Quick Take on Procter & Gamble (PG)

Fair Value Estimates (FVE):

Click for an intro on our Fair Value Estimates. Below is our estimates for Procter & Gamble:

The average FVE is $65.12 against the current share price of ~$67.50.

Financials Summary:

 

Q2 2012 Quarter Report & Conf. Call – 01/27/2012:

Organic sales growth – 4%, volume – 1%: effect of pricing.

 No growth in developed markets. But, developing markets at 37% of sales compared to 27% of sales 5 years ago is offsetting this factor well.

Market share in line or higher in businesses representing ~45% of global sales compared to 60% level in previous quarters – negative effect of price increases – expects it to be temporary as price gaps narrow either because of competitors following price increases or PG dropping the price increase. But, global market share inline with prior year levels – held or grew share in 9 of 15 countries, 3 of 6 reporting segments and 11 of 24 billion-dollar brands.

Core earnings down 3% due to higher commodity prices and tax rate headwind. Also, divestiture of PUR business had an impact.

Good and intangibles write-down at $0.53 per share – onetime non-cash – appliances and salon professional businesses – out period growth projection reduced.  Tax rate at 36.7% due to the noncore nature of charges which are not tax deductible. Otherwise it should have been 24.9%.

Six Reporting Segments Summary:

1. Beauty Segment: organic volume and sales growth of 2%. Retail hair care led the growth with India Pantene shipments increasing 80% and China Head & Shoulders shipments increasing 25%. NA weak – mid-single digit shipment decline.
2. Grooming segment: Blades and razors volume increased low single digits. CEE, ME, and Africa shipments in double digits mainly from expansion of Fusion ProGlide. NA Fusion ProGlide sales offset by Mach3 losses.
3. Health Care Segment: Oral care volume down low single digits. Crest 3D White growing. Oral-B toothpaste expansion markets delivered results ahead of expectation.
4. Fabric and Home Care Segment: Organic sales growth of 5% - flat volume. Tide PODS should start selling in less than a month. It could become the biggest launch in the US consumer product industry.
5. Global Home Care Segment: Shipments up low single digits. Challenge – US auto dish category were price was increased 8% - the consumer value versus competitive products currently outside our range and so we will reverse some of the price increases – to aggressively pursue cost savings to maintain profitability.
6. Baby and Family Care Segment: Organic sales up 6% - mainly because of price increase. Focus on strong 3-tiered portfolio.

Guidance:

Background - Tightened sales guidance and earning per share guidance mainly because of foreign exchange impact – ruble, zloty, the real, the peso, and the Turkish lira depreciated 10% to 20% against the dollar. These along with pound sterling have caused the majority of earnings impact. Historically, currency impact is offset by declining commodity costs which has not been true so far – input costs still expected to be $1.8B higher.  Developed markets all weak with US being the only one growing, albeit slowly. Disproportionate growth in developing markets also has an impact as absolute profit per unit is lower in the area.

Priorities: 

1. Maintaining our top line growth momentum – 4% organic sales growth is good, 
2. Execute pricing changes with excellence. Some corrections, but they are minor compared to $3.5B in increases this year. Pricing to continue to be a significant driver of organic sales growth, 
3. Improving productivity – Reducing number of technical centers we operate globally while opening new ones in developing markets – facility in Singapore and R&D center in Beijing – operating closer to growth areas. Overhead to be reduced by 1600 roles through selective hiring, normal attrition, and restructuring. To announce more at CAGNY. 
4. Restore solid operating profit growth – pricing should help – second half core operating profit growth to be 10 to 15%.

Guidance Summary – core earnings guided down to $4 to $4.10 from the prior range of $4.15 to $4.33. So, EPS growth to be 1% to 4% compared to $3.95 in prior year. All-in earnings per share in the $3.85 to $4.08 range – includes $0.55 to $0.65 per share gain from Pringles divestiture, restructuring cost in the range of $0.15 to $0.80 per share and $0.52 per share in non-core charges related to impairments, etc. Capital spending in the 4-5% range. Expect to pay $6B in dividends and $4-5B in share repurchases.

Jan-Mar quarter guidance – organic sales growth in the 3-5% range – compared to 4-9% projected for the back half. But, foreign exchange expected to have negative impact of 3 points resulting in flat to 2% sales growth range.

Q2 2012 Conference Call Q&A Summary:

Second year in a row were you project back end loaded guidance only to retract. What gives?

Productivity increase is a focus. To talk more about this in CAGNY. Top-line is growing. Bottom line is a function of macro effects. We will try to offset with productivity increases. But, we can’t reduce spending to offset costs as that will harm our long-term trajectory.

Pricing flexibility – please comment?

Overall successful in executing the pricing increases. There are 3 exceptions were we had to take action. The percentage increase this time around is much less and so it should be asier to implement. Also, commodities  rolled over last time with our price increases. That is not likely to happen this time. Besides, we are growing share now.

How is growth projected – volume vs pricing?

We will continue to grow top line and we are going to continue to grow the market share. The strategy is to have a full portfolio of offerings from premium priced to low priced. Example is laundry care currently – Tide total care at the premium end, Tide at the average end, to Era at the low end. PODS is the new innovation in the area. Crest 3D white is another premium priced example. Innovation at the premium end is critical.

