Procter & Gamble's Problems

| About: The Procter (PG)

Summary

A 1% dividend increase disappointed some investors - and with good reason.

But beyond simple yield issues, the increase itself shows how stretched P&G is at the moment.

Valuation still looks high here; much of the bull case rests on the impact of the current brand pruning, but I'm not sure how much value that really creates.

I still think fair value is below $80 - at least.

There's a long-running adage in politics and business that bad news should be delivered on Friday afternoon. Procter & Gamble (NYSE:PG) seemed to heed that advice last week, announcing a disappointing 1% increase in its dividend after the close.

Based on a review of PG's dividend history, the release was the announcement was the second made on a Friday in recent memory; the first was the 3% raise given last year. From my perspective, the raise indeed is bad news. The payout itself is of less interest to me than it might be to more yield-focused investors (though there's an argument the lower payout might reduce support for an interest in the stock from that class) than what the increase shows: P&G is a stretched company right now. That applies both to its capital allocation and its valuation.

The Dividend

source: author from PG dividend history

It's not just that PG's dividend increases are slowing, as seen in the chart above. It's the rate at which they are slowing. A company that regularly offered double-digit hikes (the 20-year average between 1992 and 2011, for instance, was 11.2%) has seen 7% increases (2012-2014) turn into 3% and now 1% increases. For any shareholder focused on DGI (dividend growth investing), this alone would seem to be an issue.

And it's not likely to be a temporary problem, either:

source: author from PG filings and press releases

There's not a lot of room here to increase shareholder returns; PG already is borrowing to fund share repurchases, and its targeted $7.5-$8 billion in buybacks this year are coming in large part due to the divestiture of Duracell to Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B).

Indeed, P&G highlighted the payout ratio problem in the dividend announcement issue, and it seems likely that the meager increase was offered simply to keep its now 60-year streak of dividend increases intact. But the choice to make such a low increase is an interesting one, particularly given that P&G still is expending a reasonable amount of cash on share repurchases: $2 billion in Q2 alone, for instance.

P&G said cash used in transactions - including $1.8 billion in cash sent to Berkshire in February - was part of the reason for the minimal dividend increase. But this is more a capital allocation choice: P&G is prioritizing share buybacks over the dividends. An increase to $0.70 quarterly - a 5.6% increase - would have required an incremental ~$320 million in cash this year. That's a fraction - almost certainly a single-digit percentage - of what P&G is spending repurchasing shares. But dividends don't boost Core EPS the way repurchases do, and that seems likely to have an impact on the capital allocation decisions made by the board. If the board continues to emphasize buybacks over the dividend, then 2016's meager raise looks more like the beginning of a trend than a blip on the graph.

Beyond The Dividend

At the end of the day, however, the dividend increase isn't the problem; it highlights the problem. A dividend, after all, is only a form of capital allocation: the company returns cash to shareholders instead of keeping it in its coffers or re-investing it back into the business. There are individual considerations that might justify a focus on dividend stocks - taxation and income being the two most common - but from a theoretical valuation standpoint, there's little impact derived from the transfer of control over that percentage of income.

But what the dividend increase shows to me is the fact that P&G is extremely challenged at the moment. It's worth noting that P&G's share count is declining, thanks to those buybacks, which means the absolute amount of PG's dividend over the next four quarters actually will decline against the prior period. But it still doesn't have the financial flexibility to increase buybacks, either. Cash share repurchases seem likely to be in the range of $4 billion this fiscal year ($2.5 billion has been spent year-to-date): the company has guided for $8-9 billion in share retirements in FY16, with the Duracell transaction (52 million shares) accounting for about $4.5 billion of that figure. That figure, too, is down from the $6 billion spent in FY13 and FY14, and well below the nearly $7 billion averaged in the five-year period before that.

Long story short: overall shareholder returns are stagnant at best, and those returns now are being funded with borrowed money and/or the sale of future earnings streams. The reason is that P&G's business is stagnant. Currency admittedly is a big factor here, as I've written before, but P&G's citing of double-digit constant-currency Core EPS growth doesn't account for the benefit of lower commodities driven by the strong dollar:

Click to enlarge

source: P&G CAGNY presentation, February 2016

Meanwhile, weaker foreign currencies aren't just an issue in terms of translation; they provide a competitive problem for P&G against in-market or euro- or yen-based competitors.

This is a stagnant business on the bottom line: that's why the dividend isn't being raised. There aren't enough earnings for P&G to return the capital its shareholders expect - and I'm not sure how this gets much better. Most of the cost savings from cost of goods sold and non-manufacturing labor already have been realized. There will be a benefit in FY17 from the Coty and Duracell transactions; but analysts, at least, are expecting barely $4 per share, and nearly all of that growth appears due to lower share count - not higher operating earnings.

Meanwhile, the argument that the current 'pruning' of brands will add value strikes me as fundamentally flawed. It's not as if the new, smaller P&G is going to be some sort of growth juggernaut - management seemed happy with 2% organic growth in Q2, despite the fact it came from largely unsustainable pricing increases. Unit volumes are falling across the business, and unless P&G is winning the Duracell and Coty deals in a big way, I don't see how it really moves the needle, given the performance of the remaining business lines.

The Contradiction

The response to these concerns often is that P&G is a great company, and it will rebound as it always has. But P&G isn't a great company right now - by the admission of its own executives (just listen to conference calls). And even those executives have been slow to understand the issues facing the company, judging by numerous downward revisions of guidance (most recently after Q2). Meanwhile, the price - over 20x forward EPS - is in-line with other faster-growing and better-performing companies, and above PG's historical multiples (which were in the high teens for most of the first half of this decade).

That price matters - and so does the yield. And that leads me to the contradiction inherent in the dividend-supported bull case for PG: the argument often is that PG always has been a great dividend stock, offering continual raises and long-term appreciation.

That's been true for a long time - but it hasn't been true for the past few years. Dividend growth is stalling out; the stock has been flat for the past two and a half years. A price over $80 implies some success post-FY17 which isn't assured. In other words, if you want to own a stock that offers PG's long-term characteristics, the current version of PG hardly seems to fit that profile.

From a trading standpoint, I doubt PG's announcement will move the needle much; institutional investors likely are far less focused on yield than on P&G's ongoing turnaround efforts. But I'm still skeptical about the potential success of that plan (investors have been waiting for a long time), and I wonder how long that patience will last, particularly given a 20% bounce since September. (Indeed, the most intriguing bull case I've heard came from long-time critic Ali Dibadj, who argued basically that if/when the current plan fails, P&G will benefit by doing what it should have done all along: breaking up.)

Longer-term, I still don't see why PG is considered an attractive stock at the moment, particularly for dividend investors. "They've done it before" isn't a good answer for any stock, and this isn't like before for P&G. The currency impact is significant; so is the ongoing fragmentation in consumer products. It's a different company, and a very different stock. Friday's announcement shows that P&G understands that as well.

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.