Price Increases are Not the Same as Organic Growth

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Sometimes I have trouble understanding why investors are unable to realize that companies growing solely via price increases are not real growth stories. Such is the case at Procter & Gamble (NYSE: PG). While there's no question this huge conglomerate has an extremely impressive record of paying and increasing their dividend, many investors seem to be expecting growth from the company that just doesn't seem likely.

If you look at Procter & Gamble's most recent earnings report, there is a consistent theme of foreign exchange and sales mix hurting results and the company responding by increasing prices. In the short term, this avoids a bigger problem with decreased earnings, over the long-term this is simply not a sustainable business practice. What's interesting, is the company actually states in multiple places that sales increased “organically.” What the company actually means is, they increased prices and that allowed the company to show positive revenue growth while they sold less product. In looking at other personal care and household conglomerates there is better true organic growth available. Since Procter & Gamble reports in five different divisions, let's see how each did and compare these results to other companies in the same industry.

Procter & Gamble's Beauty Care unit showed net sales down 4%, and unit volume down 1%. Through cost-cutting and manufacturing efficiencies, the company managed to turn in essentially flat earnings versus the prior year. By contrast, Colgate-Palmolive (NYSE: CL) which is best known for its personal care brands such as Colgate, Speed Stick, and Irish Spring does not report by division in the way that Procter & Gamble does. Instead, the company reports on a geographic basis. Compared to Procter & Gamble's volume down 1%, Colgate-Palmolive saw volume growth of between 6.5% and 9.5% worldwide. This would seem to indicate that Colgate-Palmolive is taking market share. In similar fashion, Procter & Gamble's Grooming division saw net sales decrease 6% with organic sales and volumes flat. Keeping with the theme from Beauty Care, the company was able to keep earnings in line versus the prior year through cost-cutting and manufacturing efficiency initiatives. While cost-cutting helped these two divisions maintain their profits, the same thing did not occur in Procter & Gamble's Healthcare division.

Healthcare net sales were down 1%. However, with organic volume in line with the prior year, the company was unable to control costs enough to avoid a net earnings decrease of 2%. This division faces competition from multiple companies, and one good example is Kimberly-Clark (NYSE: KMB). While Procter & Gamble saw no organic growth and net sales were down 1%, Kimberly-Clark's division saw sales increase 5% on volume growth of 6%. This is yet another area where it appears Procter & Gamble is losing market share to their competition. Thankfully there were two divisions that somewhat saved this earnings report: Fabric Care & Home Care, and Baby Care & Family Care.

In the Fabric Care and Home Care segment, net sales decreased 1% and unit volume decreased 1%. On a positive note, the company increased prices and lowered costs, which resulted in a 10% increase in net earnings. Even in this division where it seems the company did well, there are better opportunities out there. Another household name in cleaning, Clorox (NYSE: CLX) was able to post significantly better results across the board. In the company's cleaning division, 5% volume growth and 7% sales growth equaled 15% pretax earnings growth. Even when Procter & Gamble manages to grow earnings, it appears they are still giving away market share to other competitors. In Procter & Gamble's Baby Care and Family Care unit, net earnings increased 13%. This was actually the only division that saw real organic growth in volumes with a 1% gain. Now that we've looked at each of the company's divisions, let's see how the company did on their financial statements and review management's outlook.

Two important metrics for Procter & Gamble are their gross margin and their adjusted free cash flow. Their gross margin is showing the challenges of increased private label competition, and increased competitive pressures from other brand names. For full year 2011, Procter & Gamble's gross margin was 52%. However, in the first quarter of 2012, the company's gross margin dropped to 50%, and with this report it decreased again to 48.6%. Though the company was able to cut costs to increase earnings in multiple divisions, the decrease in gross margin will make future earnings growth more difficult. Where the company's dividend is concerned, Procter & Gamble's free cash flow payout ratio for the quarter was just under 50%. While this compares favorably to Kimberly-Clark's payout ratio of 85%, and Clorox's payout ratio of 65%, Colgate-Palmolive did just a bit better with a 45% ratio. While the dividend is safe, the company's outlook for earnings doesn't seem to match analyst estimates of 8% EPS growth.

In the third quarter, Procter & Gamble expects that net sales growth will decrease between 4% and 6%. However, the company does expect organic sales to be flat to up 2%. In a troubling note, the company expects full year 2013 sales to come in flat to down 2%. With overall sales decreasing or staying flat throughout next year, the company has a lot of work to do to grow earnings by better than 8% in the next few years. Though Procter & Gamble is a well-known dividend champion, the company's results and projections for low growth going forward should give investors pause. While it's true the company generates significant free cash flow, generic competition as well as name brand competition, seems to be hurting the company's results. This trend doesn't appear as though it will mitigate soon, and Procter & Gamble will need to produce innovative products and continue to focus on costs and manufacturing efficiencies to compete more effectively. Considering the company is only expected to grow earnings at about 8%, and yet sells for over 17 times 2012 earnings estimates, the stock is not exactly cheap. With Colgate-Palmolive showing significant volume growth, I would favor this conglomerate over Procter & Gamble at the current time.


MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of The Clorox Company. Motley Fool newsletter services recommend Kimberly-Clark and The Procter & Gamble Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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