Share price of Clorox (NYSE: CLX) fell more than 14% in premarket trading on Friday after the company reported weaker-than-expected results for the second quarter of fiscal 2022 (FY22) and cut its full-year guidance.
It was yet another quarter where Clorox disappointed investors, causing its record fiscal 20 year to fade even further into the rearview mirror.
Here’s what’s driving Clorox stock lower and how to approach investing in the company given what we just learned.
A bit of context
Clorox’s business was running at full steam in fiscal 2020, which ended June 30, 2020. Clorox’s fiscal 2020 included its revenue, net income, free cash flow (FCF) and its highest gross profit margin in 10 years. Clorox tracked performance by posting 9% year-over-year revenue growth in FY21. But his other metrics were in decline, and the cracks in his business would only widen from there.
Clorox market penetration comes at a cost
Clorox CEO Linda Rendle took over in September 2020 and launched a campaign focused on growing Clorox’s brands and taking market share from competitors. To some extent, his strategy worked.
In its remarks prepared for the second quarter of FY22, Clorox mentioned that 75% of its brands have “higher value” as measured by the company’s consumer value metric. In other words, customers rate Clorox brands as best in class a record 75% of the time. At first glance, it looks like the consumer staples company should be proud of its growing market share. But dig deeper and you will find that growth has come at a high price.
Rendle’s campaign came at the expense of much higher ad spend. At the height of the pandemic, Rendle repeatedly said that Clorox was betting on a permanent consumer shift toward improved hygiene and cleanliness by promoting its brands. The best example of Clorox’s new advertising appetite is its NBA promotion.
If you’ve been listening to the NBA lately, you’ve probably noticed a new format during All-Star Weekend called 2022 Clorox Rising Stars. The three-game tournament of 12 rookies, 12 sophomores and four NBA G League members looks entertaining and is a great way to promote less experienced players. But Clorox probably shouldn’t sponsor it, at least not in times of high inflation.
The elephant in the room
Inflation is the biggest threat to Clorox’s business right now. And this is at the heart of what has resulted, quarter after quarter, in disappointing results. Inflation increases the costs of Clorox. Some companies may pass these costs on to their customers by raising prices or reducing the impact on margins by reducing operating expenses and capital expenditures. Clorox failed to offset the impact of inflation. Couple inflation-induced costs with much higher selling, general, and administrative (SG&A) expenses, and you’ve got a one-in-two punch that cripples Clorox’s gross profit margin.
As mentioned, Clorox’s gross margin was at a 10-year high of 45.6% in its fiscal year 2020. It declined slightly in FY21 but was still at 43.6%. Clorox now expects its FY22 gross margin to be 750 basis points lower, or just 36.1%, which would be Clorox’s lowest gross margin in more than 10 years. Clorox expects FY22 third quarter gross margin to be in the mid-30s and fourth quarter in the 30s. It had previously indicated that fourth quarter gross margin would be in the range 40% low.
During its FY22 second-quarter conference call, Clorox said it has historically taken between 12 and 18 months to implement cost-cutting measures and raise prices to offset inflation. Due to severe inflationary pressures, it expects its gross margin may take even longer to return to fiscal 2020 levels. In other words, Clorox says its business will only return to its form FY20 than between FY24 and FY25. It’s a long wait for investors.
To make matters worse, Clorox has done a poor job of over-promising and under-delivering. An analyst on the call addressed this concern head-on by simply asking if the company was willing to set realistic expectations. The answer was not a vote of confidence as Clorox simply said it was too difficult to predict how much inflation will persist and continue to impact its margins.
Rip off the proverbial bandage
About the only silver lining to Clorox’s earnings is that the company has not been shy about tackling the severity of short- and medium-term challenges. Worryingly, Clorox seems to be handling these challenges much worse than its peers such as Procter & Gamble (NYSE:PG). P&G has found a way to grow its business and maintain high margins despite similar industry issues as Clorox. I blame Clorox’s overspending as a key driver of its low gross margin as well as management’s aggressive strategy during what should be a time to dig in and play defense.
Existing shareholders have no choice but to give the company time to rebuild its business or sell the shares. If Clorox stock continues to fall, it could be an interesting turnaround game for investors who don’t mind waiting a few years for the investment thesis to materialize. Clorox has a strong business with some particularly notable brands like Brita, Glad, its main cleaning brand Clorox, Burt’s Bees and others. More importantly, Clorox is a dividend aristocrat that has paid and increased its dividend for 45 consecutive years. The recent sale gives Clorox shares a dividend yield of 3.2%. Therefore, investors will be rewarded with a tidy sum of passive income in exchange for their patience.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.