Procter & Gamble (NYSE:PG) has been losing altitude since earnings were reported in January, giving back almost 10% from a high of 66.95. Shares are now trading in the 60 area, beset by questions about growth expectations and the sustainability of margins. However, a study of the company's Analyst Day presentation provides evidence that there is still room for growth on a global basis, and that management has a detailed plan to deliver high single to low double digit earnings increases going forward.
According to the earnings press release, gross margins decreased 190 basis points, with commodity price increases and negative product mix more than offsetting manufacturing cost savings and volume scale leverage. While earnings per share at 1.11 were ahead of guidance, the commodity cost increase attracted a lot of negative attention. The company also reported broad based volume and market share growth, which drew less attention.
Many large companies hold an analyst day on an annual basis, with elaborate presentations and guidance for the coming year. PG held its on 12/16/2010. The handout (pdf) is available on its website, and worth reviewing. The transcript is available online (for a fee) and I spent $39 and downloaded a copy. As a retail investor, sometimes it makes sense to spend a few extra dollars to have the same level of information as the professionals.
CEO Bob McDonald led off with a discussion focused on two main points: 1) that there is room for PG to grow, and 2) that the company has a detailed and credible plan to make that happen.
Room to Grow
The basic argument rests on a matrix analysis, where the rows and columns are countries and products, or channels and products, or price tiers and products. Placing the largest 50 countries on one axis, and 38 product categories on the other, PG finds that they compete in only 50% of the 1,900 spaces available. Adding 5 price tiers as another dimension, the company only competes in 34% of the resulting 9,500 combinations. Here's a snip from the handout:
Supporting factoids: the China market for diapers was 200 million in 2000, and 2.2 billion today. PG's sales are $20 per person in Mexico, and .70 in India. Pepto Bismol is only actively marketed in three countries, Vicks in 25.
PG has been doing an excellent job establishing its brands in emerging markets. Because middle and upper classes are not as numerous, lower price and lower margin products have been a larger part of the mix, temporarily pressuring margins. However, the middle class in China as an example will soon be as large as in the US, and will use many of the same products.
CFO Jon Moeller presented on growth prospects. PG has about a 20% share in the markets where it competes, and believes it can predictably increase that by 10 to 20 basis points per year. Expanding into markets, product categories or price tiers where it does not presently compete is expected to add another 10 to 20 basis points per year.
These two items add 1% to 2% over and above the 3% to 4% global market growth the company expects, and form the basis for the estimate of 4% to 6% top line growth. Developed markets are expected to grow by 1 to 2%, developing markets by 6% to 8%.
Long term, the company expects high single-digit to low double-digit earnings per share growth, based on organic sales growth 1% to 2% above global market growth. John Neff noted that about 7% is a critical growth rate - fast enough to make something happen, but often not adequately respected by the market.
At this late date and for a company its size, it was somewhat surprising that PG is still working on cost reductions of the type that can be gained by reducing supplier counts, unifying buying functions, closing marginal production facilities, maximizing freight efficiency, etc. From the discussion presented, the company was late to this area but is making considerable progress in harvesting these savings. Already a capable competitor based on brand strength, this should allow the company to use its size to advantage in driving lower costs.
Commodity prices have recently pressured margins. The company has been working on formula flexibility, which will allow it to manage cost increases. Over the long haul, inflation works its way through all aspects of an economy, and margins can be expected to recover over time as this process unfolds. Finally, as more consumers in emerging markets achieve middle class status, disposable personal income increases and they can afford to spend more on higher quality products.
Defining 5 price tiers, margins can be increased by moving consumers up to premium products, which carry higher margins. PG sales per person in the US are $96 vs. $3 in China. The Chinese middle class is expected to be as large as the US within a decade.
It's necessary to win the business first, then as the consumer's economic means increase, higher quality/higher margin products can be worked into the mix. While initiating this process will change the mix and reduce margins for the company as a whole, it's a sign of growth and not a cause for undue concern about the company's future profit levels.
PG has a R&D budget of 2 billion - about 2.5% of revenues. Emerging markets have human capital, in the form of capable and innovative people. PG has been tapping this resource by moving the R&D function out to the markets served and focusing on the development of products at a cost level appropriate to the market.
Large and stable companies can be appropriately valued by the use of 5 year average earnings per share, or P/E5. Using 4 years actual and 1 year guidance, average earnings works out to 3.67 per share. Applying a multiple of 20, a typical midpoint for a quality company, I arrive at a target of 73, within one year. Here's a chart, showing PG's high and low prices on that basis for the past 7 years:
(Click chart to enlarge)
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PG briefly traded at a price of 37.39 during the flash crash on 5/7/2010 - the low price otherwise was 50, and that's what I used. As many observers have noted, large cap, high quality companies have not been commanding their normal multiples in the current market. That's where the value is.
Hitting the 73 target is dependent on global economic recovery and on management's successful implementation of the plan. The company has the resources, both human and financial. The plan is realistic, relying on only 10 to 20 basis points of market share gain per year.
Dividends and Buybacks
Procter & Gamble has paid a dividend every year since incorporation in 1890, and has increased the dividend for 54 consecutive years at a compound annual rate of approximately 9.5% per year. At recent prices the dividend yields 3.19%.
The company expects to spend 6 to 8 billion on buybacks during the coming year. In recent years, share counts have declined about 3% annually.
This year the company expects the combination will result in an effective return to shareholders of 7%.
Procter & Gamble shares are attractive at today's prices. Buy and hold or dividend growth investors can establish a position with a realistic expectation of being rewarded with an increasing stream of dividend payments and eventual share price appreciation.
Beta is .50, implied volatility 16.2%, both very low and characteristic of large and stable companies. The shares are optionable, to include LEAPS.
The use of deep in the money calls as a substitute for share ownership is a natural here. The sale of either puts or covered calls as a means of funding the time value and generating income makes sense to me.
Disclosure: I am long PG.