Procter & Gamble (NYSE:PG) is usually a great defensive pick. The firm's household and personal care products are less sensitive to economic fluctuations or geopolitical issues, and its wide moat allows for positive economic profits and a generous dividend. But in the post-Brexit scramble to safety, PG has risen more than 5% and now trades at a 52-week high (forward P/E of 21.7, P/CF of 16.1). PG trades almost 33% higher than its historical average on a trailing P/E basis. This is all happening during a period of significant headwinds, and the risk profile has become more tilted to the downside than in years past. While most investors focus on currency headwinds, PG's issues extend beyond FX.
The biggest problem for PG in recent quarters has been its inability to grow volumes. Due to widespread economic weakness and increased competition, sales volumes have declined in each business segment over the past nine months. Despite raising prices, management expects to grow revenues just 1% in FY16. Weak global demand has made PG's premium-priced products less competitive. As a result, PG has lost share to private label players and other competitors such as Clorox (NYSE:CLX), Unilever (NYSE:UL), and Kimberly-Clark (NYSE:KMB) who sell closer to the lower end of the market. These firms each expect to grow volumes between 3% and 5% in 2016. PG's beauty and grooming segments are doing particularly badly; Unilever has doubled share in hair products against Olay, and the firm is having trouble coping with the rising threat of 1-800 razors in the male grooming businesses, one the company's more profitable segments.
Volume declines are a problem for two reasons. First, consumer staples firms such as P&G rely on volumes (as opposed to pricing) for growth because intense competition and commoditized products limit the extent to which firms can raise prices. Thanks to its portfolio of recognized brands that resonate with consumers, PG has more leverage to raise prices than most, but the firm can only do it so much. And it is especially challenging to grow through inflation during periods of weak economic growth as consumers become more sensitive to price. The second issue with volume losses is that earnings decline at a higher rate than volumes do as a result of negative operating and financial leverage. PG has high fixed costs (R&D, interest payments) that the firm cannot cut when it sells fewer products, which causes margins to decline.
In response to these headwinds, management has focused on cutting costs by reducing headcount, lowering overhead, and localizing raw materials sources. These initiatives have helped the firm become more efficient and convert a higher portion of sales into cash flow. But PG has also lowered its R&D budget during a period when it needs to innovate more than ever. PG is riskier now than it was in the past. The firm's massive portfolio transformation away from underperforming categories towards its core brands leaves the firm more exposed, as PG has relied on a product differentiation strategy with these brands, using price increases to offset weaker volumes in peripheral categories. The firm will be reluctant to lower prices and margins on its strongest products, but it may have to in order to boost growth.
P&G is a great defensive company, but the stock is too expensive to buy in at these levels. Despite lower earnings, management has been able to generate higher returns for shareholders through cost cuts and buybacks. But we need to see PG return to volume growth (which is what ultimately drives returns over time) before we would consider investing. This most likely won't happen until economic conditions improve or the firm lowers prices.
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