The Long Case for Procter & Gamble

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Includes: PG, VDC
by: Hobbes Investment Research

Headquartered in Cincinnati, Ohio, Procter and Gamble (NYSE:PG) is the largest consumer household products maker in the world. Operating in the non-cyclical sector, the company sells goods that people use daily. Its brands include Charmin, Cover Girl, Crest, Duracell, Gillette, Iams, Ivory, Mr. Clean, Olay, Pantene, and Tide, to name just a few. Twenty four of its brands make over $1 billion in sales annually.

Procter and Gamble has been around since 1837. The firm has paid investors dividends since 1891, and has increased those payments every year for the last 52 years.

As of writing, PG's shares are off about 15.2% from its 52 week high, set in December 2007. While the stock may certainly go lower, now may be a good time for buy and hold investors to start a position or add to one.

First, consider the headwinds the company faces:

1. As raw materials costs continue to rise, gross margins may suffer.

2. Sales growth is slowing in mature markets. Western Europe and US growth rates are both down, according to a Deutsche Bank research note. Estimates for US growth now range from 2 to 3%, while Western Europe is flat.

3. Increased competition and the emerging presence of hard discounters in Western Europe are slowing sales.

4. Emerging markets, from which PG derives almost 30% of its sales, are experiencing accelerating inflation. This could curb the current 7 to 9% sales growth there. Moreover, most of the growth in developing markets for PG comes from lower margin products.

5. The Duracell brand continues to perform poorly.

6. Competition from firms like Kimberly-Clark (NYSE:KMB), Johnson and Johnson (NYSE:JNJ), and L'Oreal (OTCPK:LRLCY) always makes for a tough operating environment.

7. The dollar may appreciate against other currencies. This may harm international sales figures.


Now on to the positives.

Procter and Gamble will sell its Folgers Coffee subsidiary to J.M. Smucker (NYSE:SJM). The $2.95 billion all stock deal (it's tax free), expected to close by the end of the third quarter, will give PG shareholders around a 54% stake in the new company. By selling off Folgers, PG is getting rid of a low margin brand and about $350 million in debt.

Analysts speculate that Duracell may be put up for sale at some point in the future if its margins don't improve.

PG's premium brands, like the fast growing Gillette Fusion, are gaining market share. Moreover, Procter and Gamble has so far been able to raise prices, offsetting raw materials costs and slowing sales in developed markets. Further, while growth in developed markets is slowing, it is only at 1%. Emerging market economies are growing at a fast clip and PG is well positioned to benefit.

The company wants to raise operating margins to 24% by 2010. Analysts think this will be difficult to achieve, but 22% margins are quite possible. This would be an improvement over the past five years. During that period, operating margins were roughly 18% on average.

Procter and Gamble also expects to make further productivity gains. The company says it will improve its productivity gains between 7 and 8% annually (up from 6% annually over the last three decades).

If the past is any indication, PG should outperform the market if the market trends down. Over the last quarter century, PG has outperformed the S&P 500 in all five major market downturns.

With a current earnings estimate of $3.87 a share for 2009, the company is trading at just over 16.5 forward earnings. This is on the low end of PG's 15 year forward price/earnings range.

While the company has around $40 billion in total debt, its operating cash flow was $13 billion in 2007. Its return on invested capital has averaged over 20% for the past five years.

The dividend yield is currently around 2.5% and the payout ratio is roughly 41%. The dividend rate will no doubt increase in the future. Procter and Gamble's five year dividend growth rate is almost 11%.

To conclude, PG is a consumer staples giant facing some headwinds, mostly in the form of rising materials costs and slowing growth in mature markets. Price increases, productivity gains, growth in emerging economies, and the divestiture of lower margin product lines should offset these problems.

With billions in sales spread out over a host of consumer non-durables, PG should weather the economic storm relatively unscathed. If the economy gets worse, people will still buy soap, diapers, razors, detergent, and toilet paper. If it gets so bad that consumers cannot afford to buy these products, then investors will have a lot more to worry about than PG's share price going down.

If you are interested in Procter and Gamble, you may also be interested in the Vanguard Consumer Staples ETF (NYSEARCA:VDC), where it is the top holding. Another way to own PG is to purchase shares directly from the company.

Disclosure: While I do not hold any shares directly, I own PG through BlackRock's Enhanced Equity Yield Fund.