Wide-Moat Procter & Gamble Astutely Navigating the Current Uncertain Landscape
Wide-Moat Procter & Gamble Astutely Navigating the Current Uncertain Landscape
Business Strategy and Outlook | by Erin Lash Updated Aug 11, 2022
It wasn’t long ago that Procter & Gamble was dogged for lackluster sales growth; however, after posting its 16th consecutive quarter of at least mid-single-digit organic revenue growth, these concerns are a distant memory. While we recognize the firm has been a beneficiary of the pandemic (with a mix that caters to consumers' penchant for cleaning and disinfecting fare), we attribute these marks to the strategic course P&G embarked on about eight years ago (rightsizing its category and geographic reach by shedding more than 100 brands to ensure resources were being effectively allocated to the highest-return opportunities, while maintaining a stringent focus on costs). As a part of this playbook, P&G also adopted a more holistic approach to brand investing (consisting of how a product performs, the packaging, brand messaging, execution in stores and online, and the value a product offers for its retail partners and end consumers) that we think should support its wide moat long term.
But even as its top line appears healthy, P&G is facing shortages across its supply chain (particularly in labor) and unrelenting commodity cost inflation that management has qualitatively pegged as some of the most significant in some time. To offset the pressures reverberating throughout the industry, P&G has been raising prices at the shelf in certain categories and geographies, similar to the vast array of its peer set. We’re cognizant consumers could balk at price hikes by trading down or out of certain categories. However, we think the degree of inflation combined with P&G’s innovation mandate (rooted in consumer-valued new fare) should make such increases more palatable. As evidence, pricing has only detracted from the firm's top line once in the past 19 years. Further, we're encouraged P&G is continuing to lean into brand spending to illustrate the value its products offer as opposed to turning off the spigot to preserve profits in this uncertain climate. This aligns with our forecast for P&G to direct around 3% and 10%-11% of sales long term to research and development and marketing, respectively, in line with the 2.6% and 10.3% expended on average the past five years.
Economic Moat | by Erin Lash Updated Aug 11, 2022
We assign Procter & Gamble a wide economic moat rating resulting from its intangible assets and cost edge. Given its position as a leading household and personal-care manufacturer (with more than 20% share of baby care, north of 60% of blades and razors, around 20% of feminine protection, and greater than 35% of fabric care, as cited by the firm), we think P&G is a valued partner for retailers, supporting its brand intangible asset moat source. We believe P&G maintains the resources to bring new products to market (spending just shy of 3% of sales or nearly $2 billion on R&D annually) and tout that fare in front of consumers (spending a low-double-digit percentage of sales or about $7.5 billion annually on marketing) to drive customer traffic into stores and onto e-commerce platforms, which we believe enhances the stickiness of its retailer relationships. In our view, trusted manufacturers like P&G, which operate with a product set that spans the grocery store, are critical to retailers that are reluctant to risk costly out-of-stocks with unproven suppliers. Despite the bargaining power garnered by a consolidating base of retailers, leading brands—like those in P&G's portfolio—still drive store traffic, supporting our contention surrounding the advantage resulting from the firm’s brand intangible asset. Bolstering its competitive position is the size and scale P&G has amassed over many years, which enables the firm to realize a lower unit cost than its smaller peers, resulting in a cost advantage.
Beginning in 2014, P&G started down a path to shed about 100 brands—more than half of its brand portfolio at the time, which in aggregate posted a 3% sales decline and a 16% profit reduction the prior three years—a decision we viewed as an indication that the firm was looking to become a more nimble and responsive player in the global consumer product arena. Even a slimmed-down version of the leading global household and personal-care firm still carries significant clout with retailers, and we think these actions supported P&G's brand intangible asset and its cost advantage. The 65 brands that remain in its mix had already accounted for more than 85% of the firm’s top line and 95% of its profits. As such, we didn't anticipate P&G would sacrifice its scale edge but would be able to better focus its resources (both personnel and financial) on its highest-return opportunities.
