P&G Still Merits a Spot on Shopping Lists

The market has long been reluctant to buy into Procter & Gamble’s PG ability to sustainably reignite its top-line performance, and as such, the shares have languished. However, we have held that the company was taking prudent steps across its organization to right its ship and support its long-term brand advantage.

Despite this, activist investor Nelson Peltz in February 2017 disclosed a $3 billion stake (about 1% of shares outstanding) and subsequently announced his desire for a board seat, which management was reluctant to offer up. Peltz suggested that P&G’s organizational structure, corporate governance, and recent financial performance lagged peers and that more must be done to accelerate the pace of change at the leading household and personal-care company.

We thought the timing of this investment was curious. Just four months earlier, management had closed the book on a significant brand rationalization that began in 2014, shedding more than 100 labels from its mix, leaving it with just 65; we believed P&G would benefit from more focused brand spending and hence an ability to more effectively tap into and respond to evolving consumer trends. This stood to not only aid its sales growth trajectory but also support the brand intangible asset that underlies its wide economic moat.

Further, P&G was working to root out inefficiencies, looking to extract another $10 billion of costs (on top of the $10 billion removed between 2012 and 2016) by reducing overhead, lowering material costs, and increasing manufacturing and marketing productivity, an effort that is set to wrap in fiscal 2021. With this in mind and given all the actions the company had undertaken, we failed to see how one new director could meaningfully speed up the sizable change that was already underway at the organization.

We believed that by pruning its mix, shedding costs, and reinvesting in its brands, P&G could enhance its results and secure its competitive edge. However, sustainable top-line growth has been hard to come by and is only beginning to show signs of emerging. While we think macro and competitive headwinds have posed a challenge, as sales have languished at domestic peers as well, we also believe the company has fallen short in responding to evolving consumer tastes and preferences, which smaller, niche upstarts have proved more adept at doing. In this vein, operating margins jumped to around 22% in fiscal 2018 (about 500 basis points above the level generated in fiscal 2013), but organic sales languished, up less than 2% on average over the same horizon.

Fundamental Improvement Just Beginning to Show P&G has not been alone in its struggles to elevate its sales trajectory over the past several years. Across the consumer product sector, much angst has centered on reigniting sales and offsetting inflationary headwinds. But if results from fiscal 2019's first quarter (ended Sept. 30) are any indication, P&G could be setting out on a new course this year. Organic sales on a consolidated basis jumped 4%, with four of the company's five segments boasting sales gains in the mid- to high single digits; only the baby and family care business, around one fourth of total sales, weighed on results, down 1%. This was an impressive feat, given the intense competitive landscape.

And while the market’s reluctance to buy into the P&G story has centered on the sales trajectory, we don’t believe the company’s path to sales growth will come at the expense of profitability. P&G’s adjusted gross margins have compressed modestly over the past five quarters, down 180 basis points to 49% in the first quarter of 2019. However, this degradation is attributable to macro factors. Cost headwinds have plagued companies throughout the space, with industry peers including Colgate CL, Kimberly-Clark KMB, Clorox CLX, and Church & Dwight CHD posting erosion of 100-280 basis points over the same period. Therefore, we don’t believe the recent pullback in margins suggests P&G is favoring top-line gains over profits.

P&G Aims to Sharpen Its Grooming Business While P&G is starting to boast some modest top-line gains, not every one of its segments is firing on all cylinders. As an example, beauty care's quarterly sales growth has averaged more than 6% over the past six quarters, but the grooming segment has seen a low-single-digit decline on average since the fourth quarter of fiscal 2017.

The challenges plaguing P&G’s grooming business are also evident in its recent market share performance, where it has fallen victim to lackluster innovation, stepped-up competition (particularly from lower-priced options in the e-commerce realm), and changing demographic trends, including an increased preference for facial hair. The impact of these pressures was compounded by the fact that P&G wasn’t playing across all price tiers, which opened the door to added competition. As evidence, while its Gillette brand continues to control more than 50% of the North American men’s disposable razor and blade category, its share position has fallen by more than 300 basis points over the past three years--losses that have gone to the benefit of other leading brands such as Schick and Dollar Shave Club.

