This Problem Isn't Going Away

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

Organic growth: It's the holy grail for investors. If a company has it, they usually show increased revenue, earnings, and cash flow. Companies that don't grow organically have to resort to buying back shares, cutting costs, and other creative measures to improve their earnings and cash flow. One problem in the stock market is that some companies have a different definition of what organic growth means. I'm looking at you, Procter & Gamble (NYSE: PG). Raising prices, even if it means less volume is not real growth. In the short-term, this might make some investors happy, but over the long-haul, this is a path to sub-par returns.

If you don't know what Procter & Gamble is, look in your shower, medicine cabinet, or other places in your house and you'll likely find their products. The company that brings us Tide, Crest, and Gillette is a household name. There is no question they face serious competition from the likes of Colgate-Palmolive (NYSE: CL) and Unilever (NYSE: UL) in particular. However, the fact that P&G has been around for over 100 years, and has raised their dividend for over 50 straight years in a row should be reason enough to buy the stock, right? Unfortunately I'm going to answer that question with a big, fat no. There are significant differences between Procter & Gamble and its two main competitors, and the issues with P&G are harder to solve.

The biggest difference between these three companies is where they will get their growth in the future. Procter & Gamble is established in some of the largest economies worldwide. By comparison, Colgate-Palmolive gets much less of its sales from overseas. Unilever is sort of anti-Procter & Gamble in the sense that they are established in some international territories, and are looking to the United States and others for growth. Each of these companies sports iconic brands like Dove, Vaseline, and Axe, as well as Colgate and Palmolive, so these competitors are able to go toe-to-toe with P&G on brand name. The biggest challenge facing the consumer products industry isn't brand recognition, it's price.

The last several years of economic turmoil have taught many people to look at prices more than before. The bottom line is, price matters and value is more important than brand. Over time this might change, as the memory of tough times fades, but for some consumers they won't go back to their old habits. The years of customers buying brands like Charmin or Pampers (P&G brands) without regard to price are long gone. Customers have come to realize that store brands offer similar traits at a lower price point. In addition, Procter & Gamble's competition has gotten smarter and is constantly introducing new product lines. With store brands on the one side and better competition from name brands on the other, P&G is getting squeezed from both ends.

The reason the new dynamics of the market are such a big deal to P&G is because of the way the company has been growing earnings. Procter & Gamble has been consistently raising prices even though volumes have been declining. In the company's three main segments of Beauty & Grooming, Health Care, and Household Care, real volume growth was negative nearly across the board. At the same time, P&G raised prices in nearly every segment to try to offset these volume declines. This is a key difference between P&G and its competition. Colgate-Palmolive has seen real volume growth in multiple categories and Unilever has seen a similar trend. Only real volume growth can make Procter & Gamble a potential buy for long-term investors. If the company thinks just raising prices is “organic growth” they are sadly mistaken.

So what can Procter & Gamble do if they want to create real organic growth? Two examples from recent earnings should give management a clue. First, in the toothpaste segment, the company introduced 3D White toothpaste, and this new product has delivered 28 straight months of growth. New product introductions that meet a need are a key way P&G can turn around its volume slide. Second, in the company's Family Care business, their merchandising around Bounty Basic and Charmin Basic have paid off in better sales growth. This is really no surprise, given that both of these brands compete much more effectively when it comes to price. Procter & Gamble needs to understand that new products and competing more effectively on price should be their two pronged attack. There is just one major problem in the short-term: The company is trying to impress the stock market instead of managing the business for the long-term.

Companies managing for the long-term don't worry about quarterly results. However, in the current quarter P&G repurchased $1.6 billion in shares even though their dividend used up over 81% of free cash flow. To be blunt, the company didn't have enough to make this repurchase, so they borrowed $2 billion to make this happen. In the last four quarters, the company has taken on a net of over $3.4 billion in new long-term debt. I don't think it's a coincidence that they targeted $4 billion in share repurchases and took on almost as much in new debt. It's one thing to believe your stock is cheap and use free cash flow to repurchase shares; borrowing money to cover share buybacks smells of trying to “buy” EPS growth.

Unilever gives us an idea of what P&G could do differently. The company hasn't been buying back shares, and their dividend uses up a chunk of their free cash flow. However, in the last year Unilever's cash has increased by about $2 billion, while they have paid down about $600 million in debt. Colgate-Palmolive, on the other hand, has basically kept their balance sheet stable. Both of these companies have instead used their extra cash flow to introduce new products and improve their efficiency. This needs to be P&G's game plan going forward.

Procter & Gamble yields about 3.3% and analysts see 8% growth in the next few years. However, without an adjustment to their marketing strategy, I fear they won't live up to their growth expectations. The company can't afford to keep buying back shares with money they don't have. Real volume declines need to be addressed with better marketing and product introductions. Until P&G solves these problems, I see better opportunity elsewhere. Unilever pays a similar yield of 3.2%, but they may beat earnings expectations of 5% by improving their category low gross margin of about 42%. Considering that P&G and Colgate-Palmolive have gross margins of 50% and 58% respectively, you can see there is plenty of room for improvement.

Among the three, Colgate-Palmolive seems the best bet. The company is constantly introducing new products, pays a decent yield of 2.3%, and their 8.4% expected growth rate is more realistic than P&G given they have real organic volume growth. When people buy more of your product that is real organic growth. Raising prices to help offset less volume is not the same thing. Unfortunately for Procter & Gamble shareholders, this volume decline is a problem that isn't going away. Until this situation changes, I would look to Colgate-Palmolive instead.

MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend The Procter & Gamble Company and Unilever. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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