Quantitative Analysis Of Procter & Gamble: It Just Doesn't Cut It Anymore

| About: The Procter (PG)

Summary

Procter & Gamble has strong international brands.

We believe they have not managed to leverage on their strengths and this is evident in the lack of growth.

Our analysis shows the company is overvalued and with better alternatives available, a switch may be a safer bet.

Investment thesis

Procter & Gamble's (NYSE:PG) streamlining and margin expansion is progressing well. However, top-line growth should be stronger, and this is where the company should focus its energy.

We briefly discuss the risks faced by Consumer Staples and how some have adapted to the changing environment. Procter & Gamble is holding a significant amount of cash and may be gearing up for an acquisition. For simplicity, we have split out the excess cash and add these back for the purpose of valuation. We identify lack of organic sustainable growth in our quantitative model as the cause of reduced valuation. For a re-rating to be warranted, we will need to see evidence of a change in strategy.

If you have not had the chance to read my previous articles, please have a look at the appendix. You will find details of our calculations and valuation methodology.

Procter & Gamble: The Risks

We have mentioned the risks faced by Consumer Staples in our analysis of Colgate-Palmolive (NYSE:CL). Increasing popularity of discount stores selling cheaper private-label products and the inability to raise prices in a low inflation environment are two issues. The greater threat is from smaller, niche and nimble start-ups. All industries are prone to disruption and Consumer Staples have not been unaffected by the advances in digital technologies. Marketing and distribution are now possible for companies with leaner budgets. Smaller companies are turning around a product quicker and using more innovating and cost-effective advertising platforms. In context of Procter & Gamble, Dollar Shave Club is the perfect example.

The larger companies have to invest in innovations and need to start thinking more like the start-ups and/or as some are doing, acquiring them. Colgate-Palmolive acquired Physicians Care Alliance and Elta MD Holdings, two of the fastest-growing brands in professional skin care in January 2018.

In our analysis of Unilever (NYSE:UN), we noticed that they completed 11 bolt-on acquisitions in 2017 alone. In 2016 and 2015, €2 billion was spent each year on acquisitions. 2016 included the acquisition of Dollar Shave Club, which grew 47% year-on-year. Along with acquisitions, Unilever also disposed its lower growth spreads business to meet its objectives of transforming into a more resilient and agile business.

Procter & Gamble: Streamlining

Procter & Gamble also has a plan to significantly streamline its product portfolio by divesting, discontinuing, or consolidating about 100 non-strategic brands. The plan is to concentrate on 65 key brands where they have leading market positions. During fiscal 2015, the Company completed the divestiture of its Pet Care business.

2016 saw the transfer of Duracell into the hands of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) in a share swap. Berkshire Hathaway owned 52.5 million Procter & Gamble and traded this in for battery business. One has to wonder what Berkshire Hathaway saw in Duracell that the management of Procter & Gamble missed. Maybe Berkshire Hathaway's aim was to exit Procter & Gamble and not to buy Duracell and was simply seduced by tax savings, the share swap offered.

The divestiture of beauty brands took place in 2017. They have a plan for disposals, but no clear strategy for growth. They do not seem to be making the bolt-on acquisitions of high growth start-ups as some of their peers are.

The other avenue for growth is a high exposure to the emerging markets. The mid- to long-term growth is going to be driven by catering for the explosion in middle-class population in Asia, Africa, and Central & South America. Excluding The US, Canada, and Europe, Procter & Gamble only account for 32% of sales. Unilever and Colgate-Palmolive both generate over 50% of sales in the emerging markets.

Procter & Gamble: Fundamental Breakdown

Sales peaked at $84.2 billion in 2013 and including the disposals are now $19 billion less at $65.1 billion. More recently, organic sales grew by 1% in year ending June 2016, 2017 saw 2% growth and a further 2% for the first half of 2018.

Procter & Gamble's productivity improvement restructuring program has helped improve margins.

Source: ROCGA Research

As part of its regular restructuring program, the company makes regular one-off restructuring related charges. They have identified a further $10 billion in potential cost saving and expects to incur approximately $1.2 billion in before-tax restructuring costs during fiscal years 2018 and 2019. The company already boasts having one of the highest margins in its peer group. Improving margins by cutting costs can be a balancing act. On one side, you increase actual productivity; on the other, you risk stifling growth and long-term performance. In our opinion, if you are already having one of the highest margins in your peer group, top line growth should be a higher priority. As mentioned earlier, the growth opportunities are either in emerging markets or truly innovative products or services. Procter & Gamble is not excelling in exploiting either.

