Stars. The three-game tournament consisting of 12 rookies, 12 sophomores, and four members from the NBA G League looks entertaining and is a great way to promote less experienced players. But Clorox probably shouldn't be sponsoring it, at least not during a time of high inflation.
The elephant in the room
Inflation is the single biggest threat to Clorox's business right now. And it's the crux of what's resulted in quarter after quarter of disappointing earnings. Inflation increases Clorox's costs. Some businesses can pass along those costs to customers by raising prices or reducing the impact on margins by cutting operating expenses and capital expenditures. Clorox has failed to offset the impact of inflation. Pair inflation-induced costs with much higher sales, general, and administrative (SG&A) expenses, and you have a one-two punch that is crippling Clorox's gross profit margin.
As mentioned, Clorox's gross margin was at a 10-year high of 45.6% in its FY20. It declined slightly in FY21 but was still a strong 43.6%. Clorox now forecasts that its gross margin for FY22 will be 750 basis points lower, or just 36.1%, which would be Clorox's lowest gross margin in over 10 years. Clorox expects Q3 FY22 gross margin to be in the mid-30s and Q4 to be in the high 30s. It had previously guided for Q4 gross margin to be in the low 40 percent range.
During its Q2 FY22 conference call, Clorox said that it has historically taken between 12 and 18 months for it to implement cost-savings measures and raise prices to offset inflation. Due to the severity of inflationary pressures, it expects it could take even longer for its gross margin to return to FY20 levels. Put another way, Clorox is saying that its business won't return to its FY20 form until sometime between FY24 and FY25. That's a long time for investors to wait.
To make matters worse, Clorox has done a poor job of overpromising and underdelivering. An analyst on the call addressed this concern head-on by simply asking if the company was ready to set realistic expectations. The response wasn't a vote of confidence as Clorox simply stated it's too hard to forecast the extent to which inflation will persist and continue to impact its margins.
Ripping off the proverbial bandage
About the only silver lining from Clorox's earnings is that the company didn't shy away from addressing the severity of short- and medium-term challenges. It is concerning that Clorox seems to be handling these challenges far worse than peers such as Procter & Gamble (NYSE: PG). P&G has found a way to grow its business and retain high margins despite facing similar sector problems as Clorox. I blame Clorox's excessive spending as a key driver behind its weak gross margin as well as management's aggressive strategy during what should be a time to dig in and play defense.
Existing shareholders have little choice but to give the company time to rebuild its business or sell the stock. If Clorox stock keeps falling, it could be an interesting turnaround play for investors who don't mind waiting a few years for the investment thesis to play out. Clorox does have a strong business with some particularly stand-out brands in Brita, Glad, its core Clorox cleaning brand, Burt's Bees, and others. Most importantly, Clorox is a Dividend Aristocrat that has paid and raised its dividend for 45 consecutive years. The recent sell-off gives Clorox stock a dividend yield of 3.2%. Therefore, investors will be compensated with a tidy sum of passive income in exchange for their patience.