Losing share to recharged competition is nothing new to P&G. The company’s beauty segment (more specifically, its Olay skin-care brand) succumbed to intense competitive pressures from established branded operators and niche local players about five years ago, when its innovation failed to align with consumer trends. Management promptly corrected course, parting ways with unprofitable products and launching fare centered on its core anti-aging messaging.

While these actions initially hampered reported sales results, the prudence of the efforts has become more evident in the financial and share performance. For one, Olay’s Regenerist Micro-Sculpting Cream chalked up 7% growth in 2016, and more than 10 years after its initial launch, management has suggested it remains the top-selling facial moisturizer in North America, with sales more than 50 times the average stock-keeping unit in the mass skin-care category. We believe P&G is also working to selectively tailor new Olay offerings to win with its core consumer. One of its initial launches under the Olay brand umbrella was a line of eye creams (where consumers tend to notice aging first). After just six months on the shelf, this lineup had already amassed 9 points of share while also driving category growth up by double digits since the launch versus a 3% category decline before its entry. We think this confirms our view that with on-trend offerings, P&G should bolster its standing with retailers and post improving top-line performance. As evidence, despite continued competitive headwinds, the Olay brand (in the aggregate) has chalked up slight market share gains since 2015 and now has a mid-single-digit share of the overall North American facial-care market.

The company isn’t resting on its laurels. Alex Keith, president of the global hair care and beauty segment, has mentioned to us that the beauty business is constantly working to better assess evolving consumer trends. Building on its own organic research and development efforts, P&G is also looking outward to aid its pipeline of innovation as it works to glean insights from consumers’ Google search patterns to determine up-and-coming trends, particularly as they pertain to new fragrances and product forms.

We think this supports our contention that management understands the need to consistently bring superiority to market in relation to how a product performs, the packaging, its brand messaging, execution in store and online, and the value a product offers for both its retail partners and the end consumer. Much discussion has centered on the necessity of being more agile, starting small with product launches, and tailoring offerings based on consumer response before rolling out this fare on a larger scale, which we view as a favorable shift. Further, P&G seems to appreciate the need to be present and innovate across all price tiers (affording the opportunity for consumers to trade up and down within its brand set) to withstand intense competitive pressures, as the inability to do so has plagued its business in the past.

While we don’t believe P&G’s recent mid- to high-single-digit beauty segment growth will prove sustainable, we forecast the company is poised to realize just more than 3% annual growth in the beauty space on average over the next decade, with around 60% of the growth driven by higher volume and the remainder from increased price.

We think P&G is positioned to leverage its insights into how to course correct to reignite its languishing grooming business. Management’s actions to recalibrate its pricing in the segment, invest in on-trend new products, launch its own subscription-based sales model, and drive trials by sending razors to 18-year-old U.S. males mirror the wide range of endeavors P&G pursued as it worked to steady its footing in beauty, in our view. One example is the recent announcement that P&G is launching a razor geared to men with sensitive skin, a condition the company claims affects 70% of males, with the intention that further launches will follow. However, even with the progress being made by its new product initiatives, Gary Coombe, president of global grooming, stressed to us that the company is still not satisfied with the packaging in this segment and believes further investments could also help stabilize its competitive position. While the fruits of these efforts have yet to show up on a sustainable basis, we don’t anticipate performance will be constrained indefinitely; we foresee grooming segment sales growth approximating 2% annually over the next 10 years, just more than half of which we expect to result from increased volume and the balance stemming from higher prices.

