Clorox won’t clean up its margins this year

Following disappointing earnings on Thursday afternoon, Clorox (NYSE: CLX) shares fell 14.3% on Friday, making it the day’s worst-performing stock on the S&P 500. One of the lowlights was the company’s gross margin, which declined 1,240 basis points year-over-year in its fiscal second quarter to 33% from 45.5% one year earlier. That contraction was primarily driven by commodity, logistics and manufacturing costs. In this newsletter, I won’t harp on margins — the entire Q&A portion of the company’s analyst call already did that. Instead, I’ll focus on what’s happening with the company’s supply chain and freight costs, with added color from SONAR.  

Clorox extended its supply chain in response to the heightened demand for cleaning supplies, leading to a higher cost structure and an elevated level of working capital. The company currently has 65 days of sales in inventory versus 55 days prior to the pandemic. That increase partially reflects the strategic decision to protect against supply chain disruptions and shortages of transportation capacity. During the pandemic, Clorox tremendously expanded its use of third-party manufacturers. That is a more expensive, but less risky, method for meeting a surge in demand relative to adding in-house production capacity. The 8% year-over-year decline in sales in the past quarter shows that the more flexible approach was prudent even though it came with drawbacks. Utilizing a larger number of contract manufacturers not only increases per-unit production costs, but also requires an additional investment in inventory. As is the case with many CPG companies that have recently made heavier use of contract manufacturing, Clorox plans to gradually reduce its reliance on third parties in the coming quarters as demand for cleaning supplies moderates. 

Clorox’s rising freight costs are being driven by higher contract rates, lower levels of carrier compliance and surging spot rates. The lower level of carrier compliance with contracts is forcing Clorox to move loads in the spot market more often. The cleaning supplies shipper also highlighted a larger-than-normal spread between contract freight rates and spot rates; Clorox has experienced spot rates that are 50%-75% higher than contract rates in the same lane. 

Transportation costs are the second-largest source of Clorox’s cost inflation. Management simplifies the company’s inflationary pressure as being about two-thirds driven by commodities and one-third driven by transportation. For Clorox, resin is the biggest part of its commodity inflation. Like most CPG companies, Clorox is looking to recover the margin pressure it has experienced during the pandemic with an acceleration in its rate of price increases, but it appears that it will take longer for Clorox’s margins to recover than most. Management stated that it expects that recovery in its gross margins to the historical mid-40s range will take 12-18 months, which is longer than it would take during most inflationary periods given the severity of the inflation that companies are currently experiencing. Like many CPG companies, Clorox said that it is experiencing lower levels of demand elasticity than it has historically. That may be true, but I believe that CPG companies that participate more heavily in the food and beverage industry will see their gross margins recover quicker since consumers seem less willing to sacrifice taste.