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Morningstar | Procter & Gamble's Sales Bounce in 1Q Exemplifying Efforts to Hone Focus; Shares Still Undervalued

Across the consumer products sector, much angst has centered on the ability of firms to reignite sales and offset inflationary headwinds, and Procter & Gamble is no exception. However, if first-quarter results are any indication (organic sales jumped 4%), P&G could be setting out on a new course in fiscal 2019. Growth was broad-based, with four of the firm’s five segments boasting sales gains in the mid- to high-single-digit range, an impressive feat given the intense competitive landscape. The one laggard remains its baby and family care segment (one quarter of sales), where underlying sales slipped 1%. However, management qualitatively discussed that this downdraft was concentrated within the mid- and value-tier categories, which offset growth of its premium offerings (where P&G has been expanding its reach with new products). As such, we haven’t wavered from our thinking that actions over the past several years to cull more than 100 brands and funnel resources to fund on-trend product launches may be positioning P&G to more effectively and efficiently respond to evolving consumer trends.

Despite this, we’ve never thought sustainable sales gains at P&G would chart a straight path north, particularly against an industry backdrop of tepid pricing and competitive pressures, but we believe this performance is evidence that P&G is investing to support the brand intangible assets that underpin its wide moat. We intend to incorporate a slightly larger hit to sales and profits from unfavorable foreign exchange in the current year (now anticipated to be a drag of 3%-4%, down from around 2% prior), but don’t see a change to our $97 fair value estimate, which is based on 3%-4% annual sales growth in the longer term and 300 basis points of operating margin expansion to nearly 25% at the end of our explicit forecast. Even after accounting for the high-single-digit rise in shares, we view the stock as undervalued, trading at around a 10% discount to our valuation.

From a category perspective, P&G’s grooming segment (around 10% of sales) was a bright spot, chalking up 4% organic growth in the quarter (a dramatic improvement from the repeated declines it posted over the bulk of the past four years). We attribute this shift in performance to P&G’s work over the course of the last few years to recalibrate its pricing, invest in on-trend new products, and launch its own subscription-based sales model. From our vantage point, P&G has sought to implement the same playbook in grooming as when it worked to turn around its beauty business (20% of sales) a few years back. In this case, it shed unprofitable products and launched fare centered on its core anti-aging messaging, which has resulted in multiple quarters of mid- to high-single-digit sales gains for its beauty segment. And while we don’t believe that the external pressures hampering grooming have entirely subsided, we expect segment sales growth will tick up at a 2% clip annually over the next 10 years.

Despite the market’s emphasis on the status of its top line, P&G has long struck us as an operator focused on growing its sales while not sacrificing profitability. In that vein, the firm has been working to extract another $10 billion in costs, aiming to reduce overhead, lower material costs, and increase manufacturing and marketing productivity. While inflation (in terms of both commodities and transportation costs) persists, we think efforts to drive efficiencies are essential to offset these headwinds, while maintaining the fuel to reinvest to support its competitive prowess. More specifically in the quarter, adjusted gross margins contracted 150 basis points (including a 60-basis-point hit from foreign exchange and a 260-basis-point negative impact from commodity costs and unfavorable mix, partially offset by a 170-basis-point benefit from efficiency savings) to 49.4%. But management’s rhetoric continues to stress the importance of upping the ante on its brand investments to support its competitive edge, which aligns with our forecast calling from 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 drive our forecast for operating margins to expand from the low-20s to the mid-20s over the next decade.