Procter & Gamble: Projecting a Resumption of Organic Growth

Procter & Gamble (PG) filed an 8-K yesterday, summarizing the contents of a presentation made to a conference of institutional investors. The tone was positive, including a statement that the company expects to see a resumption of organic growth during its second quarter, ending December 2009. Organic growth is projected in a range of 1 to 4%. The CFO, Jon Moeller, noted that comparisons will get easier going into the second quarter. The stock was up 4%, closing at 56.04.

I included PG in a bullish series of diagonal spreads I did during August, and wrote up here on Seeking Alpha, the reasoning being that large, well-capitalized companies with strong brands can be expected to perform well as the safety and reliability of their earnings streams is better appreciated during what may prove to be a slow recovery.

Target - My valuation methods for companies of this type rely on 5 year average earnings, with consideration given to margins and growth. Based on historical Price/5 year average earnings ratios, PG is trading at a discount, primarily due to loss of growth and expected pressure on margins. If growth can be restored and margins maintained, a target of 69 is well within reach, by year end 2010. The projected return of organic growth is a positive indication, strengthening the rebuttable assumption that management, having ample resources, will address the company's issues effectively.

Issues – management has been active over the past 5 years, acquiring Gillette in 2005, selling Folger's in 2008, and most recently announcing the sale of the company's pharmaceutical operations to Warner Chilcutt (WCRX) for 3.1 billion. All of this has opened to the door for critical analysts second guessing management's strategic direction. Slumping revenue has added fuel to the fire. A few years ago there was speculation that the Gillette acquisition was being impeded by culture clash, presenting a decent buying opportunity. Dividends4Life did a good job discussing some of the more recent concerns in an article earlier this month.

As a general rule, when a company has problems with growth or margins, I check to see if management is aware of the situation and has a plan to address them, as well as the resources to execute effectively. PG has ample resources, management is very well aware of the sales decline, and has plans to turn things around. Today's announcement is the first evidence that these efforts are bearing fruit.

Strategy – my options position, long the Jan11 45 call and short the Jan10 55 call, is developing favorably, but regretfully there is no upside potential beyond 55, assuming shares continue to rise. I spent some time earlier this week working on the risk and return for this strategy, developing the analysis that follows:

Now that the company is projecting a return to organic growth, I regard the risk of a return to the 52 week low as remote, and consider the risk reward profile of this strategy as very favorable. I added a few more Jan11 45 calls but did not sell any shorter expiration calls over them, leaving room for share price appreciation. Here is a chart showing why I see support at 50:

Monitoring – This situation has a way to go. I plan to review the company quarterly, including the conference calls, paying special attention to organic growth. I regard the sale of the pharmaceutical operation as a plus, and would like to see that come to fruition in November as planned before making any more additions to my position.

Disclosure: Net long PG as described.

Comments

[The Hammer:]

nice work Tom.
what is pg going to do with the proceeds of 3.1 billion for the Warner Chilcutt ?
Another thing do you know how much domestic vs intl sales and what are their plans to gain positions in emerging markets?

Sep 11 10:51 AM

[Tom Armistead:]

The quesion on the use of the 3.1 billion would be about capital deployment, the best guess is to look at what management has done in the past. Share counts have decreased pretty steadily over the years so buybacks would be on the agenda. Capex has always been low compared to cash flow, which seems unlikely to change. The Gillette acquisition was a premium quality company. If PG does any acquisitions they would be good quality and fairly pricey.

When they say "investment," PG management is often talking about additional advertising or R&D expenses. Their strategy is to grow market share by advertising and product innovation. That type of investment is treated as an expense for accounting purposes and never shows up on the balance sheet. However, if it is properly done it creates value, the brand loyalty that generates strong profits under difficult conditions.

So I see "investment," that would also be their strategy for fostering international growth.

Sep 11 11:57 AM

[Respirate:]

Tom - thanks once again for a thoughtful, well researched article. seems we have many stocks in common.

-R
long PG shares

Sep 11 02:53 PM

[Bakry:]

Hi Tom,
I shared with you the vision on P&G's share and i still do, watched it slump to 45$ then grown back steadily... I wanted to buy at 50$ but didn't have the cash then... so I bought at 55 at the time where stock price was going up almost on daily basis (July).. then it dropped immediately again and didn't recover since then except for NOW..
I'm not there for the short gain.. but do u still believe it'll go back to the +65$ by next year...? i have the alternative of selling now with a net!!

Sep 14 11:01 AM

[Tom Armistead:]

To answer your last question, I believe PG will get up to 69 by the end of nest year, providing organic growth resumes.

Rather than worrying about the day to day price fluctuations, I am going to read their press releases and the transcripts of their conference calls here on Seeking Alpha.

If they continue to report organic growth, I will hold: otherwise, I will sell.

Sep 14 02:03 PM