Procter & Gamble (NYSE:PG) is a stock that people who love dividends and stable companies think they have to own. (I know this because I own it, and have owned it for years.) We all know what it does, what it means, what its dividend record is, how long it has existed, etc. It is a great company. Nevertheless, I have just reevaluated this holding, in light of recently-reported weak quarterly results. While I have no plans to sell at this time, I have reached the following three disturbing conclusions (the respective analyses follow):
- Conclusion one: Free cash flow growth has become shockingly hard to quantify or estimate at this slow grower/stalwart. My analysis indicates the company is charitably only worth its current share price (leaving no margin of safety for purchases). Even that valuation assumes a quick return to positive free cash flow growth, which is currently negative.
- Conclusion two: Asset turnover and return on assets show a permanent change in PG's competitive profitability profile since 2006, and not in a good way. This appears to have nothing to do with the recent recession.
- Conclusion three: Related to the second conclusion, the problems all seem to start in the 2005-2006 year. They have never been resolved. I am forming a hypothesis that the Gillette acquisition in 2005 was a major turning point for PG, and not in a good way -- that it marked a classic case of a whole being worth less than its two halves individually.
Part One -- Discounted Free Cash Flow: The discounted free cash flow analysis, while always imperfect and riddled with assumptions, is my primary tool for evaluating the value of a company. Here is my latest sheet. This shows that PG has generated only between 5.5% and 6% annualized free cash flow growth in the last decade. This is more suggestive of a "slow grower," not a "stalwart." Worse still, free cash flow has gone into decline since 2007. From 2007 through 2011, notwithstanding the 2010 spike, free cash flow has actually declined at a negative 0.23% to negative 1.37% annualized rate (depending upon how you calculate free cash flow). This makes it very hard to assume positive free cash flow growth growing forward, notwithstanding the fact that one must assume -- one must believe! -- that PG will show positive free cash flow growth again soon, though it shows little sign of doing so now.
I am compromising in my calculation by assuming 3% growth for the next ten years. That is a blend designed to assume continued free cash flow decline for the next year or two, followed by an eventual return to the higher 5-6% trend later this coming decade. Using this as my assumption, and an industry-standard 8% WACC (which, as a lower-end WACC, elevates PG's valuation) as my discount rate, I derive a fair value centered on approximately $63/share. This is near today's trading level of $63.98/share, with no margin of safety.
In reality, however, if PG continues to decline (in free cash flow terms) by 1% per year for the next decade (as it has been), it is only worth $48/share. That is scary. I believe that is unlikely, and I would guess it is likely worth between $50 and $75/share. In my mind, it is not a buy over $50/share, from a valuation perspective, since I must employ my conception of a 20% margin of safety.
Part Two -- Profitability Changes Since 2005: These free cash flow troubles appear to be a sign of deeper problems in the kingdom. If you look at PG's key ratios, you will see that starting in 2006, PG's asset turnover and return on assets, both dropped precipitously, and have never recovered to prior levels. These are of course related measures. As I understand it, the drop in the former (revenue/assets) leads to a drop in the latter (net income/assets) assuming there is not cost-cutting sufficient to offset the initial drop in asset turnover. From 2006 to 2007, one was forgiven for assuming that PG was just digesting Gillette (more on that below). From 2008-2010 one was forgiven for assuming the financial crisis had harmed PG. But what now? (Days inventory is also generally up, too.) This new, less profitable, less efficient status quo has now gone on for six years. All other solutions apparently having been exhausted, one is left with the conclusion that PG's measures of profitability and its growth trajectory may have permanently changed for the worse.
Part Three -- Gillette Hypothesis: My hypothesis is that PG has potentially damaged its long term profitability with its 2005 acquisition of Gillette. Few remember the extent to which this acquisition (made at a time of maximum market and economic optimism) was heralded. No less a worthy than Warren Buffet was quoted in that piece, lauding the acquisition. Of course, it give that prior owner of 9% of Gillette a massive financial windfall, so no wonder he liked it. Note in that article from 2005 the raising of revenue growth expectations up to 5 to 7 percent from 4 to 6 percent. Actually, since the acquisition, PG grew revenue at only a 4.25% clip. That is not good. And there are the aforementioned related decreases in profitability and efficiency measures.
Here is the thing: the world is littered with bad mega-acquisitions. One of the most famous was the AOL(NYSE:AOL)/Time Warner (NYSE:TWX) transaction. I submit to you that this one, valued at $57 billion, a titanic percentage of PG's then-market-capitalization, was just too big. At best, it is has taken PG more than half a decade to digest it. At worst, it permanently damaged the company.
I realize other factors are at work. But they may be no more pleasant. Why did other consumer products companies not feel they had to match PG's recent commodity-inflation-induced price increases? Why were consumers switching to cheaper brands? (These are all from the first link, about PG's week recent quarterly report.) What does that say about PG's vaunted moat?
In short, this is a former stalwart that has become a classic slow grower. It was never a rocket stock, but something bad happened to it in 2005/2006, something that I think goes beyond the financial crisis. The only reason to own it is for the dividend and for the low beta. That is why I continue to own it. And keep in mind with regard to the 3.5% dividend, however, that the payout ratio is now all the way up to 64%, which while in line with many peers, is high. Buyer beware.
PS. When and why did I buy my stock? In mid-2006 at $57.95/share. If I recall, it was because I believed what Buffett had said about the merger, and because I thought "near-term" problems at the time were a buying opportunity. Doh!