PG’s higher-price, developed-market-skewed portfolio is still driving weaker topline growth than peers and market share losses.
I believe there are positive changes that have been put in place by PG, including strategy tweaks under a new CEO, substantial cost-cutting and a refocusing on the core decisions.
There may be upside to consensus EPS if PG share gains accelerate with a ramping up innovation pipeline. On the other hand, market share could stall with weaker consumer spending.
With increasing confidence, I continue to expect +4% growth long term, flowing through the majority of FYQ2 EPS outperformance, slightly offset by a partial reinvestment of the beat. I am raising my target price to $100 on these changes and a roll-forward in time.
P&G (NYSE:PG) took another step forward on its organic growth improvement journey. I continue to believe that the company has significant earnings flexibility with productivity savings, giving the company ample earnings cushion to reinvest in marketing, innovation, digit/channel investments and promotional spending if warranted by competitive activity. While there have been false starts before (notably in 2Q16), management commentary seemed upbeat and I expect continued improvement in organic growth in the back half to +3% resulting in 5% two-year stack organic growth.
With discrete product line exits that have hurt organic growth starting to lap in the back half including the exit of low margin powder and other laundry products in select LatAm markets, SKU rationalization in Olay, and de-prioritization of unprofitable businesses in India, I think the 3% bar is very much achievable, especially given continued reinvestment. I note these product line exits hurt sales by about a point this quarter. Acknowledging the improvement however, even if the company exits the year at 3% organic growth and a 5% 2-year stack, this is still modestly below weighted category growth and broader consumer products peers, implying the company is ceding market share.
Still, with the company in the midst of a likely fundamental inflection, valuation against the backdrop of today's new world seems relatively high. As we all know, consumer staples valuations have trended up as interest rates have been at historical lows and as investors search for yield and defensive names. The absolute forward multiple is now at 22x, about 20% higher than the 10-year average. PG data by YCharts
For the third quarter in a row, PG delivered compelling results relative to expectations into the quarter. The company delivered $1.08 in FYQ2 EPS and organic growth of +2.0% for a the bottom-line beat, driven largely by sales leverage and cost savings. FYQ2 outperformance (alongside PG's own confidence in its continued momentum) enabled PG to raise FY17 organic growth guidance to +2-3%, though it maintained EPS growth guidance prudent given higher FX/commodity headwinds and FYH2 investments.
Looking forward, PG's FYQ2 results raised my confidence in the growth algorithm I had anticipated for the company in FY17 and in its ability to sustainably accelerate performance through FYH2. Outside of a slight sales pull forward in China in FYQ2 (partially offset by competitive conditions in select categories in China, which PG was able to manage through), it appears as if PG's top- and bottom-line beats were "clean," reflective of the sales/marketing/innovation investments it has been making, offset by productivity. Though I do not expect PG to beat EBIT margin expectations as significantly in H2, H1 strength has slightly improved my long-term margin outlook. China
China is second only to the US market in terms of sales and earnings weightings for P&G, and it remains a critical market to the company. Management had no special comments regarding other Asian or emerging markets. Business conditions in Oct-Dec were largely unchanged from the previous quarter, but the figures are a fresh reminder the company is stepping up its e-commerce work. It bears repeating that if P&G's figures in China continue to improve at the current pace, it could become a threat to Japanese companies.
Sales growth in China has strengthened from YoY declines of 8% in 1H FY16 and 2% in 2H FY16 to growth of 2.5% in 1H FY17. Figures at oral care were solid, led by premium products (including power brushes and the Oral-B). In the market for disposable diapers, consumers continued to trade up to products in premium price bands, partly because of sustained promotional work. About 20% of Chinese sales are thought to be through online channels. That said, the company's share in the online market is smaller than its share in the conventional market, and management is taking additional steps to strengthen its e-commerce work. Single-month YoY growth for e-commerce improved from 30% to 50% in Oct-Dec. In skin & personal care, the SKII brand stood out for double-digit growth.
2Q pricing had little effect in all segments and foreign exchange was a common headwind. The company's largest segment - Fabric & Home Care - posted a 1% gain in organic sales and a 2% increase in organic volume. The second biggest segment - Baby, Feminine & Family Care - had a 1% gain in organic sales and a 3% increase in organic volume. Another notable performance came from the Health Care segment, which exceeded my expectations with a 7% gain in organic sales and a 4% increase in organic volume. Health Care businesses that did particularly well include oral care and personal health care. Financials
The balance sheet remained solid, in my view. At December 31, 2016, cash and equivalents totaled $6.0 billion. Short-term investments available for sale totaled another $7.4 billion. Total debt (short-term plus long-term) was $29.5 billion, or 35% of total capitalization. Shareholders' equity was $53.7 billion.
For the quarter, operating cash flow was $3.0 billion. After $745 million in capital spending, free cash flow was $2.2 billion. During the quarter, PG paid $1.8 billion in common stock dividends and spent $1.5 billion on share repurchases. This does not include $9.4 billion of PG shares retired as part of the recent divestiture transaction with Coty.
