Warren Buffett owns 2.7% of Procter & Gamble (NYSE:PG) stock. The 76.8 million shares Berkshire Hathaway (NYSE:BRK.A) owns will provide approximately $161 million in dividend income in 2011. It’s no wonder he’s held the stock since 1989. The dividend income is attractive, and it does possess a competitive advantage over many of its peers. However, I don’t think this is reason enough to own its stock. I believe you should sell. Here’s why.
Limited Upside
In the past decade, its two best years in terms of total return were 2004 at 18.3% and 2007 at 16.4%. In each case, the dividend yield was less than 2%. Today, its yield is 3.4%, leading many, including Barron’s, to suggest its stock is cheap. But unless you are in need of the $2.10 in dividend income P&G pays annually, it’s hard to understand why you’d own its stock.
Sure, it’s a stable company owned by the Oracle himself and trading at a reasonable P/E. What more could you ask for, right? Wrong. Dividend investing is a hot topic these days as large numbers of boomers reach retirement age in need of an income fix. However, equity investing is about total return, which the last time I checked, includes capital appreciation. Those familiar with the “Rule of 72” should know that it would take you just under 10 years to double your investment in Procter & Gamble. If you’re not retiring tomorrow, this is absolutely the wrong stock to own.
Balance Sheet
Warren Buffett’s 1987 annual chairman’s letter to shareholders is contradictory about debt. On one hand, he says Berkshire Hathaway looks for “businesses earning good returns on equity while employing little or no debt.” However, earlier in the letter, he suggests that he isn’t afraid of debt and if used judiciously, it can be a good thing. It’s hard to know, therefore, what he thinks of P&G’s $32 billion in total debt. The fact that he still owns its stock indicates he doesn’t feel there’s a problem.
While that might be true, there’s a number of things on its balance sheet that, when taken alone, can be construed in a negative manner. For instance, its current ratio is 0.81, less than the commonly accepted multiple of 1.5 or more. Peers including Avon Products (NYSE:AVP), Colgate-Palmolive (NYSE:CL) and Kimberly-Clark (NYSE:KMB) all do better. Another potential bugaboo is P&G’s net debt, which is 1.57 times EBITDA. Its three peers average 1.43.
Lastly, Buffett believes you need to manage both sides of the balance sheet by achieving the highest return on assets combined with the lowest cost for your liabilities. P&G’s return on assets is 7.4% while it pays 3.4% in interest on its long-term debt. Colgate-Palmolive, whose net debt is one times EBITDA, has a return on assets of 20.1% while it pays 2.7% on its long-term debt. From this perspective, it’s hard not to question an investment in Cincinnati’s finest.
Use of Free Cash
Procter & Gamble generates a fair amount. In 2010, its free cash flow was $9.9 billion, 84% of net earnings. In the two previous years, it was 102% and 87%, respectively. As an organization, it strives for 90%. In two of the past three years, Colgate-Palmolive’s free cash flow productivity was over 100%. In the past five years, P&G used approximately 60% of its free cash flow to repurchase shares, averaging $7 billion annually. Over those five years, it repurchased 546.3 million shares at an average of $64 per share. That’s a return on investment of -2.3%. That’s hardly mind-blowing.
Instead of priming the earnings per share pump, it could have eliminated debt, improved the dividend and made a few large acquisitions with change to spare. Looking at P&G in this light, it’s definitely not a great allocator of capital.
Bottom Line
If you own this stock expecting above-average capital appreciation, you’ve come to the wrong place. Sell P&G stock and find something else.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.