Share Repurchase

The company spent $5.2 billion in treasury stock purchases in year ending June 2017 and a further $4.2 billion till December 2017. Despite the repurchase, Procter & Gamble is trading significantly lower. I will leave the readers to decide on the merits of the repurchase.

Dividend

The company has increased its dividend for 61 consecutive years and currently, has an attractive dividend yield of over 3.5%. However, as can be seen in the figure below, EPS has not kept pace with the increasing dividends.

Source: ROCGA Research

Historic Valuation

Our historic estimate of the company's value matches the share price range reasonably well. Our valuation is just below the share price range between 2011 and 2014. However, from 2015, we can see the valuation drifting below the price range.

Source: ROCGA Research

The company has been holding significant amounts of cash and cash equivalents on its balance sheet. This has risen from $2.8 billion in 2011 to $15.1 billion year ending June 2017. It can be argued that this will distort return on cash generating assets and in turn the valuation. For our analysis, we take the additional cash and use it to repay debt. This has a similar effect as stripping out the cash, valuing the company, and adding cash back to the final valuation.

Source: ROCGA Research

We see return on cash-generating assets improving from 2014 onwards, the year the divestment program began with Duracell. Excluding the cash, we also see valuation improve slightly.

Source: ROCGA Research

Q2 Update

Forecasting a value range for the forecast years is complicated by the fact that the company has geared up further from year ending June 2017 to December 2017. Cash and cash equivalent has gone up from $15.1 billion to $18.7 billion and debt is up from $31.6 billion to $37.7 billion. The company may be paving the ground for an acquisition. It has been in the press that they are in talks with Pfizer (NYSE:PFE) to acquire its consumer healthcare business. Very little information is available for us to analyse a deal, but we have the flexibility in our model to examine in more detail if armed with the right information. The only bit of information available is in Pfizer's 10-K. Revenues for Pfizer's consumer healthcare in 2013 was $3.4 billion and this remained unchanged till 2017. If Procter & Gamble is looking for growth, it is not available in Pfizer's consumer healthcare business.

Procter & Gamble: Forecast Value Range

Procter & Gamble's gearing up complicates forecasting our value range. For simplicity, we use the same assumption as above and strip out the cash and value it separately. This may not be the ideal situation if the company is preparing for an expensive acquisition, but we can do a reanalysis if one is announced.

We use a generous 2.5% increase in net income for the four forecast years. Along with the estimate of forward earnings and assets, a ±2 standard deviation for internally sustainable organic growth is used for the value range. Assuming Procter & Gamble does not deviate from the historic model, our value range shows the company to be overvalued. We estimate the company to reach fair value in year two and will have to wait till year four to see any significant upside.

The dark green line is our ROCGA value projection. The outer wings showing the range with higher/lower growth.

Source: ROCGA Research

Conclusion

Given there are better alternatives, a switch to Unilever or Colgate-Palmolive is a safer bet. In the meantime, we eagerly await Procter & Gamble to reveal its strategy for growth.

Appendix

The components of returns on cash-generating assets:

Cash generating assets: The reported balance sheet numbers go through a series of adjustments, such as capitalising operating lease and inflation adjustments so we can have a like-for-like comparison and bring all companies on to an equal footing for valuation. This gives us the total cash-generating asset for the company.

+ net current assets

+ other investments

+ land

= non-depreciating assets

+ inflation adjusted PPE

+ inflation adjusted intangible assets

+ capitalized operating lease

+ goodwill

= depreciating assets

Total cash generating assets = non-depreciating assets + depreciating assets

Cash: We look at a company's cash-generating ability by using the accrual accounting information and converting it into a gross cash number.

+ adjusted net income

+ depreciation and amortisation

+ operating lease

+ interest costs

+ net pension interest cost

± other adjustments

= gross cash flow

Returns on cash-generating assets: This is the internal rate of return using the gross cash flow, total cash-generating assets, and the asset life.

To value the company, we use a systematic discounted cash flow method.

Methods by which a company can increase value: Stable total cash generating assets and higher returns translate to more value. We believe a more sustainable solution is to gradually increase total cash-generating assets and at least maintain returns on cash generating assets.

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.