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Morningstar | P&G's Upward Sales Trajectory a Plus, but Challenges Persist; Shares Not a Bargain

The prime question ahead of Procter & Gamble’s second-quarter results was whether the wide-moat household and personal care firm would be able to chalk up another quarter of top-line gains. As evidenced by the mid-single-digit climb in the share price, the market may be gaining an appreciation of the company's past strategic efforts, including shedding more than 100 brands from its mix since 2014. Organic sales ticked up 4% for the second consecutive quarter and on top of a 2% organic bump in the year-ago period. This reflected balanced improvement in volume (up 2%), price (1%), and mix (1%), which is a plus, in our view. We doubt this will entirely quell concerns surrounding the ability of leading consumer packaged goods firms to raise prices without incurring a sustained hit to volume, but we believe P&G's focus on brand spending (as it pertains to enhancing how a product performs, the packaging, its brand messaging, execution in stores and online, as well as the value a product offers for both its retail partners and end consumers) should maintain its competitive edge.

Management raised the top end of its fiscal 2019 underlying sales growth target to 2%-4% from 2%-3% based on its performance through the first half of the year, but it expressed some caution about potential competitive and macro challenges, prompting it to hold firm on the bottom end of the range. First-half results are tracking in line with our full-year forecast, and we see little to prompt a change to our $97 fair value estimate (outside of a $1-$2 increase to reflect the time value of money) or long-term outlook (based on nearly 4% annual sales growth in the longer term and 300 basis points of operating margin expansion to more than 24% by the end our 10-year forecast). With the uptick in the share price following these results, we view the stock as fairly valued and would suggest investors await a more attractive entry point.

The one laggard in the mix remains grooming (10% of sales, down 3% on an organic basis). As has been the case, management attributed this downdraft to heightened competitive pressures and volume declines following price increases beyond its home turf to offset the impact of currency devaluation. Despite this, we think the firm is pursuing a sound strategic path to rebut the pressures in this segment by recalibrating its pricing, investing in on-trend new products, and launching its own subscription-based sales model. As a part of these efforts, P&G is launching a razor specifically geared to men with sensitive skin, a condition the firm claims affects 70% of males, and has suggested us to that further launches will follow. As an example, Gary Coombe (president of global grooming) has previously said the company is still not satisfied with the packaging in this segment and believes that further investments in this realm could also help stabilize its competitive position. As a result, we don’t anticipate these pressures will constrain performance indefinitely; we expect segment sales growth will approximate 2% annually over the next 10 years.

We don’t think P&G is content with the sales performance in the remainder of its businesses, where organic sales growth ranged from 3% to 8% in the quarter. Across the firm’s mix, we’ve been encouraged by management’s repeated references to the need to be more agile, starting small with product launches and tailoring offerings based on consumer response before rolling out on a larger scale. Further, we think P&G seems to appreciate the need to be present and innovate across all price tiers (affording the opportunity to trade consumers up and down within its brand set) to withstand intense competitive pressures, as the inability to do so has plagued its business in the past.

Despite the market’s outsize emphasis on the top line, we continue to believe P&G is focused on increasing sales, but not at the expense of profitability. Although core gross and operating margins modestly eroded in the quarter (down 80 basis points and 10 basis points, respectively, to 49.6% and 22.8%), we don’t believe this invalidates our contention. For one, at the gross margin line, the firm chalked up 150 basis points of productivity savings, but this was offset by a 190-basis-point hit from commodity costs and unfavorable mix (foreign exchange, pricing, and other factors also affected margins but to a more muted degree in the quarter). As such, we believe the firm’s efforts to extract another $10 billion in costs, aiming to reduce overhead, lower material costs, and increase manufacturing and marketing productivity, are prudent. We don’t expect management will ratchet back spending on its brands to drive further profit improvement (in line with recent rhetoric). As such, our forecast calls for 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. The combination of these factors drives our forecast for operating margins to expand from the low 20s to the mid-20s over the next decade.

We believe P&G’s efforts to rationalize its product mix, reinvest in its brands, extract costs, and return excess cash to shareholders are prudent. We hope to garner additional perspective on the firm's strategic efforts to bolster its top line and competitive positioning when we attend the Consumer Analyst Group of New York conference in February.