No matter what, the reputation of Procter & Gamble Co (NYSE:PG) as a safe, dividend-paying stock seems almost bulletproof. That reputation has provided enough to keep the PG stock price relatively elevated. But that simply shouldn’t be the case.
P&G’s revenue growth has been challenged for years now, with organic growth of just 2% in FY17 (ending June) after 1% increases in each of the previous two years. That was followed by another 1% rise in a disappointing fiscal first quarter.
Dividend growth has stalled out: double-digit increases last decade have given way to an average hike of just 2.4% the last three years. And yet even that slower growth has led to an increase in the payout ratio. What the company calls “Core EPS” has been stagnant for years: the figure was $3.95 in fiscal 2011 and $3.92 in fiscal 2017.
To be fair, currency has had a huge impact on P&G’s business over that period, taking a likely 40-50% off EPS. But Fx sort of “is what it is” at this point; that headwind isn’t necessarily going to reverse, and any investor expecting it to has better options to play it.
Looking forward, this seems like a low-growth business at best. And yet PG’s price-to-earnings multiple has expanded steadily since the financial crisis – and now exceeds the levels seen last decade, when the company’s international growth was torrid, and the dividend was increasing double-digits annually.
Nothing in results of the past few years, the (finally) successful activist campaign run by Nelson Peltz or in PG’s Q1 earnings seems to support that type of expansion, or PG’s current valuation.
The 3% yield PG stock still offers looks attractive. But with fair value likely below $80, a pullback to more normalized multiples could wipe out years of those payouts. The simple fact is that the PG stock price is too high. I still expect that to change at some point.
Challenges for PG Stock
P&G is facing a number of significant challenges to its business. Private label competition is taking market share. Per the company’s Q1 presentation, “global value share” declined in four of five business units, with the Fabric & Home Care segment maintaining its share.
Commodity prices are increasing, offsetting some of the benefits from cost-cutting. The rest of those savings are being reinvested into marketing and sampling. But revenue weakness persists.
That seems unlikely to change. The very business model of P&G is to be a reliable supplier to the middle class, both in the U.S. and internationally. Domestically, still responsible in fiscal 2017 for 45% of sales and 68% of pre-tax income, according to its 10-K, that middle class is fading.
Overseas, the strong dollar has benefited local competitors and foreign-based giants like Unilever plc (ADR) (NYSE:UL).
The high-margin Grooming segment is seeing profits plunge after taking price cuts a year ago. Competition from Dollar Shave Club (bought by Unilever for $1 billion) and Harry’s is a culprit. So are cultural changes. P&G isn’t winning in China, particularly in the key diaper category, as management has admitted.
But many of the problems are structural, not necessarily a result of P&G’s failures. It can’t make men shave more often. It can’t undercut low-cost Chinese producers, or make Wal-Mart Stores Inc (NYSE:WMT) or Kroger Co (NYSE:KR) turn away from private label.
PG stock isn’t facing a short-term headwind. It’s facing a secular, permanent change, just like many of its middle-class customers.
The Activist Enters (and Finally Wins)
As for the idea that there’s some huge path to a turnaround for P&G, it’s not like the company has been standing still. Back in early October, I voiced my support for activist Nelson Peltz, who wound up finally winning a proxy fight that cost a whopping $125 million.
But as I wrote at the time, I’m not sure what Peltz really expects and he didn’t give much detail himself. Peltz wanted P&G down to three units, from a current ten, and criticized the company as being too bloated. But P&G already has cut over 100 brands, dropping down to 65.
It took $10 billion in costs out this decade, and plans for another $10 billion in the coming years.
The idea that there’s this huge amount of fat to cut at P&G seems far too optimistic. And yet, that idea seems baked into the PG stock price.
The PG Stock Price
PG stock really hasn’t performed that badly, particularly excluding a late 2014 run to $90+ and a quick dip the next year below $70. The stock has gained 9.3% so far this year, and 31.4% over the past five.
Even with dividends, those figures mean PG has underperformed relative to the S&P 500, but PG’s defensive nature suggests it probably should underperform in what of late has been an uninterrupted bull market. Even so, it’s lagged its closest peer, Colgate-Palmolive Company (NYSE:CL), since the financial crisis.
And what gains PG stock has managed have come from an expanded multiple – not earnings growth. That’s why dividend increases have been paltry, averaging just 2% over the past three years. PG itself is guiding for 5-7% EPS growth this year – but with 2 points of benefit from share repurchases.
In other words, net income is planned to grow just 3-5% this year, on the back of a 2% increase in organic revenue. And Q1 results appear to put P&G behind plan, though management insisted otherwise on the Q1 conference call.
For that, investors are paying a forward multiple of 22.1x. Last decade, the multiple was in the high teens and growth was much better.
A similar compression would value PG in the $75-$80 range, against the current PG stock price near $92. That’s what is coming if P&G can’t accelerate growth. But with cost savings taken, secular challenges ahead, and competition intense, I don’t see that growth on the way.
If I’m right, investors buying PG for the dividend are going to lose out, and maybe lose out big.
As of this writing, Vince Martin has no positions in any securities mentioned.