Procter & Gamble is an 79 billion dollar consumer goods company with well known brands such as pampers, Gillette, charmin, bounty, tide, pantene etc. The company has operations across 180 countries across the world and operates in the beauty products, health and household care segment.
PG has consistently maintained an ROE in excess of 25% with a moderate leverage of around 0.5. The drop in the ROE since 2006 is more due to the accounting related to the Gillette acquisition than a drop in the profitability levels.
The company has become a more efficient user of capital by increasing its fixed asset turns by 25% in the last 6-7 years and by turning Working capital negative during the same period. It has utilized the excess cash to reduce the debt ratios, maintain the dividend levels and buy back stock.
The company has been able to improve its Net margins from around 9% to almost 14% in the last 10 years. It has done this while maintaining an ad expense of around 10% of sales and almost 2.7% expense in R&D
The company has doubled its sales and tripled its profits in the last 10 years too.
The company under the leadership of A G Lafley has been performing fairly well. The company has increased its focus on innovation in various aspects of the business such as new product, packaging, cost management etc. This focus goes beyond the customary lip service and can be seen via the new product launches and continued volume growth in mature categories. The company continues to invest almost 10% of sales in advertising and upto 3% of sales in R&D which is the highest in the industry.
The company has a successful history of developing and maintaining strong brands. In addition the company also has an enviable marketing and distribution infrastructure which cannot be replicated easily.
The company has been able to grow the topline in high single digits for the last few years with volume growth in most of the categories in the 3-6% range. The value growth in the various categories has been in low double digits range due to the above volume growth in combination with price increases and favorable foreign exchange changes. The company is also growing in low double digits in most categories in the developing markets such as India, China and middle east.
The various financial parameters such as ROE (in excess of 20%) and net profit growth (in double digits for the last few years) have been extremely good. The company has also been able to successfully acquire and integrate Gillette and thus gain cost synergy and increased leverage in the market.
Finally the company has been able to generate free cash flows in excess of net profits which it has been using to reduce debt and buyback stock.
The company is undergoing a transition at the top with Robert Mcdonald as the new CEO. Although the company is unlikely to suddenly change direction and focus, the change is occurring at a time when the volume growth has slowed down due to the recession
The company has recorded negative sales growth in the current year. Although the volume degrowth is not alarming considering the global recession, drops in market shares in categories such as feminine care, male dry shaving, batteries, fabric care and drops in the Braun appliance range is a cause of worry and needs to watched closely in the future.
The company operates in a very competitive industry where the low priced local competitors and store brands are competing in most of the categories of the company. As a result the company faces intense competition in most of its product categories.
The company faces a host of competitors ranging from local to store brands to companies like unilever. Most of the local and store brands compete on price.
P&G has rightfully realized the need for innovating in all the categories to stay ahead of the competition and thus maintain a price premium. In addition the company has a wide portfolio of brands and an extensive marketing and distribution infrastructure. These competitive strengths allows the company to fight price based competition.
The company has been investing almost 10% in marketing and sales and 3% in R&D. These investments are key to maintaining the competitive edge of the company.
Management quality checklist
- Management compensation: The chairman received a total compensation and bonus of around 57 Mn usd, which does not appear excessive. The company has an options program which would result in a rough dilution of around 10% or less.
- Capital allocation record: The management has a very good capital allocation record. They have maintained an ROE in excess of 20% for the 7-8 yrs. In addition the company has maintained a dividend payout in excess of 40%. The excess cash has been utilized to fund acquisitions and buyback stock. I would give the management high grade on capital allocation.
- Shareholder communication: The company has communicated its strategy and focus on innovation. In addition the company has is also transparent in communicating the long term goals such as organic growth, free cash flow target etc and the achievement against the goals. The company has also discussed in detail the performance of each division with clear details of the organic volume growth to enable the investor to understand the source of the topline growth. The company has been consistent in communicating good as well as bad performance.
- Accounting practice: appears conservative and I could not find any red flags. The company seems to have made conservative pension assumptions, has minimal derivative exposures and other off balance sheet liabilities. My only concern is the benefit assumptions. Although the actual returns are negative, the company is using positive expected returns on assets (allowed by GAAP). If the returns do not turn positive, we could see higher pension expense in the future.
The company has a free cash flow which is almost equal to net profits. The company has an ROE in excess of 20% and an average growth in excess of 8%. If we assume a CAP period of around 10 years, a net profit growth of 8%, the intrinsic value comes to around 72-75 usd per share. If one reverse engineers the current price, the implied growth seems to be around 2-3% for the next 10 years.
The company thus appears to be undervalued by around 20-25% at current prices.
The company has been able to show a low single digit growth inspite of the global recession. The topline however has shown a low single digit drop. The company is in the process of disposing non core businesses such as coffee and the medical division. This should provide the company extra capital to invest in the core business, retire debt or continue with the buyback program.
The company has maintained its focus on innovation and new products and has been investing heavily in brand building and R&D, even through the recession. This should help the company when growth returns. The company has enormous competitive advantages in the form of strong brands, deep distribution network and a innovation oriented culture. Although the company is not undervalued by a wide margin, it should give moderate returns in excess of the index returns over the next few years. In summary it is moderate return, low risk opportunity.
Disclosure : No holding