Working to Improve Successful Brands, Too In its feminine care (more specifically, adult incontinence) business, P&G maintains around 30% value share and has chalked up 12 consecutive quarters of growth, averaging around 3%. To drive further improvement, P&G is working to break down the stigma associated with adult incontinence products by bringing to market new offerings that appeal to female consumers under its Always brand. Most recently, the company launched Always Discreet Boutique, which more closely resembles conventional underwear compared with other products on the shelf. According to the company, this particular product drove a 50% acceleration in category growth after its launch and increased the company's household penetration by 15 points. Despite selling at a 60% premium to base underwear offerings in this category, Always Discreet now boasts a dollar share north of 13%, up from around 10% before the launch of Boutique. We think this confirms that consumers are willing to pay up for offerings when they see the added value.

Altogether, we think P&G is poised to post consolidated sales growth of almost 4% annually over the course of our 10-year explicit forecast, nearly two thirds of which we believe will result from increased volume and the remainder from higher prices and improved mix. On a global basis by our estimates, P&G’s categories chalk up 2%-3% annual sales gains (which generally aligns with past rhetoric from management), implying that our forecast assumes the company maintains and/or modestly expands its share position on an aggregate basis over time.

From a product category perspective, we think the company is poised for mid-single-digit sales growth in four of its five segments (beauty, healthcare, fabric and home care, and baby and family care, which in total account for around 90% of its consolidated base) as it ups the ante to more nimbly respond to evolving local consumer trends.

Opportunities Overseas Viewing the company's growth through a geographic lens, we think P&G still possesses growth opportunities for its leading developed-market brands in many overseas markets. Despite slowing growth in several emerging regions, which account for around one third of annual sales, we still believe populations will grow exponentially, urbanization and private investment will create favorable disposable income tailwinds, and a younger consumer base will offer the potential for a lifetime of transactions ahead. Overall, we forecast low-single-digit growth in the company's developed-market regions and mid- to high-single-digit growth in its emerging markets.

For one, we think P&G has an opportunity to trade consumers up to more value-added products in the bulk of its emerging markets. As an example, P&G historically hadn’t sold liquid laundry detergent in emerging markets (like in China, its second-largest market accounting for around 9% of total sales or $6 billion in sales annually), only powdered detergent until just a few years ago, which creates the potential for price and volume gains. Further, the company has also begun selling diaper pants in a handful of emerging markets over the past couple of years, which is a preferred product (despite the higher price tag) even for newborns. We also believe there is the potential for increased diaper use among developing-market consumers, who use only about one diaper per day, trailing the five diapers the average developed-market consumer uses daily. In combination, we think these factors support our expectations for almost 4% consolidated sales growth over the course of our 10-year explicit forecast.

From a corporate perspective, CEO David Taylor has heightened the focus over the past three years on instilling accountability across the organization and better aligning the company’s resources and decision-making closer to the consumer. We view the potential benefits as more tangible following the company’s strategic endeavor to significantly prune its mix of offerings, which has reduced complexity and restored focus to a broad and unwieldy portfolio. But management isn’t stopping there; P&G recently announced intentions to shake up its organizational structure by focusing on six sector business units that will have direct control over strategy, product and package innovation, and supply chain in its largest markets, including North America, China, Japan, and developed European markets, which in aggregate make up about 80% of sales and 90% of aftertax profit. The remaining regions will fall under the purview of CFO Jon Moeller, who will add the title of COO. While we think this structure will help P&G to be more responsive and agile, we expect the company can still harness the benefits of its scale and negotiating leverage. The ongoing efforts support our Standard stewardship rating.

In our view, the need for increased dexterity is more pertinent now, given the heightened competition from the likes of other branded operators, small, niche startups, and lower-priced private-label fare. Management recently acknowledged that smaller, niche brands and private-label fare have gained around 300 basis points of share since 2013 in its categories. But it also said these gains have come at the expense of second- and third-tier offerings, with little impact on leading brands. We attribute this to P&G’s efforts to rightsize its mix and win at the shelf by focusing its resources on the highest-return opportunities.

