Q4 Results: The Long Term Case for Procter & Gamble

For FY09 and Q409 (note that Procter & Gamble’s (PG) fiscal year ends in June), organic unit volume fell 2% and 4% respectively, while organic sales rose 2% for FY09 and fell 1% for the quarter. With the impact of currency, sales fell more, but the dollar can’t continue to rise forever. Despite the slight drop in revenue from Q408 to Q409, they still managed to grow diluted EPS from continuing operations and adjusted for non-recurring items by 6% (including non-recurring times, EPS fell 11%). Although the market seemed to be disappointed with Procter & Gamble's Q4 earnings, I am still bullish on the company, believing it to have better than average long-term prospects.

First of all, I would hardly call their performance poor, considering we are in the middle of the worst recession since the 1930’s. P&G’s results appear to be stellar compared to that of the S&P500 – looking at S&P’s latest spreadsheet (with 88% of companies having reported), 77.3% of companies are reported lower sales this quarter as compared to the same quarter in 2008. Overall, weighted sales of the SP500 are 20% less than in the previous quarter, and operating earnings per share is 19% lower.

Second, I believe the fears about private label competition are overblown. P&G has been dealing with private label competition for decades, while at the same time realizing impressive growth. Sure, some consumers are trading down during the recession, but P&G has a three-tiered product line that allows it to participate in down-trading. As long as P&G continues to innovate and create products that create value beyond that of private label competitors, they should continue to hold on to market share while at the same time continue to realize above average operating margin and return on tangible assets.

P&G will continue to innovate because economies of scale allow P&G to spend much more than rivals on R&D. For example, P&G spends over twice as much on research and development than its nearest competitor. P&G’s largest competitors by trailing 4 quarters revenue are Unilever (UL) ($60B), Kimberly Clark (KMB) ($19B), and Johnson & Johnson’s (JNJ) consumer segment ($16B). Only Unilever has the scale to come close to what P&G can spend on advertising. Moreover, the same economies of scale allow P&G to efficiently signal this value to consumers through advertising.

Procter & Gamble’s advertising and R&D is spread over 44 brands that account for 90% of the company’s profits, and there are many opportunities to leverage proprietary technology among multiple categories. Moreover, P&G’s research and development is enhanced by a global relationship with nearly two million researchers in technology areas connected with P&G businesses. And these new products can be quickly brought to market using P&G’s existing brands and distribution system. P&G’s relative level of innovation is apparent from the results of the 2008 industrial research institute’s pace setter study that measures the top new products measured by sales. In 2008, P&G had 10 out of 25 of the top new products in the non-food category. In comparison, Unilever, J&J, Kimberly Clark, Colgate (CL), L’Oreal (LRLCY.PK), and Energizer (ENR) collectively had 7.

P&G consistently cuts costs unrelated to differentiation, giving P&G a cost advantage that acts as a barrier to entry. For example, continuous reformulation can provide the same product performance with different ingredients, allowing the formulation to be optimized for current commodity costs, this saves the company on raw material costs. They also have similar developing country margins as developed country margins, so they apparently have a manufacturing system that geographically matches costs to the point of sale. P&G saves on the costs of materials by creating purchasing pools for common materials used over multiple product lines. P&G’s distribution network reaches 800 million customers in China, 4.5M stores in India, and 80% of the Russian population.

Finally, I am bullish on P&G’s prospects because of the potential growth in emerging markets. Despite P&G’s large market share, there is considerable room for growth as the global economy expands, giving citizens of developing countries the ability to purchase consumer goods. P&G mentioned on their Q309 conference call that if per-capita use of P&G products in India reached that of Mexico, it would add $20 Billion in sales. P&G has developed products targeted at developing countries, such as their detergent optimized for single rinse, which targets consumers that wash their clothes by hand.

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Right now, I estimate P&G’s per-share intrinsic value to be $57 whereas its market price is $52. Although this is not a large discount, the company is reasonably priced considering its bright prospects. For a more detailed analysis of P&G, click here.

Disclosure: I do not own shares in Unilever (UN), Colgate (CL) and Kimberly Clark (KMB).

Comments

[Stephen Ros...:]

Fair enough.
How do you view PG's foray into beauty products? Not so sure that is the right move. I'm also wondering whether selling Folger's to SJM was such a good move. Look at the strong profits that brought to SJM. I think it turned out that they sold their best not worst division. Thoughts?

Aug 09 12:39 PM

[Brian Gaudet:]

Stephen,
I think with some of the beauty products, they saw an opportunity to provide products of similar quality to that found in department stores at a fraction of the cost. Over the last few years, the operating margin and return on tangible assets for this segment have been impressive. I guess it is to be expected that the segment would be slowing down now, but long-term I think their decision will prove to be a good one. As for Folgers, it does appear that P&G's snacks division is their least profitable (looking at operating margin), and it also appears that many food brands are not holding up as well to private label competition. Really my only complaint with management would be that I wish they would replace some of their short-term debt with longer term debt.


On Aug 09 12:39 PM Stephen Rosenman wrote:

> Fair enough.
> How do you view PG's foray into beauty products? Not so sure that
> is the right move. I'm also wondering whether selling Folger's
> to SJM was such a good move. Look at the strong profits that brought
> to SJM. I think it turned out that they sold their best not worst
> division. Thoughts?

Aug 09 01:09 PM

[David Van K...:]

P&G is one of the world's great companies. The sale of Folger's was part of a long-range strategy to exit the food segment entirely. I hesitate to question that strategic decision, given P&G's long history of making excellent capital-allocation decisions. Much of P&G's recent numbers disappointments stem from unfavorable foreign exchange rates. That wind blows both ways and over time presumably evens out.

In addition to all the reasons to own P&G mentioned in this article, it has a strong current dividend (3.4%) and a stellar record of dividend growth. They have increased their dividend for 53 straight years, including a 10% bump earlier this year. That's the main reason I own the stock. If P&G were to continue that rate of increase each year for the next 10 years, the stock will be yielding 8.8% on initial cost, on top of gains it may make in principal.

Aug 09 01:12 PM