Image Source: Proctor & Gamble Co – Fiscal 2019 Annual Report
By Callum Turcan
Shares of Procter & Gamble Co (PG), maker of household consumer products under the Pampers, Crest, Gillette, Downy, Olay, Tide, and various other well-known brands, are generously valued as of this writing in our view. Investors are apparently willing to pay a premium for well-established consumer staples firms, and while shares of PG yield a decent ~2.4% as of this writing, that premium isn’t justified given the growth trajectory of P&G’s free cash flows (net operating cash flow less capital expenditures).
In 2018, the US economy grew by 2.9% (on a constant dollar annual GDP growth rate basis). The Chicago Fed forecasts US economic growth will slow to 2.3% in 2019 and 1.9% in 2020 (please note these are real GDP growth rates on a fourth quarter over fourth quarter basis). Most importantly, what matters is the uplift from domestic fiscal stimulus (lower taxes, higher spending on a federal level) is wearing off while exogenous headwinds build. In P&G’s fiscal 2019 (period ended June 30, 2019), North America represented ~45% of its net sales.
On a global basis, the World Bank notes real annual GDP growth slowed from 3.2% in 2017 to 3.0% in 2018, falling further still to an estimated 2.4% in 2019. While the World Bank forecasts growth will improve to 2.5% in 2020, rising to 2.7% in 2022, that’s still a way off from the level of growth experienced just a couple of years ago. P&G is heavily exposed to that slowdown as it generates most of its revenue overseas. With US growth slowing as well, P&G has turned to cost cutting measures to improve its outlook.
Under the most optimistic of assumptions that we still deem reasonable, shares of PG carry a fair value estimate of $110 per share based on our discounted cash flow analysis (shares are trading north of $120 at the time of this writing). In the graphic below, from our 16-page Stock Report, we highlight our base case valuation assumptions used in our model. Revenue growth is estimated at 3.4% CAGR over the next five years under our base case scenario, keeping in mind P&G’s GAAP revenues declined from $70.7 billion in fiscal 2015 to $67.7 billion in fiscal 2019 (divestments and foreign currency headwinds played a role here).
Image Shown: As of this writing, shares of PG are trading well above the top end of our fair value range estimate of $110 per share. The graphic above highlights the valuation assumptions used within our base case discounted cash flow model.
In order to achieve a fair value estimate above $110 per share, P&G would have to significantly outperform these assumptions. We factor in upside from P&G’s ‘Beauty’, ‘Health Care’ and ‘Fabric and Home Care’ segments in our model, which have experienced strong organic volume and sales growth of late.
At the end of September 2019, P&G had a cash and cash equivalents balance of $9.3 billion on the books, versus $9.4 billion in short-term debt and $20.2 billion in long-term debt. P&G’s net debt load only modestly weighs against its equity value estimate given the strength and size of its free cash flow profile.
From fiscal 2017 to fiscal 2019, P&G’s annual free cash flow averaged ~$10.8 billion and hit $11.9 billion in fiscal 2019 (in part because P&G’s annual capital expenditures climbed lower over this period). Annual dividend obligations averaged ~$7.3 billion from fiscal 2017 to fiscal 2019. We like P&G’s dividend coverage and view its payout growth trajectory as decent, but that isn’t enough to justify its lofty valuation. Share buybacks have been substantial over the years, which were often funded in part by P&G taking on debt.
During the first quarter of fiscal 2020 (period ended September 30, 2019), P&G’s Beauty segment recorded the strongest organic sales growth rate on a year-over-year basis at 10%. Volume and price/mix were cited as key reasons why, which more than offset meaningful foreign currency headwinds (a product of the strong US dollar).
To keep the momentum going, P&G announced it was acquiring the subscription-based beauty and grooming product service company Billie on January 8, 2020. Billie primarily sells to women and its products include razors, shaving cream, body wash, and body lotion. In the future, there’s plenty of room to add new offerings to that product line-up.
Billie uses a direct-to-consumer model and can leverage P&G’s scale to grow its reach, with an eye towards consumers in the Millennial and Generation Z age demographic groups. Financial terms of the deal weren’t disclosed. Here’s what the press release had to say:
The deal complements P&G’s female grooming portfolio, which includes the Venus, Braun and joy brands, through the combination of strong digital and direct-to-consumer marketing capabilities, a growing range of personal care products, and a fresh, digitally-native brand that is especially appealing to Millennial and Gen Z consumers. Billie will continue to be led by its co-founders, Georgina Gooley and Jason Bravman.
We appreciate P&G building on its strengths and bolstering its position in an aggressively competitive market. This is a prime example of a bolt-on acquisition with clear synergies and upside, especially as the purchasing habits of younger consumers are substantially different than that of older age cohorts in many instances (i.e. greater use of digital and e-commerce offerings). Additionally, the subscription model is interesting and one other companies, like Amazon Inc (AMZN), have been pushing on consumers more recently (by offering large discounts for the first order on a reoccurring delivery of various items, including prepackaged consumer products, which has been the case with Amazon).
Management increased P&G’s guidance for fiscal 2020 during the firm’s first quarter earnings report, noting that:
The Company raised its outlook for fiscal 2020 all-in sales growth from a range of three to four percent to a range of three to five percent growth versus the prior fiscal year. This estimate includes a modest negative impact from foreign exchange, largely offset by a modest positive impact from acquisitions and divestitures. The Company increased its guidance for organic sales growth from a range of three to four percent to a range of three to five percent growth.
We appreciate the guidance increase, but please note that the company is still only forecasting mid-single-digit sales growth, at best, this fiscal year. Cost cutting initiatives will help improve its outlook, but please note P&G’s GAAP gross margin weakened by ~120 basis points from fiscal 2017 to fiscal 2019 (commodity pricing pressures and a strengthening US dollar are key here). P&G’s GAAP operating margin declined materially during this period, but that’s partially due to a large one-time charge in fiscal 2019. When removing that effect ($8.3 billion in ‘goodwill and indefinite lived intangibles impairment charges’), P&G’s adjusted (non-GAAP) operating margin still dropped during this period (largely due to the gross margin contraction).
Image shown: The red line is where shares of P&G are trading, and that means we think shares are trading above a reasonable fair value estimate range, the yellow line ($74-$110).
P&G is a prime example of a solid company trading at a rich valuation due to a dynamic some have termed the “flight to safety”. The macroeconomic backdrop just doesn’t support the kind of growth outlook investors are pricing into shares of PG, as its revenues, levels of profitability, and ultimately free cash flows would have to grow at sustained rates that we view as highly unlikely. Shares are not cheap.
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.
Additional disclosure: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.