Pershing Square Capital Management, the hedge fund controlled by Bill Ackman, has acquired 21.8 million shares of Procter & Gamble Co. (PG) and call options on an additional 8.3 million shares. At Monday's (8/20) closing price of $66.75, this $1.46 billion shareholding is equal to 0.80% of the total shares outstanding. Call options would probably not add significantly in percentage terms to the total cost of the position, but do give it greater upside potential, assuming that Pershing is long.
Considered an activist investor, Mr. Ackman has said (on CNBC and as reported by Forbes) that his firm believes that it would be very hard to lose money on P&G. Pershing's average cost for the shares is $64; so at this point, it has an unrealized gain of $60 million or 4.3% on the position, not including the gain on the call options. The speculation is that Pershing will push the company to undertake changes that would lift the share price more. Pershing's purchase of call options implies that it believes that this will happen sooner, rather than later.
Procter & Gamble is one of the world's premier consumer product companies. It focuses primarily on non-food consumer items, like detergents, paper towels, razor blades, toothpaste and shampoo. P&G has 25 brands that generate $1 billion or more in annual sales including Head & Shoulders, Olay, Pantene, SK-II, Wella, Braun, Fusion, Gillette, Mach3, Always, Crest, Oral-B, Vicks, Ace, Ariel, Dawn, Downy, Duracell, Fabreze, Gain, Iams, Tide, Bounty, Charmin and Pampers. It sells its products in 180 countries. The U.S. accounted for 35% of total fiscal 2012 net sales.
P&G's stock has underperformed both its peer group and the broader market. Year-to-date it is essentially flat, compared with gains of 12.8% in the S&P 500 and 9.5% in a peer group that includes CHD, CL, CLX, JNJ and KMB. Since the beginning of 2011, P&G's stock is up 3.8%, compared with gains of 12.8% in the S&P and 24.5% in the peer group. P&G's relative underperformance is also highlighted in the chart above, courtesy of Stockcharts.com, which compares P&G against the S&P 500's Consumer Staples sector.
Despite this relative underperformance, P&G's stock trades very close to the peer group forward P/E multiples based upon consensus earnings projections. The stock is currently valued at 17.1 times projected 2012 earnings of $3.90, slightly below the average peer group multiple of 17.6 times, and 15.8 times projected 2013 earnings of $4.22, compared with the 2013 peer group P/E multiple of 16.2 times.
In this challenging global economic environment, P&G has struggled to grow sales and maintain its profitability. Budget-conscious consumers all over the world have aggressively pursued ways to save money, in many cases scaling back their purchases of premium-priced brands, like those of P&G. The company's net sales have grown at a compounded annual rate of less than 2% since 2008. Fiscal 2012 net sales increased 3.2% with no volume growth, as expansion in emerging markets offset declines in the mature economies of North America and Europe.
Profit margins have held up reasonably well over the past four years or so, but there has been evidence recently of increasing pressure. In February 2012, P&G announced a $10 billion productivity and cost savings plan to cut overhead costs in functions like R&D, marketing, supply chain and other overhead expenses. The plan is intended to accelerate cost reductions and streamline decision-making to facilitate the execution of its growth strategy. P&G expects to incur total pre-tax charges of $3.5 billion over a four-year period in order to achieve its cost savings target.
P&G's operating margin has declined from a 2007-2010 average of slightly more than 20% to 19.1% in fiscal 2011 and then to 15.9% in fiscal 2012. In fiscal 2012, the company took a $1.5 billion or $0.50 per share non-cash charge to write down the carrying values of goodwill and intangible assets in the Appliances and Salon Professional businesses. It also incurred pre-tax charges of $721 million under its restructuring program. Excluding the impairment and restructuring charges, the fiscal 2012 operating margin would have been 18.6%, still down 50 basis points from 2011 and a sign of continuing margin pressure on the base business.
If we assume for the moment that P&G was able to achieve the full $10 billion of cost reductions in fiscal 2012, its operating margin, excluding impairment and restructuring charges, would have risen from 18.6% to 30.6% and its diluted EPS from $3.66 ($3.12 from continuing operations) to an estimated $6.73 ($6.19 from continuing operations). At that pro forma EPS level, P&G's trailing 12-month P/E multiple (on total earnings) drops from 18.3 to just under 10.0 times. This highlights the potential upside to earnings (and therefore to P&G's stock price) of the restructuring program.
One key question, however, is whether shareholders will realize the full benefit of P&G's cost reduction efforts. If this weak economic environment persists and shoppers remain price sensitive, branded products companies like P&G may be forced to adjust their business model to compete more on price. Investments in innovation and advertising may be less productive and therefore may have to be scaled back.
So how can Mr. Ackman help P&G management here?
- Accelerate the restructuring program. Four years may be too long to wait for the full implementation of the cost reduction program. Consequently, Pershing can try to push the company to achieve its restructuring objectives in three years or maybe less.
- Sell or spin-off businesses that do not seem to fit well strategic with P&G's core strategy. The company has already completed the sale of its Pringles business to Kellogg. It may consider other sales, such as its Lams pet food business, Braun personal care appliances and Duracell batteries, to name a few, that do not seem to fit well with the remaining non-durable household products and health and beauty aids businesses.
- Consider a more radical split of P&G's businesses. The company might consider making a bolder move by separating its two Global Business Units - Beauty and Grooming and Household Care. My hunch, however, is that there is less to be gained from radical financial engineering in the current environment and at P&G's current valuation. If the company's stock was trading at less than 10 times projected fiscal 2013 earnings instead of 17 times, then a big split probably would make more sense.
- Leverage up the company and pay out a special dividend. P&G's balance sheet leverage is currently low - debt is only 32% of its total book capitalization and 14% of its total market capitalization. So the company could add more debt and pay out a special dividend. This would give management an added impetus to cut costs sooner. In theory, given the relative stability of its operating earnings, P&G could borrow $50 billion or more, which would translate into a payout of $18 per share or more to shareholders. The problem here, though, is that it is 2012 and not 1988 or even 2000. Banks have considerably less enthusiasm for doing these types of leveraged recapitalization deals today (whether in the bank loan or public debt markets) and the size of any transaction that would really make a difference to shareholders would be tough for the capital markets to swallow. Given the uncertainty in the global economic environment, it makes more sense for the company to preserve its borrowing capacity so that it can respond to both challenges and opportunities that arise over the next several years. Of course, Mr. Ackman and his colleagues might see things differently.
For now, I agree with Mr. Ackman that there is probably little downside in P&G stock, as long as the global economic environment does not push consumers to tighten their belts much more. There should be decent upside potential in the stock just from executing and accelerating the cost reduction program and perhaps peeling off a few businesses. Although the company should streamline its business operations as quickly as possible, shareholders are being paid a decent 3.4% dividend while they wait. That payout would likely go up, if management, with the help of Mr. Ackman, is successful in its efforts.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.