As the decade long bull market continues and the low interest rate environment persists, it’s becoming apparent that a number of equities are trading at elevated valuations that aren’t justified over the long-term, and are sure to revert at some point in the months or years ahead.
One example of this can be found in Procter & Gamble (PG). Since I initiated my coverage in the company about 5 months ago, shares have surged close to 10% while the S&P 500 has gained 5% during that time.
Procter & Gamble is delivering fair results for shareholders from an operating standpoint and I won’t dispute that, but I’ll contend that only a few percent away from its 52 week high and all-time high, both Procter & Gamble’s total return potential and starting yield have deteriorated even further since I last covered the company.
We’ll be briefly reiterating Procter & Gamble’s dividend safety and growth potential, discussing Procter & Gamble’s recent operating results, and the company’s stock price in relation to what I believe is its fair value.
I’ll wrap up the article by offering both Procter & Gamble’s annual total return potential over the next decade from the current price and from my estimated fair value.
Procter & Gamble’s Dividend Remains Safe And Growth Is Intact
Though Procter & Gamble’s dividend remains safe compared to when we initiated coverage in May, we’ll briefly be reiterating the safety and growth potential of Procter & Gamble’s dividend.
In its previous fiscal year, Procter & Gamble generated core EPS of $4.52 against the $2.8975 in dividends per share paid during that same time, for an EPS payout ratio of 64.1% (compared to a 66.7% EPS payout ratio in the year prior).
For the current fiscal year, Procter & Gamble is expecting core EPS growth of 4-9%. This would result in a midpoint core EPS figure of $4.81 against the $3.0134 in dividends per share slated to be paid out during that time (assuming a 4% dividend increase next April), for an EPS payout ratio of 62.6%.
Moving to FCF, Procter & Gamble generated $15.242 billion in operating cash flow against capital expenditures of $3.347 billion, for total FCF of $11.895 billion (according to page 39 of Procter & Gamble’s most recent 10-K). Against the $7.498 billion in dividends paid to shareholders during this time, that equates to a 63.0% FCF payout ratio (compared to a 65.6% FCF payout ratio in the year prior).
Assuming that Procter & Gamble can generate the same free cash flow productivity that it did in its previous fiscal year and the company announces the 4% dividend increase that I expect for April, this would result in an FCF payout ratio a bit above 60%.
Based upon our analysis, it’s clear that Procter & Gamble’s dividend is about as safe as it was in my previous article.
Image Source: Simply Safe Dividends
It should come as no surprise that with the improvement in Procter & Gamble’s payout ratios, the strong balance sheet, and solid operating fundamentals, Procter & Gamble’s dividend safety remains at a 99 via Simply Safe Dividends’ rating system.
With dividend safety now addressed, we’ll transition into a brief discussion of my expectations for dividend growth going forward.
Given that Procter & Gamble’s payout ratio is making considerable progress in being lowered to an even safer and more sustainable level to allow the company to engage in share buybacks and reinvest back into the business for future growth, I believe that dividend growth will roughly mirror whatever earnings growth the company is able to deliver over the long-term.
When we consider that analysts at Yahoo Finance are expecting Procter & Gamble to grow its earnings at an annual clip of 7.3% over the next 5 years, I believe that the company will be able to deliver at least 6-7% dividend growth over the long-term.
Now that we have established our expectations for long-term dividend growth, we’ll be discussing developments since we last covered Procter & Gamble in May to evaluate how the company will deliver upon our dividend growth expectations.
Procter & Gamble’s Fundamentals Remain Strong
As illustrated above, it’s clear that Procter & Gamble continues to deliver strong operating results.
In each of the three categories where Procter & Gamble initially provided guidance for last fiscal year, the company was able to meet or exceed its guidance.
Organic sales growth was a major positive for Procter & Gamble and this suggests that after the company’s years of divestitures, Procter & Gamble is showing major results. The company’s organic sales growth of 5% in its previous fiscal year well exceeded its initial guidance of 2-3% organic sales growth.
Core EPS continued to show the mid-single digit growth of Procter & Gamble’s past that investors had come to expect from the company prior to the implementation of its long-term growth program.
And even more striking was the fact that Procter & Gamble was able to deliver 7% core EPS growth despite significant currency headwinds. Factoring in neutral currency exchanges, Procter & Gamble delivered a staggering 15% core EPS growth rate in its previous fiscal year.
Procter & Gamble was also able to deliver a 6.7% growth rate in its FCF compared to FY 2018 due to its solid 105% FCF productivity rate, which is yet another impressive metric for a mega-cap consumer goods company such as Procter & Gamble.
