P&G to Find Increasing Sales Volume Elusive

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The world’s leading fast-moving-consumer-goods (FMCG) manufacturer and a Dow Jones titan, Procter & Gamble (NYSE: PG) has posted strong results for its fiscal second quarter, beating Wall Street’s estimates twice in a row. The business has been facing criticism from activist investor Bill Ackman as the firm’s strategy caused it to grow overseas, particularly in China and India while its market share started slipping to competitors, such as Colgate-Palmolive (NYSE: CL), at home. Mr. Ackman’s hedge fund, Pershing Square owns 1% of the company.

P&G’s quarterly revenues of $22.2 billion were $290 million more than estimated and showed 2% year-on-year growth, while organic sales growth was 3%. Profits increased significantly from $1.69 billion in the same quarter last year to $4.06 billion. This translated into adjusted earnings per share of $1.22 versus analysts’ estimate of $1.11.

Meanwhile, gross margins expanded sequentially from 50.1% to 50.9%. The earnings target for the current fiscal year has been increased to $3.97 - $4.07 non-GAAP EPS. P&G would be able to meet Wall Street’s estimates this year even if it touches the low end of its new target. The company now expects organic sales to grow by 3% - 4% as opposed to 2% - 4% announced earlier. This is in stark contrast to Johnson & Johnson’s (NYSE: JNJ) latest guidance of $5.35 to $5.45 per share which, even at its higher end, is below analysts’ estimate of $5.49 per share.

P&G’s share buybacks are now going to be in the range of $5 billion - $6 billion as opposed to $4 billion - $6 billion announced earlier, which is partly how it will be meeting these new earnings estimates.

Whether these current results can be credited to Mr. Ackman’s pressure, who has been very vocal in his opposition to CEO Bob McDonald the company’s cost structure, is ultimately irrelevant.  McDonald has responded with a massive cost reduction plan that will shave $10 billion over the next three years and 5,500 job cuts. Moreover, a further 2%-4% per year workforce reduction plan will be carried out over the following three years through 2016.   

The current results have indicated that P&G’s global market share in those areas that account for 50% of its total sales is falling, but the company insists that this is an improvement given the fact that it was 55% in the quarter before. Much of the increased sales have come from the rise in prices rather than the increase in sales volumes. This is evident in P&G’s beauty and grooming segment, which reported flat to declining sales volume. On the other hand, its rival Unilever (NYSE: UL) reported a 7.2% increase in sales volume in a similar segment.

The increased margins have come from the price increases, which were initially raised by $3.6 billion last year and then reduced by about $450 million.  This is a price sensitive market which means that real growth has to come from finding either new products to introduce or a more focused approach to new market penetration. P&G is spending heavily on expansion in India and is looking for 8-9% organic growth in emerging market in FY 2013.  

In the U.S, P&G’s strong performers were Tide Pods, Cascade dish detergent, Gillette Fusion razor and Crest toothpaste. In the emerging markets, its two-thirds Chinese portfolio reported increased market share while the newly introduced products 3D White Toothpaste (Brazil) and the low cost razor Gillette Guard (Egypt) have performed well in their respective countries. 

The current problem I have is with volume and while P&G has been working on a new line in 2012 that "obsoletes current products and creates new categories and new brands,”  there is a gulf between what management is “confident” of and what the consumer can afford. P&G is a relatively safe, bedrock investment with its 3.6% yield and low beta.  But the sector is looking rich at a multiple of 20 and consumer confidence numbers in the U.S. deteriorating along with bond yields and rising energy prices.

As 2013 unfolds I’m seeing a potential return of 1970’s style stagflation along with lower take-home pay for the lower and middle classes in the U.S., the beginnings of which we are witnessing in P&G’s numbers here – flat sales with higher prices – from a company with lower exposure to overseas markets than Unilever.  In this scenario for 2013 and likely into 2014 U.S. consumers are going to be even more price sensitive than normal, and this quarter’s expanding margins may be a one-off event.  Cost cutting, staff reductions and stock buybacks are all good but as a defensive play against deteriorating market fundamentals.  I would steer clear of a new long position in P&G at these prices.

<table> <tbody> <tr> <td> <p><strong> </strong></p> </td> <td> <p><strong>PG</strong></p> </td> <td> <p><strong>CL</strong></p> </td> <td> <p><strong>JNJ</strong></p> </td> <td> <p><strong>UL</strong></p> </td> </tr> <tr> <td> <p><strong>Stock 6M</strong></p> </td> <td> <p>14.4%</p> </td> <td> <p>7.7%</p> </td> <td> <p>9.5%</p> </td> <td> <p>20.6%</p> </td> </tr> <tr> <td> <p><strong>Beta</strong></p> </td> <td> <p>0.23</p> </td> <td> <p>0.33</p> </td> <td> <p>0.44</p> </td> <td> <p>0.75</p> </td> </tr> <tr> <td> <p><strong>P/E</strong></p> </td> <td> <p>20.4</p> </td> <td> <p>21.6</p> </td> <td> <p>19.16</p> </td> <td> <p>20.14</p> </td> </tr> <tr> <td> <p><strong>EPS</strong></p> </td> <td> <p>3.59</p> </td> <td> <p>5.1</p> </td> <td> <p>3.86</p> </td> <td> <p>1.99</p> </td> </tr> <tr> <td> <p><strong>Yield</strong></p> </td> <td> <p>3.20%</p> </td> <td> <p>2.30%</p> </td> <td> <p>3.30%</p> </td> <td> <p>3.20%</p> </td> </tr> <tr> <td> <p><strong>ROE</strong></p> </td> <td> <p>14.05%</p> </td> <td> <p>94.13%</p> </td> <td> <p>17.40%</p> </td> <td> <p>32.30%</p> </td> </tr> </tbody> </table>


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