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Morningstar | After Three Quarters of Improving Sales, P&G Ticks up Its Full-Year Outlook; Shares Not a Bargain

We think Procter & Gamble’s third-quarter results (5% organic sales growth and a 40-basis-point increase in adjusted operating margins to about 20%) showcase the fruits of its multiyear effort to rationalize its brand mix and hone investments on its highest return opportunities. Not only did this performance mark the third quarter in a row of mid-single-digit organic sales gains, but in our view, was more favorable given the balanced contribution from price, mix, and volume improvement (to the tune of 2%, 1%, and 2%, respectively).

Management raised its fiscal 2019 underlying sales growth target to 4% from 2% to 4% to reflect year-to-date results (ahead of our 2% prior outlook), but again articulated a bit of caution stemming from impending competitive and macro challenges, and held the line on its underlying EPS outlook (up 3%-8%). As such, we don’t expect to alter our $98 fair value estimate or long-term outlook (based on nearly 4% annual sales growth long term and a 300-basis-point bump in operating margins to more than 24% by fiscal 2028). Despite the low-single-digit pullback in shares, we view the stock as modestly inflated relative to our assessment of its intrinsic value; we’d suggest investors await a more attractive margin of safety before building a stake in this wide-moat name.

Consumer product firms throughout the industry have suggested an intent to raise prices to offset inflationary headwinds (related to transportation and commodities), and management qualitatively alluded to competitors matching the higher prices it has already brought to the market. While the sustainability of its top line will likely remain in focus given it plays in a hotly contested market, we posit P&G's more holistic approach to brand investing (encompassing how a product performs, the packaging, brand messaging, execution in stores and online, combined with the value a product offers for both its retail partners and end consumers) should support its competitive edge.

While growth was fairly broad-based, as has been the case for the better part of the last four years, grooming (nearly 10% of sales) continues to be plagued by competitive angst (particularly on its home turf) with sales down 1% on an organic basis. However, we surmise the firm is pursuing a sound strategic path to rebut competitive pressures in this segment by recalibrating its pricing, investing in on-trend new products, and launching its own subscription-based sales model. In line with our thinking, management suggested that efforts to bring men back into the category while also increasing the frequency of shaving (partly stemming from new products like its recently released razor geared to men with sensitive skin, a condition the firm claims affects 70% of males) has boosted sales within Europe and other emerging markets (without quantifying the level of improvement). And we don’t believe opportunities to win with consumers are limited to new products. Rather, Gary Coombe (president of global grooming) has previously suggested to us that the company is still not satisfied with the packaging in this segment and believes that further investments in this vein could also steady its competitive position. As such, we don’t anticipate these pressures to impede its prospects longer term; our forecast calls for grooming segment sales growth of around 2% annually over the next 10 years.

Further, even with its increased emphasis on reigniting its top-line trajectory, we don’t surmise P&G has abandoned its pursuit of efficiency gains. As evidence, the firm boasted 160 basis points and 260 basis points of productivity savings at the gross and operating income lines, respectively, in the quarter (a portion of which was offset by inflationary headwinds, unfavorable mix, and negative foreign currency movements among other factors). These savings can be traced back to P&G’s initiatives to extract another $10 billion of costs from its operations through fiscal 2021 (centered on reducing overhead, lowering material costs, and increasing manufacturing and marketing productivity). However, we don’t believe the impetus for this course is to juice profits, but rather to fuel additional brand spend. As such, we forecast P&G to direct 3% and 11% of sales to research and development and marketing, respectively, up from historical levels of less than 3% and 10.6% in fiscal 2018. This underlies our expectations for operating margins to expand to the mid-20s by the end of our 10-year explicit forecast, up for the low-20s it has chalked up over the past few years.

Even as it works to drive sustainable and profitable financial performance, we perceive its commitment to enhancing shareholder returns as unwavering. In this vein, the firm recently announced a 4% increase in its dividend (its 63rd consecutive year increase and 129th year of dividend payment) and expects to return more than $12 billion to shareholders this year (through both dividends and share repurchases). And we expect it to continue to direct excess cash flows (which we forecast will amount to a high-teens level of sales on average over our explicit forecast) in a similar fashion. More specifically, we anticipate its dividend to grow at a high-single-digit clip over the next decade, implying a 60%-70% annual payout range (in line with historical levels).