At first glance, Procter and Gamble (NYSE:PG) reported a good quarter - the headline numbers, in their own words, were "P&G Delivers +2% Organic Sales, +9% Core Earnings Per Share."
Dig below the surface, though, and there are a few issues that suggest to me that the company has not yet turned the corner. While they've done a good job on the expense side and are making the tough (but right) decision to shed unprofitable lines even though it pressures sales in the near term, I question whether there's really enough levers they can pull here to drive significant value creation for shareholders.
Pricing and Volume: Different "Quality" Earnings Growth
Consumer brands are renowned for their pricing power; Coca-Cola (KO) has countered declining CSD volumes with price increases. This is not a bad thing - but when pricing increases are merely offsetting volume declines, to me, that growth is worth a little bit less because eventually you will hit some sort of price cap. In the case of P&G, this table from the earnings release was very interesting:
Particularly given that developing economies are the major volume growth drivers for CPGs - the thesis is that the "emerging middle class" will increasingly seek higher-quality, branded consumer products - I don't know how far you can push price. Razors and shampoo are not nearly as cheap as soda to begin with, and there's thus less room for boosting prices here over the long term in emerging markets. P&G CFO Jon Moeller admitted this on the call - "we're not going to be able to take 3% pricing indefinitely, nor is that our intent in any way." In fact, P&G appears to be playing a game of chicken to some degree; he went on to say:
Competitors can take six to nine months sometimes before they respond or they cannot respond at all. In the cases where they don't respond to the levels that are necessary to maintain our value equation comparisons, or where they don't price at all, we will reduce price. We're not going to be uncompetitive. We're not going to lose share on a sustained basis.
Thus, while pricing has provided some near-term respite, it's likely not sustainable, particularly in emerging markets.
Even domestically, actually, Procter & Gamble is facing pricing pressures. In the razor business, there is increasing competition from the likes of Dollar Shave Club, who rode a viral video to an astonishing level of market share (nearly 10%!) very quickly. P&G's response has been to tell people to shave less often to save money - hardly a strategy which portends future pricing power.
To be fair to P&G, some of this pricing/volume change is likely driven by their renewed focus on profitability rather than sales growth at all costs - in India, for example, they're dropping empty calorie revenue; sales were down 15% in businesses they're exiting but up 10% in the part they're maintaining, and they went from "losing money to triple-digit profits." The same applies to Mexico. That said, according to the company, this only impacted organic growth by one point - so it's not, on its own, enough to offset the volume declines.
Currency: Seemingly Not Just A Temporary Headwind
A major issue for Procter & Gamble has been its exposure to weak markets - as CFO Jon Moeller pointed out at the Barclays conference last September, P&G has leading positions in countries like Russia, Ukraine, Venezuela, Japan, China, and the Middle East. All of these countries have their own idiosyncratic issues, but the commonality is that they're not pleasant places to have a lot of exposure right now.
Beyond the direct weakness in these end-markets, currency has been a very big impact. Not just a few percentage points - Moeller discussed this pointedly:
That brings me to the next challenge, significant devaluation of almost every non-US currency, which has had an extreme impact on gross margin, operating margin, and earnings per share. On a constant currency basis, gross margin has increased each of the last four quarters. Core operating margin has increased each of the last three fiscal years, up 60, 150, and 130 basis points respectively. Core earnings per share is up double-digits in each of the last three fiscal years, plus-10, plus-14, and plus-11. It is up meaningfully in each of the last four quarters.
Some of these numbers turn negative with the tidal wave of FX we've been managing against. And our ability to offset this has been impacted by our need to compete with the euro and yen functional currency companies.
Key in on that last line. Until and unless weak end-markets turn around, currency is not something I'm willing to "adjust" for. At some point, if these markets do strengthen, P&G will be poised to benefit, perhaps significantly - but that day could be a long way off, and in the case of markets like Ukraine and Russia, it's not clear whether the currency (and economic) impairment is temporary or structural.
Wrapping It Up
Even if you look out to FY17 numbers, analyst consensus is for $4.20 in EPS - and absent a material improvement in emerging economies (and their currencies), it's hard to see them doing better than that. For 2016, "Core EPS" including foreign exchange is expected to be down 3 - 8 % vs. last year's $3.76 number; if on a constant-currency basis, they would earn closer to $4.00 (but as I discussed above, I don't think this is a useful adjustment here). All in all, that puts P&G at a price that doesn't exactly look like a bargain.
Yes, I know CPGs trade expensive, and I suppose you could justify $90 or above in a couple of years if the company does manage to execute to plan and doesn't take another hit from emerging markets - but why bother? Amidst the recent sell-off, there are plenty of companies trading for seemingly reasonable multiples that have firmer long-term growth prospects (or at the very least, fewer execution risks).
If you're looking for long-term exposure to emerging markets, then I do think that a multinational like P&G is an easier play than owning companies in those markets (for a variety of reasons, governance high among them). For everyone else, though, it's not clear that P&G has a strong value case today outside of the dividend. Shares could trade higher, but they could also very well stay in the trading band they've been in since 2013. There seem to be easier returns elsewhere, and at the current price, P&G just doesn't look very appealing to me.
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.