Procter & Gamble (NYSE: PG) is the definition of a stable consumer staple stock. By making money from every day essentials like personal care products and detergent, the company has been able to generate profits year after year without fail. This is one of the reasons why many investors have flocked to the company ever since the market sentiment took a drastic turn last fall.
(click to enlarge)
Despite the stability of the underlying business, the stock itself is actually quite volatile. While it can't be compared to say, an oil and gas E&P company, the stock has experienced some dramatic swings in the past. How should we view this volatility? I believe there are two contributing factors: emotions of the market and expectation of fundamental improvement.
The emotion component consists of the overall sentiment about the economy. As I mentioned in my article on macros, defensive stocks have been performing well given the high degree of uncertainty in the global economy. Of course, whenever the market transitions into a "risk-on" environment, then the opposite happens. Note that the underlying fundamentals of defensive stocks have nothing to do whether investors' appetite for risk increases or decreases. For this reason, Procter & Gamble's stock will continue to shift regardless of how the business is performing.
The second component relates to the fundamental improvement of the business. The stock is currently trading at a TTM P/E ratio to 26x, clearly the market is pricing in a substantial improvement in earnings. We know that higher earnings will not come from growth as P&G is a mature company, as evident by recent organic sales growth:
(click to enlarge)
Hence earnings improvement must come from enhanced productivity.
On June 16th, the CEO elaborated on his plan at the dbAccess 2016 Global Consumer Conference. Indeed, the major focus will be on cost reduction (i.e. enhanced productivity). The current goal is to achieve $10 billion of cost savings over the next five years, adding $0.75/share to the annual EPS. If we take these savings into account, the pro forma P/E ratio would be around 21x, a more acceptable multiple for a slow growing consumer staple stock. But what are the steps needed to reach this goal? There are two low hanging fruits: reducing non-manufacturing overhead and decreasing the cost of goods sold. The former will be achieved by reducing non-essential office jobs that don't directly contribute to sales. The CEO specifically stated that the company will be focusing on "costs that don't impact reach frequency or continuity of our advertising and trial generation programs." The existing overhead was likely built up as new products were launched, but now that the products have matured, the initial team will no longer be needed. The cost of goods reduction will result from an improved supply chain. Some steps include more automation and moving production sites closer to distribution centers.
It may sound a bit complex, after all, how can we be sure that the management will realize their goals? If you haven't been paying attention to the stock over the past couple of years, you may have missed the fact that these cost reduction initiatives have been in place since 2012, the new goal of $10 billion is merely an extension of the last cost reduction program. Because the management will essentially be doing the same thing this time, execution risk will be greatly reduced. Furthermore, the management has been rather conservative in their estimates last time. For example, the current pace of cost cuts for non-manufacturing overhead has greatly exceeded initial estimates. The goal from the last restructuring announcement was to just eliminate 10% whereas more than 24% have been already been eliminated to date. Going forward, the management expects to bring the total reduction to 25-30% by the end of 2016.
It is very important for these cost cuts to take place because in my view, organic growth opportunity for Procter & Gamble will be limited (as past results have shown). However, that should be expected for a large consumer staple company. With low growth, efficiency becomes an important source of return. You may not like a slow growing company, but I believe that value creation resulting from increased efficiency is much better as cost savings do not fluctuate with sales. If a business does poorly, the cost savings will still be there.
If you are a long-term investor, then I believe Procter & Gamble is a good choice for your portfolio. With the new cost reduction initiatives, you can expect the P/E ratio to fall into a more acceptable range as earnings increase.
Keep in mind that just as the stock may rapidly appreciate in a "risk-off" environment, the stock will fall just as quickly once the market calms down. Just to be clear, Procter & Gamble will not save you in the event of a full-blown crisis, even if the fundamentals remain sound (EPS actually improved during the recession). Equity as a whole will still carry systematic risks, and Procter Gamble is no different. But if you have a long-term horizon, these short-term swings should not concern you in the slightest.
Click the "Follow" button beside my name on the top of the page to be updated with my latest insights. To learn more about the V20 Portfolio (+40% in 2015), whose goal is to compound capital at 20% over the long term, I encourage you to read the introduction to my investment process. Premium subscribers get full access to the V20 Portfolio. Track the portfolio through the latest update, here.
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.