One area where the success of this focus has been evident is in its feminine-care (more specifically, adult incontinence) business, where the firm cites that it maintains more than 20% value share and has chalked up multiple consecutive years of quarterly growth (averaging a low- to mid-single-digit pace). As a part of this effort, P&G sought to break down the stigma associated with adult incontinence products (a market it re-entered in July 2014) by bringing to market new offerings that appeal to female consumers under its Always brand, including the launch of Always Discreet Boutique, which more closely resembles real underwear compared with other products in the aisle at the time (late in calendar 2017). According to the firm, this particular product drove a 50% acceleration in category growth after its launch and increased the firm’s household penetration by 15 points. Despite selling at a 60% premium to base offerings in this category, management has asserted that Always Discreet now boasts a dollar share in the low-teens, up from around 10% before the launch of Boutique.
We think this supports our contention that management understands the need to consistently bring superiority to market (as it pertains to how a product performs, the packaging, its brand messaging, execution in store and online, as well as the value a product offers for both its retail partners and the end consumer). However, we don’t believe the firm is content to stop with its recent gains. Much discussion has centered on the necessity of being more agile, starting small with product launches and tailoring offerings based on the consumer response before rolling out on a larger scale, which we view as a favorable shift. Further, we're encouraged that 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.
Returns on invested capital (including goodwill) have averaged just more than 12% annually over the past 10 years, exceeding our 7% cost of capital estimate, and we think the firm can continue to outearn its cost of capital over the next 20 years, supporting our take that P&G maintains a wide moat.
Fair Value and Profit Drivers | by Erin Lash Updated Aug 11, 2022
We're bumping up our fair value estimate for P&G to $126, from $124, after digesting fiscal 2022 results, reflecting the benefit of time value. Our revised valuation implies fiscal 2023 price/adjusted earnings of 21 times and an enterprise value/adjusted EBITDA of 16 times. However, we aren't wavering on our long-term outlook, which calls for 3%-4% annual sales growth and nearly 25% operating margins in fiscal 2032, up from an average of 22.4% over the past five years.
Despite more recent gains from consumers' penchant for cleaning and hygiene fare since the onset of COVID-19, we had viewed the acceleration in P&G's top line throughout fiscal 2019 and into 2020 as a testament to the merits of its strategic agenda to rightsize its brand mix and drive productivity savings to fuel further investments behind consumer-valued innovation. Although we expect competitive angst to resurface and challenging macroeconomic conditions around the globe to persist, we think P&G is well suited to navigate this uncertain landscape. For one, since the last economic downturn (during which P&G chalked up low-single-digit quarterly organic top-line gains), the firm has prudently taken a more holistic approach to brand investing, encompassing how a product performs, the packaging, brand messaging, execution in stores and online, and the value a product offers its retail partners and end consumers. Further, management has altered the mix to include more daily-use fare, pruning more discretionary offerings, including its professional beauty brands, a few years back.
However, P&G isn't immune to recent cost pressures—which are now expected to prove a $2.4 billion headwind in fiscal 2023, on top of $3.2 billion in fiscal 2022—we think the firm remains squarely focused on unearthing efficiencies in its underlying business (reducing overhead, lowering material costs from product design and formulation efficiencies, and increasing manufacturing and marketing productivity) and raising prices (referenced as a mid-single-digit rate across the majority of its mix) to offset this barrage of challenges, which we view as prudent. Despite this, we're encouraged by its intentions to continue to lean into brand spending as an opportunity to showcase the value its products offer consumers, as opposed to preserving profits in this uncertain climate. We forecast P&G will allocate about 3% of sales to R&D and 10%-11% of sales to marketing annually long term.
Risk and Uncertainty | by Erin Lash Updated Aug 11, 2022
We assign P&G a Low Uncertainty Rating. Throughout the sector, much angst has surrounded the competitive landscape and the ability of firms to offset commodity, labor, and transportation cost inflation with higher prices. Adding to these challenges from an environment, social, and governance perspective, any product recalls (necessitated by substandard quality) or claims of price-fixing could also weigh on volume; however, we don't see either of these factors as likely to materially impair its brand standing or cash flows. With 50%-60% of its sales derived outside the U.S., P&G is exposed to changes in foreign-exchange rates, which could constrain its reported financials, with a more pronounced profit impact, as the firm isn't always manufacturing in the locations where its selling, a challenge that is unlikely to ever entirely abate.
