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29 May 2023 J P M O R G A N
Gross Margins Poised to Improve – Can Return to 2021 Peak
by 2025
KVUE􀋖s gross margins expanded by +125 bps in 2020 and another +164 bps in 2021
before compressing -88 bps in 2022 to 58.1% as the company dealt with inflationary
cost pressures seen throughout CPG (raw material inputs, freight, packaging) and supply
chain challenges, primarily in the Skin Health and Beauty segment. Prior to 2022, gross
margin expansion over the past few years has been driven by productivity (e.g., ZBB),
rationalization of smaller third-party manufacturers (60% of small external
manufacturers eliminated), portfolio optimization (21% SKU reduction), and favorable
segment mix (higher margin Self Care growth).
Figure 38: KVUE Gross Margin Bridge
58.1%
-0.6%
56.1% 0.1% -1.2% -4.0%
0.7%
1.1% 57.4% 0.4%
0.5%
2.1% 59.0% 0.1% 0.4%
1.7%
1.0%
55%
56%
57%
58%
59%
60%
61%
62%
Source: Company reports.
We model for +54 bps gross margin expansion in 2023, slight -6 bps compression in
2024, and +38 bps expansion in 2025, which would return gross margins to 2021 levels
at 59.0%.
We see a number of drivers of gross margin expansion: 1) further optimization of
supply chain and COGS efficiencies; 2) rollover of 2022 pricing actions as well as
incremental pricing in 2023 and beyond; 3) abating cost headwinds; and 4)
favorable segment mix with continued faster growth in higher margin Self Care
and Skin Health and Beauty segments (although some Skin Health and Beauty profit
growth likely to be reinvested). Relating to our estimates, expectations for 2024 could
admittedly be conservative as we leave our margin assumptions unchanged despite a
stronger than expected start to 2023 – the aforementioned drivers and abating
inflationary pressures could lead to better gross margin performance than we have
modeled.
Inflation should remain a headwind in 2023 (perhaps roughly -240 bps to gross
margins), albeit to a lesser extent than 2022 where we estimate costs could have been a -
400 bps headwind. On COGS, we estimate roughly 40% is in raw materials and inputs,
30% in internal and external manufacturing costs, and the remaining 30% in other
overhead, freight, and amortization. Within KVUE􀋖s cost buckets, raw materials are
relatively diversified, in our view, with resins, pulp and paper, agro chemicals (like
ethanol and glycerin), and packaging materials the largest exposures, although in total
these represent less than 20% of total COGS. From an FX perspective, the company
hedges its transactional exposure for forecasted revenues, purchases, receivables, and
payables, but it does not hedge translational risk. Key currencies include EUR, GBP,
JPY, CNY, CAD, BRL, and INR.
This document is being provided for the exclusive use of DAVID WANG at MARLOWE PARTNERS LP.
27
Andrea Teixeira, CFA AC
(1-212) 622-6735
andrea.f.teixeira@jpmorgan.com
North America Equity Research
29 May 2023 J P M O R G A N
Exit of TSA and TMA Is Another Source of Margin Improvement Longer Term
Within the cost outlook, we also note that KVUE entered into a Transition
Manufacturing Agreement (in addition to Transition Services Agreement that sounds
more related to operating services), which covers pharmaceutical products like Tylenol,
Zyrtec, Motrin, and Benadryl, among others. The company noted that the products
covered under the TMA accounted for less than 10% of its sales in 2022. The TMA is
based on a cost-plus model and ranges in terms from 3 to 60 months depending on the
product (3-60 months for Tylenol, 21-60 months for Zyrtec, 21-60 months for Motrin,
and 21-60 months for Benadryl), although the company notes that these terms could be
extended for up to three additional 12-month periods if there are issues, which we think
would be mostly due to regulatory processes and facility validation. Management
expects to be out of the TMA within three years for most of the products. Exiting these
TMA agreements should allow for better margin profile over time as the company no
longer pays the markup associated with the agreement.
Relative to peers, KVUE􀋖s adjusted gross margins (including amortization of definite
life intangible assets to make more comparable) compare favorably to most HPC and
consumer health peers (ranks below only HLN, RKT, and BEI) but are well below those
of more pure-play beauty names. Overall, KVUE􀋖s category exposure to OTC and
beauty lends itself to strong gross margin profile vs. HPC more exposed to everyday
essentials, and many companies in the peer set have also faced greater inflationary cost
pressures given COGS exposure more weighted to the oil complex, pulps, and
transportation/logistics costs.
Figure 39: Gross Margins vs. Peers
CY22
0%
10%
20%
30%
40%
50%
60%
70%
80%
Gross Margin Average Median
Source: Company reports and J.P. Morgan estimates.; *KVUE adjusted gross margins including amortization of definite life intangibles;
**CL adjusted gross margins adding back shipping & handling costs
Post-2023 Leverage in Middle of P&L to Help Drive Solid
Earnings Growth
Following 2023, which will be burdened both by costs related to TSA and separation