Procter & Gamble: On Sale Amidst Continued Challenges

About: The Procter & Gamble Company (PG)
by: The Value Investor

P&G continues to struggles, yet this is not really a surprise.

The Consumer OTC Health deal with Merck looks reasonable on paper, but does little to change the narrative in a big way.

Trading at a market multiple, I fail to see appeal given the challenges despite a resilient balance sheet and activist investor, as I am waiting for a larger dip.

Procter & Gamble (PG) continues to be a very challenged story despite a relatively resilient balance sheet and involvement of an activist investor in the name of Mr. Peltz, as it too cannot escape the real pricing and organic growth challenges faced by most of its peers as well. Appeal is increasing as multiples have been compressing quite a bit, although they are not below the market multiple as of yet.

That being said, a strong balance sheet and activist involvement make that I am attracted to P&G, yet with similar companies being on sale as well, I am looking to cherry pick within the wider sector before initiating a full position in a single name.

Quick Review Of Q3

The third quarter results did not contain huge surprises, at least not to me. Reported sales were up by 4% to $16.3 billion, entirely explained by the impact of a softer dollar. Organic sales growth came in at an uninspiring 1%, yet the underlying nature of this growth was relatively good with 2% increase in volumes, a percent increase in the mix, offset by a 2-point drop in pricing. A large part of the pricing impact has been the result of price cuts in the shaving segment to fend off competition from Dollar Shave Club and similar initiatives which are really disrupting this segment.

Following the results, the company maintains the full-year organic sales growth guidance of 2-3%, although it recognises that growth is likely to come in at the lower end of the range. The company reported a 4% increase in so-called core earnings per share to $1.00 per share, with diluted GAAP earnings coming in five cents lower than that. Recently, the company announced a 4% hike in its dividend as well, the 62nd year of hikes in a row. Earnings growth kept up with sales growth on the back of productivity gains, offset by inflation and selling price pressure.

For the year, the company sees core earnings up 6-8% versus the $3.92 per share reported last year, for earnings power of close to $4.20 per share. While the "core" earnings metric is a non-GAAP earnings metric, the gap with realistic GAAP earnings is very modest, hence, I am comfortable to use this number.

Shares dropped to a low of $75 per share following the earnings announcement, as the wider sector at large has been weak for a long time amidst concerns about rising rates and real growth/margin challenges by the underlying companies. At $75 per share, P&G trades at 17-18 times earnings, more or less in line with the market.

The balance sheet remains very resilient with cash and equivalents totalling $15.5 billion, offset by $35.2 billion in debt. This net debt load of around $20 billion looks bit in absolute terms, but with EBITDA running at close to $17 billion, leverage ratios are fairly modest.

Adding To Leverage, Buying Into Growth

Alongside the release of the third quarter earnings, P&G announced the purchase of the consumer healthcare business of Merck (OTCPK:MKGAY) (the German version). This adds to P&G's expertise in the OTC market and replaces the arrangement which the company had with Teva (NYSE:TEVA), on track to end in July of this year.

With the deal, P&G will add about a billion in sales which are growing at mid- to high-single digits, driven by products which focus on the self-treatment of minor ailments related to muscle pain, back pain, and headaches, among others. While it is not a small business, the pro-forma impact for all of P&G amounts to roughly 1.5% in annual sales, a drop in the bucket. The deal comes at a price tag of around $4.2 billion which makes those leverage ratios remain very reasonable by all means.

Not many details were announced in the press release as the deal presentation provided a little bit more information. The billion dollar in sales really works out to $1.1 billion at current exchange rates, reducing the sales multiple to 3.7 times, while P&G at large is valued at close to 3 times sales. While the added growth profile will be beneficial, the real impact is very limited. Even if organic growth of the business would magically top the high end and come in at 10%, that adds just about 15 basis points to all of P&G's organic growth rate. In reality, organic growth will improve by less than 0.1% in all likelihood as a result of the deal.

While the sales multiple marks about a 20% higher valuation than the multiple at which P&G trades, the discrepancy grows in terms of earnings multiples. Pro-forma EBITDA multiples come in at 19.5 times, suggesting EBITDA margins of 19% while those of P&G come in at levels in the mid-twenties!

What Now?

Reality is that P&G has been challenged for a longer time as a strong reputation, optimism on a turnaround, and activist investor have pushed up expectations. While I understood the involvement of Mr. Peltz to some extent, fact is that margins are sky high already around 20% as I realistically do not see much room to expand these. In fact, maintaining these margins in the long haul will be a daunting task in my opinion.

With lack of sales growth and potentially margin pressure to come, earnings are flat at best which makes that even as P&G has limited leverage and trades at a market multiple, I do not necessarily see appeal. This comes even as the stock has been flat for years, as the actual underlying performance has been dead flat as well for years, with little prospects for real improvement.

A 3.7% dividend yield does a lot to compensate for the lack of growth, even as rates have already moved higher in recent times yet leave little room for M&A action as well. The payout ratio of roughly two-thirds of earnings makes that retained earnings amount to roughly $4 billion, just enough to pay for the Merck deal which adds 1.5% to sales, while organic sales continue to struggle as well.

As the entire sector and even related sectors are on sale at this moment, I am not considering P&G at these levels just yet, although a relative strong balance sheet and involvement of Mr. Peltz are a plus. If shares dip to the $70 mark, I am happy to gradually start buying into the shares, but for now, am holding my buying powder dry.

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.