Image Source: Procter & Gamble 2019 Annual Meeting of Shareholders Presentation
The reason that Procter & Gamble was able to post such impressive organic sales growth numbers for FY 2019 was due to all around impressive growth numbers in 9 out of Procter & Gamble’s 10 categories, with Skin and Personal Care and Personal Health Care leading the charge.
Adding to the company’s impressive year is the fact that all 6 of its regions were able to grow their sales, while all of its 15 top markets were able to maintain sales or grow.
Another encouraging sign in Procter & Gamble’s previous fiscal year was that the company was able to deliver 25% online organic sales growth, increasing the company’s online sales to about 8% of total sales for FY 2019.
Image Source: Procter & Gamble 2019 Annual Meeting of Shareholders Presentation
Due to Procter & Gamble’s strong sales growth in FY 2019, the company’s market share increased in 33 of its top 50 category/country combinations compared to 26 in the year prior, and 23 in FY 2017.
Capping off Procter & Gamble’s strong FY 2019 was the company’s ability to improve its efficiency through productivity driven cost savings, increasing its core operating margin by 130 basis points on a currency neutral basis.
In addition to its great operating fundamentals, Procter & Gamble’s balance sheet remains strong.
Procter & Gamble’s credit rating from S&P remains firmly investment grade at AA-.
As illustrated above, Procter & Gamble’s net debt to EBITDA, net debt to capital, and interest coverage ratios for FY 2019 are holding strong.
Procter & Gamble’s net debt to EBITDA ratio deteriorated a slight bit from 1.40 in FY 2018 to 1.49 in FY 2019, but that should dip back below 1.40 over the next 12 months. And when we consider that Procter & Gamble’s net debt to EBITDA ratio is about a third of what Simply Safe Dividends considers to be a decent ratio, it really demonstrates the strength of Procter & Gamble’s balance sheet.
The same narrative played out in the company’s net debt to capital ratio, with the ratio weakening a bit from 0.31 to 0.35, but once again, Procter & Gamble’s net debt to capital ratio is about half of what Simply Safe Dividends considers to be acceptable.
Finally, Procter & Gamble’s interest coverage ratio slightly improved from 28.08 in FY 2018 to 28.11 in FY 2019. This is well over triple what Simply Safe Dividends considers to be an ideal interest coverage ratio, which is another testament to the strength of Procter & Gamble’s balance sheet.
When we take into consideration Procter & Gamble’s strong operating fundamentals, firmly investment grade balance sheet, and management team delivering those strong operating results, it’s obvious that Procter & Gamble is a company capable of creating meaningful wealth for shareholders over the long-term at the right price.
Risks To Consider:
Despite the fact that Procter & Gamble is a company with a lengthy track record of enriching its shareholders, that doesn’t mean the company is an investment without its share of risks.
As stated on page 1 of Procter & Gamble’s 10-K, the company generated 15% of its total sales in 2019 from Walmart, and Procter & Gamble’s top 10 customers accounted for 36% of total sales in 2019. As further mentioned on page 3 of the company’s 10-K, Procter & Gamble generates the vast majority of its sales through relationships with mass merchandisers, e-commerce, grocery stores, drug stores, department stores, distributors, and wholesalers.
Procter & Gamble faces two key challenges as a result of the above.
The first is that because of the consolidation within the retail industry, a smaller number of retailers account for a larger share of the retail industry. This is significant to note because with increased market share comes increased leverage over suppliers, such as Procter & Gamble. Whether retailers demand that Procter & Gamble sells products at lower prices or that the company increases their promotional or marketing spending, either of the two could weigh on Procter & Gamble’s financial results.
The other risk is that if Procter & Gamble is unable to maintain good working relationships with its key retail customers or its negotiations break down with a major retailer, the company could face a significant loss in sales with a particular retailer that it is ultimately unable to otherwise replace.
Another risk to Procter & Gamble is that as a company with products sold in more than 180 countries and territories throughout the world, the company generates more than half of its sales in foreign currencies, which are then translated into U.S. Dollars (page 2 of Procter & Gamble’s most recent 10-K).
While the risks associated with foreign currency translation tend to even out over time, the more valid concern over both the short-term and long-term is from the standpoint that Procter & Gamble also has operations in approximately 70 countries and territories throughout the world.
As a result of Procter & Gamble’s global presence, the company is exposed to numerous regulatory, economic, and geographic risks.
It’s worth noting that the enactment of new regulations or the modification of existing regulations in key markets that dictate Procter & Gamble’s operations could result in a significant expense to the company in order to comply with such regulations.