Volume will be a bigger component going forward. Out of 4 to 5 top line, 3 to 4 points will be volume – mix and pricing help.

Discontinuous innovation by – growing categories. Not seeing that. Why?

You should be seeing it. Febreze auto product is an example – gets us into a category in fragrances in automobiles that we have never been in before. Tide PODS is another example – it will be expansive to the laundry category – it’s the most condensed laundry product you can buy – much better for environment – it is expected to be 30% of category.

Cost cutting needs to happen faster. Also, its just too complex and needs to be broken up – what is your take?

Scale is a tremendous advantage. Wants to be in the top-third in peer group w.r.t. total shareholder returns. Improving productivity is part of the deal – you will hear more at CAGNY. We have been doing similar to what Kraft did. The key question is whether we can scale and win versus the more focused company and we think the answer is Yes.

Cost savings and role of advertising related question?

Over time, advertising cost increases should moderate – more choices, less expensive in the digital space.

Macro Assessment:

Global economic growth is a big positive for the company. Strong dollar is a negative.

Checklist:

1.        Is it a business I understand very well squarely within my circle of competence? – somewhat.

2.        Do I know the intrinsic value of the business today with a high degree of confidence? – somewhat.

3.        Is the business priced at a large discount to intrinsic value today and in two to three years? – No, FVE showed it being fairly valued.

4.        Would I be willing to invest a large portion of my net worth into this business? – No.

5.        Is the downside minimal? – may be – beta is low at 0.30 – so it should hold up very well in a correction.

6.        Does the business have a moat? – may be – many of its products are household names and so there is a certain level of user loyalty.

7.        Is the business run by able and honest managers? – may be – compensation is very high.

8.        How much is the Margin of Safety? – A good investment needs good downside protection – margin of safety is very low but (~$65 was our average FVE). beta is very low as well and so there is some downside protection.

9.         Moats – A good investment needs to have a good upside earnings engine. Is there a solid moat? Could the moat be shrinking/evaporating? – see above.

10.    Is it a simple easy to understand business? – somewhat. 

11.    Are the revenues and cash flows of the business sustainable? Are you looking at normalized earnings or boom-time earnings? – Example Cort Furniture purchase by Wesco – the volumes were high due to Internet bubble – Buffett/Munger mistake. Given the complexity of the business, it is tough to gauge – it appears we are looking at normalized earnings.

12.    Is it a Graham Net/Net play? – Bought below net working capital. Special Situation – good downside protection and chance of high returns, but probability is very low - Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) - total liabilities. No – big negative number.

13.    Is the company’s business becoming unregulated? – that could cause the moat to quickly evaporate  - regulated businesses have high cost structures which would be disastrous in a competitive unregulated landscape – an example of such a mistake is Warren Buffet’s investment in US Air which he acknowledged as a mistake in the 1996 letter to shareholders. No.

14.    Assets to Equity – Is the company too leveraged? – the ratio is at ~200% - so, the company is leveraged - good will and intangibles make up roughly half of the assets.

15.    Could the company have made bad lending decisions? – bank specific – NA.

16.    How much will high unemployment and recession hurt the business? – it will affect the company negatively.

17.    Is the investment correlated to one or more of your existing holdings? – holding many business that are correlated can result in an undiversified portfolio – Yes – KFT is in the same general area (consumer products conglomerate), but it is splitting up – after the split-up, will have to reassess..

18.    Can this business be decimated by low-cost competition from China or other low-cost countries? – example – Warren Buffett’s investment in Dexter Shoes – No. But, private-label is a threat.

19.    Is this a win-win business for the entire ecosystem? – avoids tobacco, gambling, predatory lenders, etc –Yes.

20.    Mohnish Pabrai has said he has ten check-list questions on leverage – How much?, What are the covenants? Are they recourse or non-recourse?, etc. – Not clear.

21.    There are five questions on management - Management Compensation? Interests of Management – Is it aligned with shareholders? Management’s historical track-record?, Does Management have a large stake in the company? – Very little insider ownership.

22.    Unions & collective bargaining issues related questions – Does the company have union issues? – don’t know.

23.    Pension funding status? – unfunded amount is pretty high - ~$11B.

 

Quick Take:

As a huge conglomerate, the company is very complex – there are myriad factors that affect the company that one needs to consider to analyze it well. On a pure fundamental basis, the company has a TTM PE of 17.05 and because of the anemic guidance; the projected forward PE is down only by a small amount to 16.5. The PE is comparable to companies in its peer group.

Our average Fair Value Estimate (FVE) came in at $65.15, only a slight discount to the current price of $67.43. Financials show a healthy picture with a couple of concerns: Asset to Equity ratio is high at ~200% indicating a fair amount of leverage and the Graham Net-Net is a large negative number, again indicative of the large leverage.

The company has a focus on productivity & cost savings and has a plan to realize ~$10B in productivity and cost savings by 2016. It includes a target of ~$3B in overhead reduction. The savings has to come from a projected $85B cost pool for 2016 that includes $52.1B in COGS and $32.8B in SG&A. The projected savings account for 12% of the projected cost pool and that level of savings is easier said than done. But, if the company is able to pull off this, earnings-per-share could double based on this factor alone, within the next 4 years. Investing in the company at the current price level is a bet that the company’s management will be able to deliver on this objective.

Last Updated: 03/2012.