Tuesday, January 8, 2013

Procter & Gamble Equity Research and Analysis

When looking at Procter & Gamble (NYSE: PG) I am reminded about the new adage of managements finding it funny how the luckier they get the more they think they practiced. Okay I am being slightly harsh here but the point remains that PG has some hugely powerful brands and the opportunity is there for its management to do more to release the value in them. The stock has underperformed the main index this year but since lowering guidance at the Q3 results in the summer it has put on an impressive run.

So has the company finally turned the corner?

Procter & Gamble Refocuses

Going back to the low point of the year, PG announced a plan to refocus on its top brands and its top 10 developing markets. At the time it looked like a series of piecemeal measures rather than the kind of fundamental overhaul that PG seemed to have needed. No matter, the market liked the idea and investors who bought in would have been rewarded handsomely.

My thesis with PG is that this is a company that is structured to deal with recessions by trying to holding pricing at the expense of market share during the slowdown in order to benefit when the economy recovers. This kind of approach usually makes perfect sense because mass consumer companies will likely lose more customers by hiking pricing in the recovery than they would lose by not cutting them in the downturn. At least that’s what the behavioral finance theorists would have us believe.

Unfortunately for PG this recovery has been different and uneven. The mass market has suffered inordinately with employment and income security issues and it is taking a lot longer to recover. Consumers are becoming extremely price and promotion conscious and are increasingly shopping through alternate channels like discount stores and off-price retailers. As such, PG’s strategy has left them susceptible to losing market share in categories like toothpaste and laundry detergent to companies like Church & Dwight (NYSE: CHD). Meanwhile more focused companies like Colgate-Palmolive (NYSE: CL) and Kimberly-Clark (NYSE: KMB) are competing for PGs business as well.

CHD has managed to successfully leverage its value brands and niche products in order to generate the kind of growth that PG hasn’t got anywhere near. As for CL, it has successfully implemented a program of innovation in oral and personal care while expanding its emerging market presence. Even a relative laggard like KMB has outperformed PG by over 20% in the last five years. In a typical example of the kind of flexibility that has been lacking in PG, KMB recently pulled back on diapers in Western Europe.

A chart of relative evaluation in the sector shows how PG’s star has fallen.

PG PE Ratio TTM data by YCharts

Mixed Results but Good Enough

The Q1 2013 results came in at the high end of expectations for organic growth at 2% and PG continues to convert income into free cash flow (FCF) at a rate of 90%+. In a sense this is the most important metric for investors because the stock is surely being held as a proxy for low yielding government bonds. The main attraction of the stock is the ability and commitment of its management to use its FCF to pay dividends and make buybacks.

From an operational perspective PG delivered an unusual set of results in that it appears to be stabilizing market share in the US but growing slower than the market in within emerging markets. This is partly a function of how well it is established within developing markets (even though they represent a smaller part of its revenues than its rivals) but also a reflection of concerted action by its more innovative rivals. Growing revenues at 7% in China is fine but when the market is growing at 11% it means that PG is losing market share in a key growth market.

As for developed markets, PG claims to be holding or expanding its market share in the US in markets representing 60% of its sales when in June it was closer to 15%. Initiatives in categories like toothpaste, laundry detergent, dish washing, razors/blades and oral care have seen some stabilization but beauty and skin care remain challenged businesses for PG.

There is still much work to do.

Where Next For Procter & Gamble?

With full year organic revenue guidance of 2-4% growth and core EPS forecast to be down 1% to up 4% this stock remains a dividend play with some upside from the possibility of its management outing the latent energy in its brands. There is nothing wrong with this. Indeed it is an approach that has worked for investors this year. However, it strikes me that should bond yields start rising then stocks like PG will be disproportionately affected.

In addition and, as ever, I would point out that I am a growth at reasonable price investor who doesn’t buy such stocks normally. Moreover I think even a value investor is going to have to look hard at PG’s evaluation and think twice. Value is being outed here but it will take time

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