Consumer products icon Clorox (CLX 1.90%) reported earnings after the close on Feb. 3, and when the market opened for trading the next day, the share prices plunged as much as 14%. Investors were clearly displeased with the news, and rightly so in many respects. The stock is now off by around 40% from the peak it hit in mid-2020.
But is the situation really that bad? Maybe not. Here's why.
Going to extremes
You can't talk about Clorox today without discussing the coronavirus pandemic. Early on during the scare, which really gained speed in early 2020, nobody had any clue what was actually happening. One of the easy go-to precautions was to disinfect everything you could, just in case the illness spread via contact with surfaces. As it eventually turned out, the coronavirus is mostly transmitted via air. But that is knowledge gained in hindsight.
So, early on, consumers and businesses rushed out and bought as many cleaning supplies as they could. There was so much demand that store shelves were left bare. Clorox, which has a highly recognizable cleaning business, was one way that investors played the trend, bidding the stock up to extreme heights. While Wall Street likely got ahead of reality, which is often the case, it is true that Clorox witnessed a big sales boost in its cleaning line.
The company leaned into that demand as well, upping advertising spending to cement its position as a trusting disinfectant brand. And it ramped up production so it could get store shelves filled -- as much as possible given what was, at the time, a near-insatiable appetite for the products. Now that the world knows more about the coronavirus, however, the temporary demand boost Clorox benefited from has reversed course. Sales declined 8% year over year in the just-ended fiscal second quarter of 2022. In the previous fiscal year, Q2 witnessed sales growth of 27%.
On top of that lackluster top-line performance, the company's gross margin shrunk by a huge 12 percentage points to 33%. A big piece of the problem was inflation, which resulted in increased costs that Clorox wasn't able to pass on to consumers. It was a rough report to read, but it wasn't all bad.
There's some good news
The big problem on the sales front was Clorox's health and wellness division, which houses the cleaning products business, where sales fell a massive 21%. The company pretty much knew that hit was coming. Pushing big cost increases through when demand is set to tank after an exogenous shock that led to a demand spike would likely have made matters much worse. So the company basically just took the sales hit without working to offset the pain.
The fact of the matter is that two other divisions, household and lifestyle, saw sales increase 3% and 2%, respectively. And the international business was basically flat. If it weren't for the deflating demand bubble in cleaning, the quarter would have looked very different. To be fair, that business makes up 38% of sales, so it's important. However, when you look past that negative headline, things aren't actually going so badly for Clorox on the top line.
Costs are a different issue, with companies across the business landscape working hard to offset rising prices with cost-saving efforts and price increases. As noted, price hikes would probably make matters worse for Clorox right now, so it needs to be careful in the cleaning segment. And while the company spent on marketing that clearly didn't pay off right away, that outlay could end up being a valuable benefit if the Clorox brand gets cemented in consumer minds as the go-to disinfectant brand. It will take time to find out how this decision plays out, but it's likely too simple to just say that the advertising spending was a waste of cash.
As for cost savings, Clorox was judicious with its production ramp-up. It made sure to hire outside manufacturers so it could cut ties when demand started to fall. Thus, it can curtail production and the associated costs without material roadblocks. That will allow the company to trim its spending and support margins. So the margin hit in the fiscal second quarter could, in fact, be the nadir, which is pretty much what management seemed to be saying during Clorox's earnings conference call.
A slow road back
The last problem here is that there's no easy fix that will get Clorox back on track. It will have to wait out the supply/demand shock from the pandemic and figure out, along with the rest of the world, where the right balance is on demand for cleaning supplies going forward. That process makes price hikes and the cost-cutting process a little uncertain. Management specifically stated that restoring margins will likely take longer than the 12 to 18 months it would normally expect. So weak results could be the norm for a bit, though improving margins should be an important part of the story.
If that's the case, then it's hard to believe that Clorox is worth less today than it was before the pandemic, but that's exactly what Wall Street has priced in. For long-term dividend investors, this period could be an interesting buying opportunity. Indeed, the 3.2% dividend yield is toward the high end of its historical range and Clorox may not actually be doing as badly as some investors think given the unusual pandemic backdrop.