Investors Seem To Already Buy Into Procter & Gamble's Turnaround Story

By Stephen D. Simpson, CFA | December 13, 2012 AAA

Turnarounds can be great investments, but you generally have to buy in at a point where the Street is still questioning the survivability of the company and pushing for dramatic, sweeping changes. In the case of Procter & Gamble (NYSE:PG), the pressure is still very much on management to deliver better results, but the shares don't reflect all that much uncertainty or pessimism about the company's prospects. On the contrary, it looks like the Street already pretty much expects this story to have a relatively happy ending.

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Share Is Improving, and More Innovation Is Coming
One of the negatives aspects to the P&G story for some time has been the company's share loss. Over the last year, the company has seen its market share fall in the majority of its top 20 categories, with rivals like Clorox (NYSE:CLX), Unilever (NYSE:UL) and Johnson & Johnson (NYSE:JNJ) picking up some of the business. More recently, though, this trend has improved as P&G has started showing sequential share improvement. While market share data can be notoriously wobbly, it does look as though better merchandising/promotions have made a difference.

Now, the company is also looking to add a bit more growth to the picture through product innovation. The company's November analyst day highlighted a variety of innovation opportunities across all of the major categories (like beauty, grooming, healthcare, etc.). With recent successes like Gillette ProGlide and Crest 3-D White, I'd give P&G at least the benefit of the doubt with respect to the anticipated "hit rate" for these new products.

Cost Controls - What the Street Wants, but Do They Represent a Risk?
Wall Street seemed to like what the company had to say about its ongoing cost-cutting initiatives. In addition to cutting non-manufacturing headcount, the company is looking to cut packaging costs and lower its marketing budget by about $1 billion per year.

This is all well and good, and a look at rivals like Clorox, Unilever and Colgate Palmolive (NYSE:CL) would seem to suggest ample opportunities to reduce SG&A and improve operating margin. This is not without risk, though. I'm particularly curious to see how the company will blend this lower marketing spend with its other goals of launching innovative new products and expanding its emerging markets footprint - I would think that trimming marketing spending would put the "hit rate" of those new products at some risk. Likewise, if the company is focused on trimming near-term expenses, will they be able to make the necessary investments to close the gap on rivals like Colgate that have significantly more emerging market exposure?

To be fair, though, the company's efforts have shown some good early results. In addition to a 2% organic revenue growth (at the high end of management's guidance range) for the third quarter, the company delivered an 80 basis point gross margin improvement that seemed to be better than most sell-side expectations.

Are There More Non-Essential Parts to Sell?
P&G has been in a mostly selling mood of late, selling Pringles to Kellogg (NYSE:K) and selling PUR to Helen of Troy (Nasdaq:HELE). At the same time, the company is launching an over-the-counter (OTC) drug business venture with Teva (NYSE:TEVA). I think increasing its exposure to the OTC health market makes good sense for P&G, but I do wonder if there are additional parts and pieces that can be sold off with an eye towards better overall margin performance and returns on capital.

The Bottom Line
At this point, I like most things about P&G apart from the share price. While the company has received a lot of well-deserved criticism for marketing, brand management and overall performance missteps, I think the company's remedial measures are cogent and reasonable.

I find it interesting that many sell-side analysts still express skepticism (or at least caution) regarding P&G's turnaround plans, while simultaneously projecting a pretty quick recovery in free cash flow conversion. As it stands, I believe P&G is likely to regain its average free cash flow margin (around 14%) in about two years, with steady (if slow) improvement from there. I'm also looking for about 3% long-term growth in revenue - well below the company's trailing growth rate above 7%.

These estimates point to a fair value in the high $60s, which is a bit below today's share price. Increasing the revenue growth estimate to 4 to 5% would bump the fair value up to the mid-$70s, but it would seem that it takes quite aggressive estimates for revenue growth or margin improvement to drive a truly compelling target relative to today's price.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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