EUR 850.00 For Business Accounts Only

Morningstar | Procter & Gamble Works to Stem Tide of Share Losses; Shares Undervalued

The main question leading up to Procter & Gamble’s fourth-quarter results centered on the company's ability to boost sales and market share amid the industry's tepid pricing and competitive pressures. Organic sales ticked up just 1% in the quarter, driven entirely by increased volume; as has been the case, performance was weighed down by grooming (10% of sales) and baby (27%), which were each lower by 2%-3% on an organic basis. Excluding these two segments, sales popped more than 3%, with beauty (one fifth of sales) again the standout, up 7%. Management highlighted sequential market share improvement across the majority of its mix, a shift from the recent past, when share gains proved elusive on a consolidated basis. We think this gives credence to P&G's past strategic endeavors to rightsize its brand mix (culling more than 100 brands) and funnel added resources to support the brand intangible assets, particularly its entrenched retail relationships, that underlie our wide moat rating.

We don’t think P&G is opting for top-line gains at any cost. The firm is working to extract another $10 billion in costs, aiming to reduce overhead, lower material costs, and increase manufacturing and marketing productivity; this positively affected gross margins by 270 basis points. However, this gain was offset by higher input and transportation costs (110 basis points), unfavorable mix (120 basis points), lower pricing (80 basis points), foreign exchange (40 basis points), and one-time investments (60 basis points), leaving adjusted gross margins 140 basis points lower at just under 48%.

With fiscal 2018 results and 2019 guidance in line with our outlook, we see little change to our $98 fair value estimate, which is based on 3%-4% annual average sales growth and operating margins approaching the mid-20s over the next decade. The shares trade at a 15%-20% discount to our valuation, and with a nearly 4% dividend yield, we think investors would be wise to stock up.

Despite the dearth of material improvement to date, we think P&G is poised for modest sequential gains in the intensely competitive grooming category because of its work to recalibrate its pricing, invest in on-trend new products, and launch its own subscription-based sales model over the last several quarters. Our contention stems from the success of past efforts to steady the beauty business, which just a few years ago was plagued by intense competitive pressures from established branded operators and niche local players at a time when P&G's innovation failed to align with consumer trends. Since then, the beauty segment has been buoyed by efforts to shed unprofitable products and launch fare centered on its core anti-aging messaging, resulting in organic sales gains that have consistently amounted to a mid- to high-single-digit pace. While we don’t expect the external pressures hampering grooming will abate soon, we expect segment sales growth will tick up at a 2% clip annually over the next 10 years.

From a capital-allocation perspective, P&G continues to generate robust levels of free cash flow, amounting to 17% of sales in fiscal 2018. Despite a handful of smaller, strategic tie-ups over the recent past, which afforded the firm opportunities to enhance its competitive capabilities or grant it entry into less penetrated geographic regions and distribution channels, we think P&G's main goal is to return excess cash to shareholders in the form of dividends and share repurchases, the combination of which amounted to about $14 billion in fiscal 2018. Overall, we still believe P&G’s actions to rationalize its product mix, reinvest behind its brands, extract costs, and boost shareholder returns are prudent. We don't expect activist investor Nelson Peltz’s position on the board to accelerate change, but rather think the proxy battle in and of itself will ensure management remains focused on delivering sustainable top-line gains longer term.