Image Source: Phil Manker
When Procter & Gamble (PG) first reported its calendar fourth-quarter 2014 results in January, we came out on the stock suggesting investors need not panic. When we rolled the model forward (what this means), however, our team was left scratching our heads. We ended up cutting our fair value estimate on P&G’s shares to $74 from $84, and we felt we were even being generous to get to the mid-$70s with that estimate.
We’re torn.
We love the strength of Procter & Gamble’s core brands (especially Pampers, Tide, and Gillette), its dividend track record, and its robust free cash flow, but its valuation has become out of line – mostly due to a reset of its future projections, not because its price has advanced uncontrollably, which it has not. Frankly, we want to take some shares off the table in the Dividend Growth portfolio, but we don’t think there’s too much of a hurry. Even as we say P&G is pricey, it’s been hard to justify the valuations of most consumer staples entities these days, and we’d hardly classify P&G as a high-risk investment.
Further, there’s a lot going on with P&G that could support a premium share price relative to our standalone valuation. Recent news suggests that CEO A.G. Lafley is looking to sell $10-$12 billion in its beauty brands (e.g. Wella, Clairol, CoverGirl, Max Factor, Hugo Boss, Gucci), and Reuters reported that Henkel (HENKY), Revlon (REV), and Coty (COTY) are preparing bids. The company’s ‘Beauty, Hair and Personal Care’ segment has been the worst-performing division so far this year, with organic volume and organic sales off 4% and 3%, respectively. This could be an opportunity to shed an underperforming operation.
Selling its beauty brands or spinning them off in an IPO would follow recent moves to unload Duracell to Berkshire Hathaway (BRK.A, BRK.B) and a few of its soap brands (Camay and Zest) to Unilever (UL, UN). In smaller deals in March, Helen of Troy (HELE) bought P&G’s Vicks VapoSteam business, while Inter Parfums (IPAR) scooped up P&G’s Rochas business. Management has already divested 40 brands in all, representing ~40% of the sales it wants to eliminate.
We probably won’t know what the “new” P&G will look like until sometime in July/August 2015 when it completes its brand review process. When all is said and done though, it looks like P&G will have exited 100 brands, leaving only the top ~65 brands in its portfolio. In doing so, management plans to eliminate the complexity that comes with owning a significantly larger brand portfolio, while retaining ~85% of sales and ~95% of before-tax profit. At face value, it’s not a bad plan, and optimization is always well-received.
However, we simply hope management is not motivated by timing, but rather in getting the best opportunistic offer for the brands that it is looking to shed. At this point, we’re not completely sure that P&G is doing the best it can to get the most from the brands it plans to sell (this is what our model picked up when we rolled it). Frankly, we’re somewhat puzzled by the rapidity of the brand sales, and on the basis of P&G’s financial health, we see no reason to rush through the process. Why won’t management look to divest the brands over the next 5 to 10 years, for example, instead of rushing to wrap things up by the end of 2016? We’d have to look to management incentives to uncover the true reason.
P&G’s calendar first quarter results, released April 23, weren’t terrible, but they could have been better. Organic currency-neutral sales advanced 1%, while constant-currency core earnings per share leapt 10%. Currency-neutral gross and operating margin expansion benefited from over 400 basis points of productivity savings, pricing growth, and mix enhancement. Operating cash flow totaled $3.6 billion in the period and the company announced an increase to the dividend for the 59th consecutive year. For the nine months ended March, free cash flow was $8.16 billion, up from $6.85 billion in the same period last year. The company ended the calendar first quarter with $17.4 billion in long-term debt and $8.4 billion in cash and cash equivalents.
Performance in fiscal 2015 will be a mixed bag. P&G now expects slower organic growth during the year, and while the company maintained its outlook for currency-neutral core EPS growth in the double-digits, core earnings per share will be in-line to down low-single-digits from last year’s level. Can you believe–due in part to negative currency impacts and a variety of non-core costs—that GAAP diluted EPS will be more than 20% lower in 2015 relative to last year’s mark? Following the myriad measures that the company discloses is enough to give the average investor a headache.
We love P&G, and with its history dating back to the end of the 19th century, the firm is not going anywhere. But the company has seen better days, and with the planned divestitures, impact from currency, coupled with the various measures of earnings guidance, we’re losing faith. We’re keeping P&G in the Dividend Growth portfolio for now, but if we don’t get a clear sight of the company’s direction by the end of the year, we would view it as a source of cash.
It breaks our heart.