No Growth, No Problem: P&G Still Has Lots to Love

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It’s been a less-than-ideal couple of quarters for consumer giant Procter & Gamble (NYSE:PG). A series of underwhelming earnings, agitated by ongoing headwinds in domestic and international markets alike, have sent the stock nowhere but sideways over the past six months. Shares have spent the time oscillating in a band between $73.61 and $85.82, at about $80 after the company reported fiscal third-quarter earnings that, once again, did little to excite the market.

Fiscal third-quarter net sales of $20.56 billion were effectively flat on the year and slightly below the mean analyst estimate of $20.68 billion, and for the nine months ended March 31, net sales of $64.04 billion were up 1 percent on the year. Organic volume growth, which is arguably a more important metric than net sales, increased 3 percent on the year, in line with established growth targets.

Organic volume increased the most (6 percent) in P&G’s Fabric Care and Home Care unit, followed by Health Care and Grooming (2 percent each) and Beauty (1 percent). Baby, Feminine, and Family Care (all one unit) showed no growth. Given unfavorable foreign exchange this quarter, the Fabric Care and Home Care unit was the only positive contributor to net sales.

“Fabric Care was up behind new innovation, developing market growth, higher pricing and initial innovation shipments,” P&G commented in the earnings release. “Home Care and Personal Power sales grew behind innovation and market expansion in developing regions, and Personal Power and Professional increased sales due to distribution expansion.”

On the bottom line, core earnings increased 5 percent on the year to $1.04 per share (or, up 17 percent on a currency-neutral basis), beating the mean analyst estimate of $1.02 per share. Diluted net earnings of 90 cents per share were up 2 percent on the year.

GAAP gross margin narrowed by 140 basis points to 48.4 percent of revenue, while adjusted gross margin narrowed 110 basis points to 48.9 percent. GAAP SG&A expenses as a share of revenue fell 170 basis points (down 130 basis points, adjusted), yielding an operating margin of 16.8 percent, up 30 basis points on the year (19.0 percent adjusted, up 20 basis points).

“P&G’s third quarter results came in as we had expected,” commented P&G Chairman and CEO A.G. Lafley. “This leaves us on track to deliver our top- and bottom-line growth objectives for the fiscal year. We’re operating in a slow-growth, highly competitive environment, which places even greater importance on strong innovation and productivity improvement. We’re delivering meaningful product innovations that are attracting more consumers to our brands. We’re making good progress on our productivity plans, with cost savings and enrollment reductions ahead of going-in targets for the year. We’re confident that the cumulative benefits from these innovations and productivity improvements will lead, over time, to improved value creation for consumers, customers and shareholders.”

Lafley is referring to P&G’s ambitious $10 billion cost-cutting program and a fairly severe restructuring program. P&G’s cost reduction plan is broken down into four broad parts. The lion’s share of the savings ($6 billion) will come from reductions in the cost of goods sold. The rest will be more or less split between overhead savings, marketing efficiencies, and operating leverage that assumes 5 percent organic growth (in line with the 2000-2009 average under Lafley, but ambitious compared to post-2009 growth).

The cost-cutting plan, combined with organizational restructuring, will be key to putting P&G back on track for growth in the near future. At least, this was the argument made by hedge fund manager Bill Ackman, who last year at the Sohn Investment Conference laid out a particularly bullish argument for the company.

Ackman argued that P&G is “vastly under-earning relative to its intrinsic earnings power” for a number of reasons. In his eyes, the company is suffering from a “bloated overhead cost structure,” some of which is due to the incomplete integration of Gillette in 2005. Manufacturing productivity also hasn’t been optimal over the past few years (but that may be more an issue with global demand than anything), and pricing in certain categories could use some editing (P&G owns many premium brands, which some consumers shied away from during and after recession).

Still, Ackman touted P&G as “one of the great businesses of the world,” and argued that through a mix of management and structural changes, the company could increase earnings per share by 50 percent, and nearly double its stock price over the next few years.

While P&G has a place in most long-term investment portfolios (a 3.1 percent dividend yield and time-tested stability is pretty attractive), it’s less clear that the company is ready to grow in the same way that some of its competitors have over the past few quarters.

Those competitors — primarily companies like Johnson & Johnson (NYSE:JNJ) and Kimberly-Clark (NYSE:KMB) — have had much more vitality than Procter & Gamble recently. Compared to negative year-to-date returns on the stock chart, shares of Johnson & Johnson are up 10 percent, and Kimberly-Clark stock is up 4.4 percent. On the year, Johnson & Johnson stock is up more than 17 percent, although Kimberly-Clark’s performance has been much more modest at about 2.7 percent growth.

Relatively slow growth is not a huge problem for Procter & Gamble, though. With the cost-cutting initiative well under way and with a new organizational structure, it seems like the spirit of Ackman’s bullish thesis is alive. That is, that there is opportunity for the company to meaningfully grow earnings in the near future, and that the company is doing what is necessary to capitalize on those opportunities.

In the coming months, analysts are expecting Johnson & Johnson to report sales of $18 billion, up 2.8 percent on the year, and earnings of $1.48 per share, up about 2.8 percent on the year. Kimberly-Clark is expected to post sales of $5.31 billion, down about 0.1 percent on the year, and earnings of $1.47 per share, down about 0.7 percent on the year.

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