I hope that you have been enjoying this Dividend Growth Stock of the Month series. This is the ninth installment. Previous articles in the series can be found at the link just provided.
This month’s company is another iconic dividend growth stock. Procter & Gamble (PG) has been in business for 178 years, and it has increased its dividend every year since 1956.
PG has been in a price decline in 2015. That has resulted in an opportunity to buy this stock at a higher yield than normal. So this is a good time to consider whether the price decline is justified or likely to be just a temporary phenomenon that we can take advantage of.
PG’s dividend resume is a little spotty.
At 3.5%, PG’s yield is 30% higher than the average Dividend Champion. Thus I rate the yield amount as Good. The nice yield is partly a result of recent price weakness.
All else equal, when a stock’s price falls, its yield rises proportionately. That’s because yield is computed as $ Dividend / $ Price.
At 59 years, PG’s streak of consecutive annual increases is one of the best in existence. Its 5-year dividend growth rate of 8% is a percentage point higher than the average of all Dividend Champions.
But weakness appears in PG’s payout ratio. Currently standing at 79% (per the Dividend Champions document), that ratio of payouts to profits is probably not sustainable. While the raw numbers from Ycharts are higher than the Champions document figures, you can clearly see the 5-year trend in PG’s payout ratio here.
It is a safe bet that the reason for this year’s dividend increase of just 3%, compared to PG’s 5-year average increase of 8%, is that the payout ratio has climbed so high.
Management needed to conserve some cash.No company can pay out nearly all of its profits as dividends without constantly borrowing or issuing new stock.
Every company needs to retain or acquire capital to sustain its operations and to grow.
I do not believe that PG’s dividend is in any sort of danger.
But we may be looking at a couple of years of small increases while earnings growth allows the company to lower the payout ratio.
The positive side of that, of course, is that PG’s yield is pretty high to begin with at 3.5%.
Of the 8 categories, PG gets “Excellent” in 3 of them, “Good” in 2, “OK” in 2, and “Weak” in one. While that is not the strongest Quality resume that we have seen, it is still quite good.
• PG has been delivering returns on equity (ROE) in the high teens for more than 10 years, including the Great Recession years 2007-2009. ROE is a measure of a company’s efficiency in converting the money invested in it into profits.
• S&P Capital IQ’s quality rating is the highest grade that they give, A+. Capital IQ describes its quality rankings this way: “Growth and stability of earnings and dividends are deemed key elements in establishing S&P Capital IQ’s earnings and dividend rankings for common stocks.”
• Morningstar awards PG a Wide Moat rating, its highest grade. That means that Morningstar believes that PG has strong and sustainable competitive advantages compared to its peers. PG’s advantages include its extensive collection of well-known brand names, diverse portfolio of businesses, and sheer scale.
• PG’s debt-to-equity ratio (D/E) is 0.5. That compares to 1.1 for the average Dividend Champion. PG uses a moderate amount of debt to finance its operations, a level that is half the average of all Champions. As a general observation, the use of debt by corporations has climbed in recent years, probably because of the very low interest rate available.
The single weakness is in the area of earnings growth. PG’s past 5-year earnings growth rate has been just 3%, which is low even for a huge established company like Procter & Gamble. What has caused that?
One thing hurting PG has been the strong dollar. More than half of PG’s sales come from overseas, and currency translations hurt U.S. companies when the dollar is strong. The company recently estimated the negative foreign exchange impact as 6% of sales. We have seen this currency headwind with every multinational company that we have looked at. One could argue that this is not the company’s “fault,” but nevertheless it has an impact in real dollars.
Another reason is structural and strategic. PG, it is fair to say, became bloated and wandered into too many non-core product areas. Over the past few years, management has been attempting to correct course by selling off non-core brands and improving productivity. We will explore this process in the next section.
How Does Procter & Gamble Make Money?
Founded in 1837 as a candle-and-soap company, Procter & Gamble has evolved into a global behemoth in household and personal-care products. It is the world’s largest producer of consumer products.
PG designs, manufactures, and distributes branded, high-quality products into more than 180 countries. The U.S. and Canada account for about 40% of total sales. Other large markets are Europe (28%) and Asia (16%). Emerging markets account for 39% of sales.
PG sells to mass merchandisers, grocery stores, membership stores, and drug stores. PG is the market leader in several categories, with over 30% of the baby care market, 70% of blades and razors, 30% of feminine protection, and 25% of fabric care.
PG operates in 5 segments:
• Beauty (24% of sales and 23% of earnings)
• Grooming (10%; 17%)
• Health Care (9%; 9%)
• Fabric and Home Care (32%; 26%)
• Baby, Feminine and Family Care (25%; 25%)
PG has 23 “blockbuster” brands that generate more than $1 billion in sales each year, including Pampers, Charmin, Bounty, Tide, Olay, Pantene, Gillette, Crest, Oral-B, Vicks, Dawn, Downy, and Fabreze.
Recently, PG released its earnings report that ended its fiscal year of 2015, gave guidance for the next year, and had its conference call with analysts.
It did not go well. There were many questions about the company’s minimal revenue growth and decline in earnings. Full-year revenue was down in all five segments, and the forward guidance was for little growth. PG’s share price fell about 4% on the release.
