By Kris Rosemann
Multinational corporations have seen reported revenue punished in recent quarters as a result of the strong US dollar relative to other currencies around the world. In keeping with this theme, Procter & Gamble (PG) reported net sales falling 9% in its fiscal second quarter of 2016 on a year-over-year basis to $16.9 billion. However, after backing out all the noise, the company’s constant-currency core earnings per share leapt more than 20% on a year-over-year basis in the period. Reported free cash flow trends were fantastic through the first half of the fiscal year, too, and while we think the company’s valuation remains stretched, we’re not rushing to remove it from the Dividend Growth Newsletter portfolio anytime soon.
The real “story” of the P&G quarter lies in the firm’s ability to continue its pricing strength across all five of its reporting segments, which has led a return to companywide organic sales growth. Pricing had a positive impact of 3 percentage points on total net sales in the quarter, led by an impressive 6 percentage point jump in its ‘Grooming’ segment, while organic sales in aggregate advanced 2% in the quarter, flat or higher in all five reporting segments from the year-ago period. Volume growth in every segment, however, was lower (down 2% organically), with ‘Beauty’ products volume dropping 7% led by weakness in its Olay brand. Though the large drop in volume across the board was rather concerning, we were very pleased with the company’s pricing performance, which could offer material upside for the rest of fiscal 2016.
P&G’s ‘Grooming’ and ‘Health Care’ segments led the charge with both achieving 3% organic sales growth in the fiscal second quarter. Though volume in the ‘Grooming’ segment shrank 2% in the period, the division benefitted from significantly higher pricing in shave care, and innovative growth in its Braun brand in developed markets more than offset lower volume in the remainder of the segment. The ‘Grooming’ segment also reported the highest pricing benefit of any of the firm’s segments with a 6% benefit in the quarter. Constant-currency net earnings in the ‘Grooming’ segment, however, faced some headwinds (down 5%) due in part to mix, and we’ll be watching closely to see if there may be something else going on that’s not easily adding up. The ‘Health Care’ segment, on the other hand, was boosted by a favorable geographic mix and sales growth in Oral Care in developed markets and Personal Health Care in developing markets. The segment received a 3% benefit on its top line from pricing and mix, while losing 3% from organic volume. Unlike the ‘Grooming’ segment, however, where constant-currency net earnings fell, the ‘Health Care’ segment turned in robust constant-currency net earnings growth of 20% in the quarter on a year-over-year basis.
Procter & Gamble’s ‘Fabric Care and Home Care’ segment grew organic sales by 2% from the year-ago period, and it was the weakest of the five divisions in terms of pricing strength in the quarter, as it only received a 1% top-line benefit from pricing. Both ‘Fabric and Home Care’ performed well in developed markets, but this growth was partially offset by ‘Fabric and Home Care’ declining in developing markets. The segment turned in the highest constant currency net earnings growth in the quarter with a 26% jump from the same period in fiscal 2015 thanks to a material decline in commodity costs associated with the division. Organic sales in Procter & Gamble’s ‘Beauty’ segment grew a mere 1% in the quarter, as a 4% positive impact from pricing was offset by lower volume. Poor performance from the Olay brand partially offset gains from one of the segment’s super-premium skin care brands. The ‘Beauty’ division advanced its constant-currency net earnings 9% on a year-over-year basis; currency headwinds remain a major issue for reported results in the segment.
Volume was also an issue for the ‘Baby, Feminine, and Family Care’ segment, where organic sales remained unchanged from the year-ago period. The division’s organic sales declined as growth in its Pampers brand in the US was offset by declines in other regions, and Family Care organic sales were unchanged despite increasing in North America as well, while Feminine Care organic sales increased thanks to innovation in developed markets and pricing strength in developing markets. Currency headwinds have had a strong impact on this segment as well, as net earnings fell 10% in the quarter but grew 5% on a constant currency basis when compared to the year-ago period.
Procter & Gamble’s pricing strength added to a strong quarter for earnings. Gross margin jumped 170 basis points in the quarter thanks to pricing gains but also due to lower commodity (input) costs. SG&A expenses declined 180 basis points as a percentage of revenue in the quarter thanks to overhead spending reductions in-line with its productivity efforts and lower restructuring and other charges. These improvements led to operating profit margin increasing 340 basis points versus the fiscal second quarter of 2015. P&G’s core earnings per share grew 9% on a year-over-year basis to $1.04, and when excluding the impact from currency exchange rates, core earnings per share leapt 20%+ in the quarter. Through the first half of the fiscal year (ending December 31), free cash flow surged thanks to stronger cash-flow-from-operations generation ($8 billion versus $7.1 billion) and lower capital spending ($1.2 billion versus $1.6 billion). The firm continues to repurchase shares at a high rate, spending $2 billion on buybacks in the most recent quarter, though we think the dividend is a better use of its cash.
As we look to the rest of fiscal 2016, Procter & Gamble is maintaining its expectation for organic sales growth to be in-line to up low-single digits from fiscal 2015, while “all-in” sales are expected to be down high-single digits on the year due to currency headwinds, minor divestitures, and deconsolidation in Venezuela. Major top-line growth should not be expected anytime soon from the company. The company projects core earnings per share to be down 3%-8% compared to fiscal 2015’s $3.76 core earnings per share, but on a currency-neutral basis, core earnings-per-share is expected to increase at a mid-to-high single digit rate pace for fiscal 2016. P&G also changed its adjusted free cash flow productivity to 100% (was 90%) of adjusted net earnings for the full fiscal year after a strong quarter of free cash flow generation.
Procter & Gamble’s pricing strength and productivity initiatives offered a material boost to margins and currency-neutral core earnings per share in the quarter, and the growth in a variety of the firm’s brands in developed markets thanks to innovation initiatives showed that the decision to reconfigure its portfolio holds merit. We’ll also be paying attention to its new ‘limited home laundry pickup initiative, and whether that gains any meaningful traction. That said, however, volume pressures across the board are hard to overlook, and management still has a long way to go to successfully transition the portfolio for the long term; significant currency headwinds certainly are not helping the situation. Shares are trading at 20+ times fiscal 2016 constant-currency core earnings per share, as the firm retains a $17 billion net debt position. We’re maintaining our high-$60’s fair value estimate at this time.