Extracting More Inefficiencies Competition and cost inflation are unlikely to subside, partly because of the structural nature of the pressures, resulting from truck driver labor shortages and increased regulation. As such, we've been encouraged that P&G has been taking steps to extract inefficiencies from its operations as a means to fuel additional spending behind its brands. P&G currently targets taking out another $10 billion of costs (a high teens percentage of its cost of goods sold and operating expenses, excluding depreciation and amortization) over the next few years by reducing overhead, lowering material costs from product design and formulation efficiencies, and increasing manufacturing and marketing productivity. The benefits of its focus on realizing efficiencies from added automation and standardized manufacturing platforms also stand to further entrench its business with retailers. We think the combination of six new mixing centers and dedicated shipping lanes has contributed to P&G's ability to service 80% of its customers in less than one day, ultimately improving in-stock levels for retailers and propping up one aspect of its intangible asset moat source.

As part of these efforts, P&G has been extending common manufacturing platforms globally, which is proving advantageous for its diaper business--a product that had been manufactured in a disparate form using different materials around the world, inherently limiting its negotiating leverage over suppliers. Streamlining its manufacturing and using the same inputs on a global basis should enable P&G to exploit its purchasing leverage and ultimately enhance its cost edge.

We believe the company will direct these savings to fuel further investment behind its brands, with a bent toward bringing value-added innovation to market and touting this fare in front of consumers, in line with management rhetoric. We forecast the firm will allocate 3% of sales to research and development and 11% of sales to marketing annually.

Whether this level of spending will be sufficient to offset competitive pressures and ensure its products win with consumers is debatable, but to put this spending in perspective, we compared the percentage of sales we expect P&G to allocate to cost of goods sold, selling, general, and administrative expense, marketing, and R&D over our 10-year explicit forecast with a group of its industry peers. While we forecast P&G’s COGS will remain about 100 basis points above its peer set on average over the next decade, at nearly 50% of sales, we expect its SG&A will be more muted at less than 10% of sales (although we note that there is a significant amount of variability in the levels directed toward SG&A across the peer set, ranging from high single digits to high teens). We forecast P&G’s R&D and marketing spending to generally align with the midteens average directed by its other branded rivals. We view these investments as crucial to ensuring that P&G is supporting its relationships with retailers and differentiating its mix relative to its competitive set on the shelf.

In the aggregate, we expect that P&G’s profits will be boosted longer term (including around 200 basis points of gross margin improvement, relative to the average over the past five years, to more than 51% and 400 basis points of operating margin expansion to 24% over the next 10 years) by efficiency gains and the mix shift to a focus on more profitable offerings.

Alternatives to Slim Down Further Could Ensue As he wrangled for representation on the board throughout 2017, Peltz suggested a handful of initiatives he believed could enhance the underlying value of P&G's business, including further dividing its operations. We never viewed his directive to organize the business into three stand-alone business units--beauty, grooming, and healthcare; fabric and home care; and baby, feminine, and family care--as prudent, given the potential to increase the costs and the complexity of the business while also tarnishing its ability to leverage its scale, negotiating leverage, and consumer insights to the same degree as a combined organization. However, P&G could ultimately opt to take other strategic actions. If efforts to reignite sales cool, we think the company could still part ways with other brands in an effort to direct additional resources toward its highest-return opportunities.

We think the consumer tissue business (particularly the Charmin and Bounty brands, which we estimate generate around $4 billion in total sales annually) could ultimately fall on the chopping block. Consumer tissue tends to be a category where purchase decisions are driven by price rather than brand, given the more commoditylike nature of the product; as such, we believe these offerings lack much in the way of pricing power. This is evidenced by the low-double-digit operating margins that tend to characterize sales in the tissue category, materially lagging the high teens to low to mid-20s margins of other subsegments of household and personal care. We don’t believe this category holds the same clout with retailers as other areas in the company’s mix. Further, given consumer tissue’s mere mid-single-digit percentage of sales, we don’t believe that parting ways with this set of offerings would jeopardize the company’s scale and negotiating leverage with its retail or supplier partners.

