Procter & Gamble: An Activist Investor Takes A Stake, But We Say Wait To Buy

| About: The Procter (PG)


Procter & Gamble has been undergoing a transformation program whereby it divested many of its non-core, less profitable brands to focus on its dominant, most profitable brands.

Just as the company approaches the end of transformative activities, an activist investor emerges to exert additional pressure on it. Cost reduction efforts, however, continue.

Analysts/investors see such activist holding as an effort to add to the pressure on the company to slash costs further and jump-start growth more rapidly.

We believe investors should hold out to invest any new money in such shares unless Procter & Gamble stumbles in its efforts to reinvigorate revenue/profit growth.

With rising interest rates, markets at all-time highs and price cuts for the company's most profitable Gillette products, investors will be able to buy shares at a more value-oriented price.

Procter & Gamble (NYSE:PG), a global consumer product innovator and marketing giant, has been undergoing a transformation program in recent years, whereby it divested many of its non-core, less profitable brands to focus on its dominant, most profitable brands. Subsequent to multiple business and product line divestitures, PG now focuses on 65 core brands. The company's retained core brands are leaders in their industry category or segment, about 20 with sales of $1 billion to $10 billion, about 15 with sales of $0.5 billion to $1 billion and the remainder with strong brand equities in sales of $100-500 million. Such remaining core brands also account for about 90 percent of company sales and over 95 percent of its profit. As PG has carried out its divestiture strategy, it also continued to decrease its expenses by streamlining management, reducing costs and eliminating jobs under a restructuring plan. While it continues to show progress from its transformative activities, some critics remain who believe PG will remain unwieldy due to its size and should be broken up into multiple companies that are better able to focus on their core strengths. (We discussed the positives and negatives of a PG break-up in an earlier article.)

Just as PG approaches the end of its most significant transformative activities along with its cost reduction efforts, an activist investor emerged to exert additional pressure on company management to improve its performance and shareholder rewards. In fourth quarter 2016, Trian Fund Management added a single stock to its portfolio: PG. According to an SEC filing in February 2017, the activist hedge fund Trian, co-founded by billionaire Nelson Peltz, held 6,416,284 PG shares valued at $539.5 million as of December 31, 2016 (about 1 percent of shares outstanding). The fund now has a $3 billion holding in the company, its largest holding.

Analysts and investors see such a holding as an effort to add to the pressure on PG's CEO, David Taylor, to slash costs and jump-start growth more rapidly. (In its previous activist campaigns against large conglomerate companies, Trian pressured companies such as Mondelez International (NASDAQ:MDLZ) and DuPont (DD).) Upon the announcement of Trian taking a stake in PG, the company's shares jumped almost 5 percent. With PG trading higher on the Trian announcement, we believe new investors should hold out to invest any new money in such shares unless the company stumbles in its effort reinvigorate its revenue and profit growth and its shares dip.

The timing of Trian's investment appears to be an opportunistic one. As noted above, PG has just completed its two-year brand divestiture program (disposing of more than 100 brands, while retaining its strongest and most profitable 65 brands). The "heavy work" of its transformation program has ended, and we believe Trian is jumping on board the "PG train" just as the company is positioned to benefit from more focused brand spending, and, therefore, an improved ability to more effectively recognize and respond to changing consumer trends.

In addition, the company's transformative investments will also cause improvements across its product mix, thereby driving accelerating sales and volume growth. Not only will PG benefit from narrowing its brand focus to drive revenue/profit growth, but it will also continue its cost reduction efforts by removing an additional $10 billion in costs by decreasing overhead, decreasing material costs, and increasing manufacturing and marketing productivity. With PG continuing to move forward with its transformative efforts, it is unlikely that Trian will push for additional efforts unless the company fails to sustain its revenue and margin gains. If, however, its ongoing efforts stumble, expect Trian to step up with additional pressure to push for additional cost efficiencies and the disposal of additional brands and/or businesses.

PG's latest quarterly results showed it recording adjusted earnings of $1.08 per share, a 3.8 percent increase from the year-ago quarter due to higher margins. (Currency-neutral core earnings showed a 9 percent increase.) The company recorded net sales of $16.86 billion, flat with the year-ago quarter due to adverse currency effects. Organic sales, however, increased 2 percent due to an increase in organic volumes. Each of PG's five business divisions recorded positive organic sales growth. The healthcare business recognized 7 percent sales growth. The beauty business recorded 3 percent growth, while the grooming, fabric and home care baby, and feminine and family care businesses saw 1 percent growth. The company's core gross margins increased 70 basis points to 51.5 percent due to productivity cost savings and higher volume benefits that were offset by an unfavorable product mix and commodity cost increases.