In April 2016, PG raised its quarterly dividend rate by 1% to a quarterly rate of $0.6695 per share. This marked 60 consecutive years of dividend increases. With the recent strategy of exiting non-core businesses, PG now has a lower revenue base compared to several years ago. I expect another dividend increase, yet still below historical growth rates, to be announced around April 2017. I continue to find PG's dividend yield, currently at 3.2%, a positive investment factor. The recent yield for the S&P Consumer Discretionary sector was 2.7%, while the yield for the S&P 500 was 2.0%. Beauty segment transaction with Coty
In October 2016, PG completed a Reverse Morris Trust transaction with Coty Inc., which sent the bulk of PG's beauty business to Coty. This included PG's global fine fragrances, salon professional, cosmetics and retail hair coloring business, and select hair styling brands. Affected brands included Wella, Clairol, Sassoon, Nice & Easy, Max Factor, and Covergirl, among others. The plan was part of PG's stated strategy to divest non-core businesses and focus on its most profitable and faster growing products. PG shareholders who tendered their shares received 3.9033 shares of COTY for each share of PG accepted in the exchange. PG accepted 104,969,205 tendered shares, which were then retired. The number of shares tendered by shareholders was 691,105,648, thus pro-rationing went into effect. In addition, about $1.4 billion of PG debt went to Coty.
I consider the transaction a net positive for PG, as it represented one of the biggest changes to the product portfolio in the company's recent history. The EPS impact of the departing Beauty brands is expected to be roughly offset on an annualized basis through a combination of overhead elimination, some debt reduction, and shares retired via the deal structure. Primary financial objectives of a now-streamlined PG include sustainable top and bottom line growth and cash generation that can propel shareholder value creation. The company now has about 65 brands classified under 10 categories.
Management updated its financial guidance for FY17, with some revisions. Highlights of this outlook include:
- Organic sales are expected to rise by 2%-3%, up from the previous view of a 2% increase.
- Management expects foreign exchange and minor brand divestitures to reduce sales by 2%-3%.
greater than the previous view of 1%, leading to roughly flat net sales rather than the previous view of 1% growth.
- Gross margin is expected to improve from the FY16 level, and the share count will be lower due to the recent transaction with Coty and regular repurchase activity.
- Core EPS (including currency impacts but excluding nonrecurring items such as a one-time gain associated with the Coty transaction) are expected to rise in the mid-single digit percentage range from the $3.67 figure from FY16, unchanged from the previous view.
I believe much of the appeal of PG shares and the company outlook relates to the longer term. The company's product portfolio transformation is essentially complete, with an acquisition strategy possibly back in the picture. More aggressive spending on product innovation and advertising could move organic sales growth above recent levels. Also, the overall cost structure should continue to tighten and the share count could continue to decline due to ongoing repurchases dictated by free cash flow generation.
I consider the "heavy lifting" phase of PG's product portfolio transformation to be complete, with the divestiture of numerous beauty brands having recently been completed. Over the past few years, changes at the company have related to the product portfolio (divestitures), operating execution (efficiency improvements), and leadership (CEO and Chairman changes). Over the past two years, the company has divested, discontinued, or consolidated over 100 brands. Combined, these brands represented about 14% of PG's recent annual sales and 6% of annual profits.
I continue to believe there is upside potential with PG's financial and operating performance, including measures such as market share positions, product innovation, product quality, profit margins, and earnings. Ongoing cost savings programs and continued investments in the business in order to maintain and grow market share are priorities at the company, and ones that may serve as catalysts for future stock price appreciation.
As with most stocks, I believe PG shares are primarily influenced by earnings growth, which I expect to return in FY17 and continue in FY18. In the longer term, I believe pricing can be a potentially more meaningful tool, market share positions could be boosted by product innovation, the product portfolio could sport higher margins, and the recent detrimental foreign exchange impact could reverse. As a result, and with some beneficial impact from share repurchases, I believe long-term EPS growth could be at upper single-digit levels on a fairly consistent basis and occasionally reach low double-digits. Potential acquisitions, which I have not assumed but consider a reasonable expectation, could help.
My rating on PG remains Long-term Buy. I am maintaining two year price target of $100 per share. I assume a price/earnings multiple of 21.0x and expected forward earnings of about $4.75 two years from now. This is similar to the 21.2x multiple on estimate of current forward earnings yet above the fifteen-year median forward multiple of 19.2x. Two year target reflects potential total return, including dividends, of over 10% on an annualized basis. Risks
As a worldwide consumer products company, there are numerous factors that could affect operations and possibly the stock price. These include changes in consumer demand for the company's products, competition, pricing pressures, changes in input costs (such as commodity prices, raw materials, and labor), risks associated with international operations such as exchange rate fluctuations and geopolitical risks, relationships with retail trade customers, and the global economy. The recent divestiture of non-core businesses is another key investment factor, as it represents a considerable change to the company's profile. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
OBJ Price at posting:
6.0¢ Sentiment: Buy Disclosure: Held
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