To assess how lucrative a sale of these brands could be, we examined past deals in the broader sector. Taking into account this analysis, we think P&G could probably garner 2 times sales if it put its tissue brands up for sale, the proceeds of which could be used to finance additional organic and inorganic investments in the business. This is less than the 3 times sales expended for recent transactions in the space (based on data from PitchBook and company filings), but we believe it’s warranted, given that price is more important to consumers than brands in a commodity category like consumer tissue.

How would P&G allocate such a potential cash inflow, which we estimate could approximate $8 billion? We believe the company would prioritize returning this excess cash to shareholders through increased dividends and additional share repurchases, similar to its stated intent following the brand divestments made over the past several years (since fiscal 2014, P&G has allocated more than $50 billion toward dividends and share repurchases). Even absent further brand rationalizations, we think P&G will funnel its sizable free cash flow toward enhancing shareholder returns. The company has paid a dividend to its shareholders consistently for 128 years, with increases in each of the past 62 years. We forecast high-single-digit dividend increases over the next 10 years, maintaining a dividend payout ratio of just under 70%. Given its yield consistently above 3%, we think P&G is likely to win favor with income investors.

Further, we expect the company will repurchase around 2% of shares annually over the next decade, which we view as prudent when shares are trading at a discount to our assessment of the company’s intrinsic value. Finally, we forecast P&G will continue to expend about 4% of sales toward capital expenditures, down from the approximate 5% of sales allocated over the past five years on average (a period that included outsize efforts to build out and upgrade its global manufacturing footprint) but generally in line with the levels spent by other consumer product manufacturers.

Despite its narrowed focus, we would not be surprised to see P&G selectively pursue acquisitions from time to time. CEO Taylor has alluded to an openness to exploring acquisition opportunities as a way to enhance competitive capabilities. This initially followed on the heels of Unilever’s UL/UN announced tie-up with Dollar Shave Club in July 2016, which wasn’t significant in terms of its financial impact to Unilever’s consolidated operations but afforded the company entry and insights into the expanding e-commerce channel.

In April 2018, P&G inked a deal to acquire Germany-based Merck KGaA’s consumer healthcare brands for $4 billion (3.7 times trailing 12-month sales and 20 times EBITDA). However, we don’t view this deal as a reversal in the company’s strategy to operate with a leaner brand mix. At just 1%-2% of sales, we think this addition evidences management’s openness to bolstering its reach in attractive categories (consumer health is growing at a mid-single-digit clip) and geographies, as opposed to suggesting it maintains an appetite for more transformational deals. Bringing smaller, niche operators into its fold could also afford P&G the opportunity to gain insights into how to respond to evolving consumer trends in a timelier fashion. We think the inability to do so has plagued companies throughout the grocery store category and view efforts to grease the wheels of its innovation cycle positively.

Overall, we believe P&G will continue being a prudent capital allocator, with adjusted returns on invested capital that have exceeded our weighted average cost of capital estimate each of the past five years by more than 3 times. We forecast that returns will average in the mid-20s over the next five years.

Valuing P&G We believe P&G's strategic endeavor to rightsize its brand mix, extract inefficiencies, and reinvest behind its brands has been a prudent course that stands to yield improving sales and profitability. Our $97 fair value estimate incorporates 3%-4% annual sales growth, about 80 basis points of gross margin improvement (relative to the average over fiscal 2016-18) leading to just over 50% over the next decade, and 260 basis points of consolidated operating margin expansion to about 24% by fiscal 2028. While the shares currently trade less than 7% below our fair value estimate (which could suggest the market is beginning to buy into P&G's enhanced prospects, particularly as it relates to top-line performance), we believe investors would be wise to keep this wide-moat name on their radar.