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Recently-transformed consumer staples giant Procter & Gamble’s fiscal 2018 third quarter report left a bit to be desired as pricing woes weighed on organic top-line performance. The company is also shifting its Consumer Health business as it has agreed to acquire Merck KGaA, Darmstadt, Germany’s Consumer Health business.

By Kris Rosemann

Shares of former simulated Dividend Growth Newsletter portfolio idea Procter & Gamble (PG) hit their lowest mark since early 2016 in the trading session April 19 following its fiscal 2018 third-quarter report. We believe the company may have made its transition to a more-focused entity too rapidly as it continues to navigate multiple difficult operating environments around the globe. Its strategy to focus only on its highest-quality brands in its core markets was intended to reveal a stronger, more efficient company that held the strongest of its once-massive brand portfolio, which should translate the retention of pricing power via refined brand strength.

That wasn’t the case in the most-recently reported period at Procter & Gamble, however. Organic sales at Procter & Gamble grew 1% in the third quarter of fiscal 2018 on a year-over-year basis as volume growth of 2% and favorable product mix of 1% (largely thanks to an increase in premium beauty product sales) were partially offset by a 2% decline in pricing. The pressure on pricing was primarily due to price reductions in its US shave care portfolio, and management was quick to note that its pricing trajectory should improve as it enters next fiscal year. We’re not completely convinced, however, and we’ll be monitoring pricing trends at Clorox (CLX), Kimberly-Clark (KMB), Church & Dwight (CHD), Colgate-Palmolive (CL), and Unilever (UN, UL), among others, for incremental information.

Though net sales advanced 4% in the quarter from the year-ago period thanks to favorable foreign currency-exchange fluctuations, the combination of weakened pricing, muted organic sales growth, and a contracting gross margin are not indicators of confidence in what is supposed to be a refined and strengthened brand portfolio. Currency-neutral core gross margin contracted 90 basis points in the fiscal third quarter as 230 basis points of productivity savings were more than offset by increases in commodity costs, unfavorable geographic and product mix (including an increase in transportation costs), unfavorable pricing, and innovation reinvestments.

Nevertheless, Procter & Gamble’s free cash flow performance through three quarters in fiscal 2018 has been impressive as the measure advanced 15% from the comparable period of fiscal 2017. Such strength gave management the confidence to raise its annual dividend for the 62nd consecutive year, a track record matched by few others. The company’s balance sheet health might give the most debt-averse investors a reason for pause, however as its cash balance of ~$15.5 billion as of the end of the third quarter of fiscal 2018 is easily overshadowed by its total debt load of ~$35.3 billion. However, its net debt load of ~$19.8 billion implies a net debt-to-annualized EBITDA ratio of just over 1.1x.

Management’s decision to acquire the Consumer Health business of Merck KGaA, Darmstadt, Germany (MKKGY) for €3.4 billion, or ~$4.2 billion, shows its willingness to grow inorganically, even after the recent portfolio transformation. However, the deal comes with the announcement of Procter & Gamble’s decision to terminate its consumer health JV with Teva Pharmaceuticals (TEVA) on July 1 of this year, a decision that came following a review of Teva and Procter & Gamble that revealed differing priorities and strategies. 

Merck KGaA’s portfolio of OTC remedies for muscle relief, joint and back pain, colds and headaches, among others, should complement the existing assets Procter & Gamble will retain following the break-up of its JV with Teva, and management expects the business to provide it with adequate scale it needs to operate a global OTC business without the help of a healthcare partner. Merck KGaA’s key markets include Europe, Latin America, and Asia. The purchase price of €3.4 billion implies a trailing EBIT multiple of more than 34 times 2017 EBIT, a bit pricey, but roughly in-line with the average trailing EV/EBIT multiple for healthcare product firms of approximately 35 times, according to NYU Stern. Merck KGaA had been looking to divest the business for some time, and it appears as though Procter & Gamble has agreed to pay a fair value—perhaps a bit more than fair value.

Regardless of the developments related to its Consumer Health business, Procter & Gamble has its work cut out for it moving forward. Price reductions have helped volume performance, but a core tenet of its portfolio transformation strategy was refocused brand power, which it has yet to be on display in a sustained and meaningful way since the shift. Gross margin pressures only add to our concerns, but the company remains a strong free cash flow generator with one of the strongest dividend track records available. Fiscal 2018 guidance points to expectations for solid performance but nothing to get excited about. Organic sales growth is expected to be 2%-3%, and core EPS growth guidance was raised to 6%-8% after the fiscal third quarter from previous guidance of 5%-8% growth.

Procter & Gamble will continue to be a consumer staples bellwether, but we are content with our decision to rid the simulated Dividend Growth Newsletter portfolio of shares in early April at $77.93 per share as it continues to work through multiple challenging operating environments and get a better grasp on its “new” business. Shares yield ~3.8% on a forward-looking basis as of this writing.

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