With such quarterly results in mind, PG increased its organic sales growth guidance to about 2-3 percent, up from 2 percent. However, the company now expects adverse currency effects and smaller brand divestitures to decrease sales by about 2-3 percent, down from 1 percent. As such, PG expects its total sales growth to remain flat for fiscal 2017, while it maintained its core earnings per share growth at the mid-single digit range.

The most significant takeaway from the latest quarterly results was the company's revenue improvement, as organic sales increased 2 percent, reflecting increased volumes. With such results, it is clear that PG's focus of its financial and personnel resources on its highest-return products/brands will position it for accelerating sales growth in the future. The second-most significant takeaway from the results were its efforts to reduce cost efficiencies and to target another $10 billion cost reduction by decreasing overhead, lowering material costs and increasing manufacturing and marketing productivity.

While PG will continue to face competition along many of its product lines from branded and private-label products, the company supports its multiple billion-dollar iconic brands with its expertise of innovation, marketing and promotion to fend off and stand up to such competition. In addition, the company's research and development capabilities enable it to launch new products and to extend product lines so as to adapt to changing consumer tastes. We see a value-oriented investment in PG's shares as a cornerstone in a more conservative portion of an investor's long-term portfolio.

Despite PG's transformative moves, there are investors who believe the company may be underestimating its competition and lacking innovation. For example, there is analyst and investor concern in regard to PG's recent price cuts for its Gillette products. In late February 2017, the company announced a 12 percent average wholesale price reduction across its U.S. Men's blades and razors business to "better position" the products in the mid- and value product tiers. Although such price reduction is likely to result in a 3 percent reduction in PG's total sales, the product line is the company's highest-margin product category. Such price cuts will adversely affect near-term organic sales growth, and the resultant volume increase may not fully offset the price cuts. Although the blade and razor price cuts are relatively small to PG's overall business, the cuts may be a foreshadowing of a broader product category slowdown, increased competition and retailer pressures. Therefore, while activist investor pressures and merger rumors will support PG shares somewhat, be aware that pricing pressures across parts of the company's businesses are likely to present a better potential PG investor with a better share price entry point.

If PG is unable to reestablish consistent revenue/earnings growth in the near term, the analyst/investor push to break up the company is likely to reappear. While we recognize the adversities that PG faces, we also recognize that it is a peerless global consumer innovator, manufacturer and marketer of convenient, effective and value-added products that consumers want and trust. As our regular readers may know, we always say we never bet against American consumer product companies' ability to adjust and adapt to changing consumer product consumption trends. A company such as PG has too many levers to pull to right its ship and return itself onto a course for more consistent revenue/earnings growth.

The only question, then, for a potential PG investor is at what price they should consider picking up PG's shares for a long-term hold, and we refer them to our price range noted below for the suggested buying range. Although we believe the company may split into two pieces in the intermediate term, PG's strategy in the near term remains focusing and growing its core power brands, cost restructuring and product innovation.

Our View

All investors should consider owning PG shares for the dividend and the likely benefits from the company's transformative actions. With this said, however, such investors should consider buying the shares at price point lower than where they currently trade (near a 52-week high). PG shares trade near a 52-week high due to the above-mentioned announcement of a Trian stake in the company. With rising interest rates, overall markets at all-time highs and the company engaging in price cuts in its most profitable Gillette product lines, investors are likely to be able to start a position in PG at a more value-oriented price point.

In particular, potential investors should preferably purchase the company's shares at a price that allow them to collect an initial dividend yield ranging from 3.25 percent to 3.50 percent, and then reinvest such dividends until PG's transformative actions and restructuring efforts show more consistent results. As noted above, the company is concluding its transformation towards its best-selling and most profitable core brands, with an overall goal of driving more consistent revenue/earnings growth over the long term. Such efforts to reshape the company's product portfolio, however, adversely affect its near-term sales and profits. PG's additional multi-billion dollar cost reduction efforts will also allow it to reinvest cost savings in product innovation and advertising, in order to drive revenue growth.

The current price-to-earnings ratio for PG is about 16.60, and the shares yield 2.95 percent. The company's forward price-to-earnings ratio is about 23.60 based on fiscal year 2017 earnings estimates of $3.84, and about 21.90 based on fiscal year 2018 earnings estimates of $4.13. We should note that estimates for each year have fallen slightly over the past three months. We believe investors with a long-term horizon should purchase shares in a price range of $74.35-78.50 (on a price-to-earnings ratio range of 18.00-19.00 based on fiscal 2018 earnings estimates) during the next overall market sell-off, and reinvest the dividend until the company's transformation begins to show positive results or until it announces a break-up.

Over the long term, PG, an expert innovative product developer, marketer and seller of multiple iconic billion-dollar brands, will succeed with its strategy of divestiture of its lesser brands to reward shareholders for years to come with share price appreciation, improved dividend increases and share repurchases.

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Disclosure: I am/we are long PG, DD, MDLZ.

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.

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