Investors seem to love gaudy expense-reduction programs, and Procter & Gamble (NYSE:PG) shares have certainly done better since Bill Ackman's Pershing Square got involved and management announced a $10 billion cost-cutting program. P&G's performance isn't so unusual in the wider context of a hot market for consumer staple stocks, but it's looking more and more like investors are overpaying for the margin improvement potential and earnings consistency of these names. Barring a quick turnaround in volumes, it looks like P&G shares have overshot the mark and offer less compelling potential from today's level.
Fiscal Third Quarter Results Come Up Short On Growth
Procter & Gamble is the sort of company where a single percent of growth here or there makes a difference to the stock price. To that end, organic growth of 3% wasn't bad relative to management guidance, but it was a little less than sell-side analysts wanted. What's more, analysts don't seem to like the weak volume numbers – overall volume was up 2% (against expectations of around 3% to 3.5%), with volume down in beauty care and flat in grooming.
P&G also showed less margin improvement than expected. Gross margin improved another 20bp from last year, but the pace of improvement has definitely slowed to a considerable degree. This will likely stoke fears that the expense cuts were front end-loaded and the company has already picked the low-hanging fruit. Operating income performance was mediocre, as operating income rose 2% on an adjusted basis and the operating margin improved just 10bp.
SEE: Analyzing Operating Margins
Is Better Performance On The Way?
One of the curious things about the performance of P&G is how it compares to Nielsen data. For the trailing twelve weeks ended March 16 (so, covering most of the quarter), PG did well relative to Energizer (NYSE:ENR) in razor blades, gained share on Colgate-Palmolive (NYSE:CL) in toothpaste, gained share on Church & Dwight (NYSE:CHD) in detergent), and gained share on Kimberly-Clark (NYSE:KMB) in diapers and paper towels.
So why did Kimberly-Clark outperform Procter & Gamble on organic sales growth this quarter, and why were P&G's numbers a little soft relative to guidance? Nielsen data doesn't track all of the sales around the globe, and there can be a difference between what happens at the checkout and what happens in the stockroom.
Even so, it looks momentum is improving and that new product launches are seeing some success. The bigger issue may be, then, what happens to overall industry volumes. It certainly has looked recently as though overall shopping volume trends are not that strong right now, so P&G's share gain may be coming at a time when over volumes are softer.
SEE: Can Earnings Guidance Accurately Predict The Future?
Are Expectations The Bigger Threat?
I don't expect companies like Energizer, Colgate, Church & Dwight, or Unilever (NYSE:UL) to give up an inch when it comes to market share or promoting their products. To that end, P&G isn't going to get any breathing room or favors in the market. P&G isn't the only company introducing new products at a fast clip and some of this apparent share growth could quickly move over to newer rival products.
That said, I'm not all that worried about P&G base business. The company has strong share in a variety of home and personal care products, and the company's efforts to build plants and distribution facilities overseas should help support ongoing emerging market growth.
What does concern me, though, is investor expectations. Shareholders are absolutely right to insist that managers run companies as efficiently as possible, but cost-cutting and margin improvements are only part of the solution. Moreover, if the cost-cutting goes too deep, P&G risks compromising its ability to develop, market, and distribute new products and that will harm long-term growth. More to the point, these are slow-growing business and investors seem to be either overpricing the perceived security of these business or the future growth (or both).
SEE: A Guide To Investing In Consumer Staples
The Bottom Line
I do expect P&G to flip its growth rates relative to the past ten years – I expect long-term revenue growth to be in the low-to-mid single-digits, while I expect free cash flow (FCF) to grow in the high single digits on better margins and cash flow conversion. Even so, though, I don't believe these shares should trade above the mid-$70s today.
This is not tantamount to a call that P&G is going to decline. Rather, I would expect P&G to continue to appreciate but at a lagging rate relative to the market. As such, investors who view P&G as a key part of a balanced long-term portfolio can likely just hang on (though perhaps consider trimming or selling into strength), but I think investors with more of a short-term outlook should probably look for better-priced stocks.
At the time of writing, Stephen D. Simpson did not own shares of any of the companies mentioned in this article.
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