A week ago, Kimberly-Clark (NYSE:KMB) released its third-quarter earnings. The results weren't great, but they weren't that bad, either. The larger issues were increased energy costs, lack of visibility into the future trend of those costs, and a market-share struggle in Europe. Although Kimberly-Clark's stock initially popped on its earnings news, it quickly reversed course and hit a new 52-week low yesterday.
The bad
Many companies have felt the pinch from higher energy costs after hurricanes Katrina and Rita. Restaurants like BrinkerInternational (NYSE:EAT) and furniture companies like Motley Fool Income Investor selection La-Z-Boy (NYSE:LZB) have suffered, as has any company with significant shipping operations. Kimberly-Clark has also felt the energy pinch at multiple points in its manufacturing operations and in its distribution structure.
Investors who follow Packaging Corp. of America (NYSE:PKG) and other paper producers, or who may have read a portion of Packaging Corp.'s conference call on Jeff Matthews' blog, know that it takes a fair amount of energy -- often natural gas -- to create finished paper goods from pulp. There are some things that companies can do, like switching to alternative sources of fuel, but in general, everybody feels the increased cost of energy in manufacturing.
It's the same for Kimberly-Clark, except that its business suffers an energy double whammy because a fair portion of its consumer business in diapers and other absorbency products requires polymers. And polymers come from oil, which means Kimberly-Clark feels a bit more of the energy pain. Finally, Kimberly-Clark gets hit with the cost of transporting its finished goods from point to point. In short, Kimberly-Clark is fairly dependent on energy.
The good
The steep increase in energy costs should slowly revert back to pre-hurricane levels, and there are a number of positives at Kimberly Clark. Like General Electric (NYSE:GE) and Johnson & Johnson (NYSE:JNJ), Kimberly-Clark generates large amounts of free cash flow every year and can be counted on to reliably increase its dividend. Over the past few years, the company's level of free cash flow has increased steadily from $1.15 billion in 2001 to $2.22 billion last year. Given the company's guidance for the rest of the year, it looks like its free cash flow should come in lower than last year but should still be substantial.
There's still a bit more good news. The company has a number of initiatives in place to reduce its cost structure and is targeting an improvement in its return on invested capital (ROIC) by 40 to 50 basis points a year. At the end of the third quarter, the company's ROIC already stood at 14.9%, which isn't too shabby. All totaled, the company expects its cost-cutting initiatives to yield between $300 million and $350 million a year in pre-tax savings by 2009, money it can use to reinvest in its strongest businesses. And let's not forget that Kimberly-Clark has increased its dividend for 33 consecutive years.
Is it cheap?
The most relevant question for investors is whether Kimberly-Clark's stock is cheap enough to buy now. The answer largely depends on the growth assumptions you're willing to attach to the company. Given the competition in Europe and the hit the company is taking on energy costs, I don't expect growth in free cash flow much beyond 6% in the next couple of years. If the company delivers on all of its cost-cutting goals, my expectations could prove to be overly conservative.
Plugging the assumptions above, along with a 10% discount rate, into my discounted cash flow model, my conservative value estimate for the company is $58.50, which isn't a tremendous margin of safety from today's price of $56.20. I could get a much higher value if I were to step up the company's growth rate by a percentage point or two and combine this with a continuation of significant share buybacks by the company. I'm not ready, however, to make those leaps of faith just yet.
Foolish final thoughts
I'm inclined to believe that Kimberly-Clark's energy troubles are temporary and that the company's cost-cutting efforts will pay off. With a trailing P/E multiple of 16.5 and a dividend yield of 3.2%, Kimberly-Clark's stock looks fairly priced, and this is confirmed by a quick discounted cash flow analysis. However, the shares lack a significant margin of safety unless the company is able to sustain high single-digit growth in free cash flow. Stay tuned.
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Nathan Parmelee has no financial stake in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.