Additionally, the company’s global presence exposes it to a unique set of economic risks. One such example of this is evident in the United Kingdom (page 5 of Procter & Gamble’s most recent 10-K). The issue of the UK’s pending withdrawal from the European Union has led to a level of uncertainty for that market, which has resulted in currency fluctuations, and has the potential to impact taxes, regulations, and the movement of goods, services, capital and people from between countries.
The final risk category as a result of Procter & Gamble’s global presence is from a geographic perspective.
It’s worth noting that any major natural disasters or terrorist attacks in key markets could result in a disruption in the company’s supply chain, which has the potential to adversely impact the company’s financial results.
One other key risk to Procter & Gamble is that as a consumer driven brand, the company is dependent upon upholding the reputations of its brands and innovating to meet the preferences of consumers (pages 4-5 of Procter & Gamble’s most recent 10-K).
Any quality or safety concerns with key brands could lead to a recall of its products, the possibility of additional regulations, the need for increased spending to improve quality control, and the need for additional spending to potentially restore the reputation of a brand in the aftermath of a major quality or safety concern.
Any deterioration in the perception of Procter & Gamble’s brands or an inability to meet the shifting preferences of consumers could adversely impact both Procter & Gamble’s market share and the its financial results.
While the above discussion of risks is certainly not comprehensive, I do believe that we have covered most of the key risks that both potential investors and current investors in Procter & Gamble must consider and periodically monitor to ensure the investment thesis remains intact. For a more complete discussion of the risks associated with an investment in Procter & Gamble, I would refer interested readers to pages 2-6 of Procter & Gamble’s most recent 10-K.
Procter & Gamble’s Stock Price Simply Isn’t Justified
While Procter & Gamble is executing fairly well from an operating perspective, we’ll be discussing the extent to which I believe shares of the company are overvalued since the run-up in stock price the past few months.
The first valuation metric we’ll be using to arrive at a fair value for Procter & Gamble is the 13 year median TTM yield.
According to Gurufocus, Procter & Gamble’s TTM yield of 2.52% is well below its 13 year median TTM yield of 3.05%, and is approaching its 10-year low.
Assuming a reversion in Procter & Gamble’s TTM yield to 3.05% and a fair value of $97.38 a share, shares of Procter & Gamble are trading at a 20.7% premium to fair value and pose 17.1% downside from the current price of $117.53 a share (as of October 20, 2019).
The second valuation metric we’ll use to determine the fair value of shares of Procter & Gamble is the TTM price to FCF ratio.
According to Gurufocus, Procter & Gamble’s price to FCF ratio of 25.59 is well above its 13 year median TTM price to FCF ratio of 20.51.
If we assume a reversion in Procter & Gamble’s price to FCF ratio to 20.51 and a fair value of $94.20 a share, this implies that shares of the company are trading at a 24.8% premium to fair value and pose 19.9% downside from the current price.
The third and final valuation metric we’ll use to assign a fair value to shares of Procter & Gamble is the 13 year median TTM PE ratio.
According to Gurufocus, Procter & Gamble’s TTM PE ratio of 25.94 is also well above its 13 year median TTM PE ratio of 19.63.
Assuming a reversion in the company’s PE ratio to 21.00 and a fair value of $95.15, shares of Procter & Gamble are trading at a 23.5% premium to fair value and pose 19.0% downside from the current price.
When we average the three fair values above, we arrive at a fair value of $95.58 a share.
This indicates that shares of Procter & Gamble are trading at a 23.0% premium to fair value and pose 18.7% downside from the current price.
Summary: A Disconnect Between Valuation And Fundamentals Makes Procter & Gamble A Hold
Procter & Gamble’s 63 consecutive years of dividend increases are exceeded by only 3 U.S. companies, which reinforces the idea that Procter & Gamble has made generations of investors rich over the past 60+ years.
While Procter & Gamble is exposed to a number of risks as a consumer staple, the company maintains a strong balance sheet, boasts strong brand recognition, and an experienced management team to counter these risks.
Unfortunately, shares of Procter & Gamble are trading at a 23% premium based upon the fair values that I arrived at above.
Between the near 10 year low yield of 2.5%, 6-7% annual earnings growth, and 2.0% annual valuation multiple contraction, shares of Procter & Gamble are likely to deliver 6.5-7.5% annual total returns over the next decade.
At my fair value yield of 3.2%, Procter & Gamble offers the same annual earnings growth and a static valuation multiple, for annual total returns of 9.2-10.2% over the next decade.
In my opinion, a yield of close to 3.2% would offer an attractive opportunity to either add to an existing position in Procter & Gamble or to initiate a position in the company.
Disclosure: I am/we are long PG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.