Beyond these external factors, P&G had also been challenged by executional missteps, which saw it overextend as it sought to build out its category and geographic footprint. But we think it's been charting a new course, as it has been working to reduce head count and overhead, improve manufacturing efficiency, and free up funds to reinvest in its business.
Although much attention has centered on P&G's inability to drive durable sales gains in the past, particularly in its grooming arm, we see similarities to the challenges that previously plagued its beauty business. In the latter case, beauty had succumbed to intense competition from established branded operators and niche local players at a time when its innovation failed to align with consumer trends. However, management took prompt actions to course-correct, opting to part ways with unprofitable products and launch fare centered on its core anti-aging messaging. We think P&G is also taking a sound strategic path to rebut the pressures in its grooming business—by recalibrating its pricing, investing in on-trend new products, and launching its own subscription-based sales model.
Capital Allocation | by Erin Lash Updated Aug 11, 2022
We aren't wavering on our Exemplary capital allocation rating for P&G, which is based on our assessment of the company's sound balance sheet, fair record of investment, and appropriate shareholder distributions. Jon Moeller assumed the CEO role in November from David Taylor, who stepped down after six years at the helm and nearly four decades at the firm. Moeller is a 33-year company veteran who had been CFO since 2009 until March 2021 and more recently assumed the role of chief operating officer and vice chairman. Because Moeller has been intimately involved in scripting the firm’s strategic playbook (centered on stringently extracting costs from its operations while directing additional resources toward product innovation that resonates with consumers and marketing that fare), we don’t expect it will pivot off its current course.
For one, we continue to believe that the relative lack of cyclicality of its operations combined with low leverage levels will ensure its pristine balance sheet persists. We also expect bolstering shareholder returns will remain a key capital allocation priority under Moeller’s watch (building off of the more than $100 billion returned in total over the last 10 years). Our forecast still calls for high-single-digit annual increases in its dividend and a low-single-digit percentage of shares repurchased each year, which we view as a prudent use of cash when orchestrated at a discount to our assessment of intrinsic value.
The soundness of P&G's capital allocation and corporate governance came under fire five years ago when activist Nelson Peltz amassed an ownership stake of more than $3 billion, or around 1% of shares outstanding. He took aim at P&G’s insular culture and lagging financial performance. Our contention had been that P&G was already on the path toward driving significant and lasting change in the business. While we think bureaucracy impaired the company's ability to more adeptly respond to competitive headwinds and evolving consumer trends in the past, we’ve been encouraged by the firm's goal over the past several years of enhancing accountability across the organization. The impediments that plagued P&G during former CEO Bob McDonald’s tenure have not been lost on management, and we think the organization has been keen to avoid succumbing to the same pitfalls of overemphasizing operational improvement at the expense of value-added innovation.
In this vein, the firm announced in late 2018 intentions to shake up its organizational structure by focusing on six sector business units that now have direct control over strategy, product and package innovation, and supply chain in its largest markets, including North America, China, Japan, as well as developed European markets, which in aggregate make up about 80% of sales and 90% of aftertax profit. The remaining regions had fallen under the purview of Moeller (though Shailesh Jejurikar, formerly CEO of fabric and homecare, now bears this responsibility after assuming the COO role in October). This shift aligned with Taylor’s goal to better align the firm’s resources and decision-making closer to the consumer, which we view as wise. While we think this structure will help P&G to be more responsive and agile, we don’t expect it to jeopardize the company's ability to harness the benefits of its scale and negotiating leverage.
Beyond his prior critique of corporate governance, we don’t view as prudent Peltz’s previous directive to organize the business into three stand-alone units: beauty, grooming, and healthcare; fabric and home care; and baby, feminine, and family care. Rather, we think this move could ultimately increase the costs and complexity of the business, unwinding the progress made to date. Further, we believe this organizational structure would impede P&G's ability to leverage its scale, negotiating leverage, and consumer insights to the extent possible as a combined organization. While we perceive a split of its operations as unwise at this juncture, we think the firm could still look to part ways with other brands, including its consumer tissue business (particularly the Charmin and Bounty brands, which we estimate generate around $4 billion in total sales annually), if efforts to reignite sales cool. Although we don't anticipate that P&G will resort to acting as a consolidator, we think it could selectively pursue smaller, bolt-on tie-ups as a means to enhance its capabilities or category exposure when the opportunity arises.
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