I once worked for a major multi-national company that was executing a strategy of improving by shrinking. It may seem weird, but it can work. The idea is that focusing on the most profitable core products and most favorable markets will improve bottom-line numbers. It allows significant costs to be cut, margins to improve, and everyone to have better focus on the most important things.
In 2014, PG announced that it would shed up to 100 brands, or more than half of its brand portfolio. That is a significant reshaping of the company. As reported by Reuters:
The maker of Gillette razors and Tide detergent said it would consider selling about 90 to 100 brands whose sales have been declining for the past three years.
P&G said the 70 to 80 “core” brands it will focus on accounted for 90 percent of sales and more than 95 percent of profit over the past three years. Twenty-three of the brands have sales of between $1 billion and $10 billion.
“Less will be much more,” Chief Executive A.G. Lafley said….
P&G’s top 80 brands had sales of about $84.1 billion in 2013 while the other roughly 100 brands had sales of just $2.4 billion, according to Sanford Bernstein analyst Ali Dibadj.
A strategic turnaround and restructuring like this takes time, with the hoped-for payoff being a more nimble and better-focused company. The brands that it is exiting had (in the aggregate) negative sales and profit growth, while the brands it is keeping account for about 90% of the company’s sales and 95% of its profits.
Since 2012, PG has been on a major cost-reduction program, aiming to carve out $10 billion over 5 years. It is always hard to tell the impact of programs like this, as cost reductions in one area can be made, while spending and acquisitions rise in other areas.
PG’s well-known brands, and its reputation for quality products, constitute significant competitive advantages. That said, PG’s markets are highly competitive, with similar products and well-known brands being available from other companies, not to mention boutique and private-label brands that compete on quality, style, and price.
Also, consumers are well-known to turn to less expensive products during times of economic stress. Many of PG’s markets are in economies that are less strong than the USA, so price becomes an important factor in results.
Last November, PG agreed to sell its Duracell business to Berkshire Hathaway (BRK.B) in exchange for $4.7 billion in PG shares held by Berkshire. The deal is expected to close in the second half of 2015. Assuming those shares are retired, the reduction in share count will improve EPS and other per-share numbers by a few percent all by itself.
Overall, I rate Procter & Gamble’s business model as above average. It gets credit for its huge established foundation of successful products and brands, and it loses credit for its past strategic wandering. The company has a lot of moving parts. Some aspects of the company are excellent while others present challenges, which management is trying to address via its long-term strategic initiatives.
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation. Here are the steps applied to PG.
FASTGraphs 1. The first step is to compare the stock’s current price to FASTGraphs’ default estimate of its fair value.
PG’s price (black line) is just on the border between the 3rd and 4th channels above the fair-value line (orange). This is overvalued. PG’s price is 28% above fair value by this metric.
FASTGraphs 2. The second valuation step is to compare PG’s price to its “normal” long-term average P/E ratio. The stock market often gives higher- or lower-than-normal valuations to particular companies. Quite often, a high-quality company like PG seems to be perpetually overvalued.
When we set the fair value of PG at its long-term average P/E ratio, the picture changes considerably.
PG’s long-term average P/E ratio over the past 19 years has been 20.7 (blue line). At its current price, PG’s P/E ratio of 19.2 is actually a bit below that long-term average. I call that fair valuation on this second metric.
Morningstar. Morningstar uses a comprehensive NPV (net present value) technique for valuation that many investors consider to be a superior method rather than using P/E ratios.
Under this method, Morningstar makes a comprehensive calculation of all the company’s future expected profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all those future earnings is considered to be equal to the fair price for the stock.
On Morningstar’s 5-star system, 4 stars indicates undervaluation. In other words, Morningstar believes that PG is selling at an advantageous price right now. They calculate that PG’s price is 10% below where it “ought” to be.
Current Yield vs. Historical Yield. My final step in valuation is to compare the stock’s current yield to its historical yield. It is better to be near the top of that range instead of the bottom.
As you can see, PG’s current yield is quite near the top of the range of what it has yielded since the 1980’s. Back in 2000, when the stock was way over-valued, it barely yielded a little over 1.0%. Morningstar calculates that PG’s current yield is 13% above its average yield over the past 5 years.
Therefore, this historical yield comparison suggests that PG is undervalued right now, and that this is an opportune time to purchase the stock.
I generally grade valuation on a 5-point scale for each factor. The grading scale looks like this:
Applying this grading scale to the values for PG, the average score is 3.25, which is a little better than fair value. Our valuation summary looks like this:
There are a couple of factors that I like to look at that do not fall neatly into any of the earlier categories.
Beta measures a stock’s price volatility relative to the market as a whole. Most dividend growth investors like to own stocks with low volatility, because then you are less likely to become emotional about them.
JNJ’s beta of 0.6 indicates a very stable stock price. Most dividend growth investors would consider that a strong plus for this company. Its price movements are generally much smoother than the S&P 500’s.
The second miscellaneous factor is analysts’ recommendations. I usually get this information from S&P Capital IQ, but their current report on PG omits the section on analyst rankings. An alternative source is Morningstar.
As you can see, Morningstar compiled the ratings of 10 analysts, and overall they score it 3.3 on a 5-point scale. 1 = Strong Sell and 5 = Strong Buy, so a rating of 3.3 means that the consensus is a little up from Hold.
Procter and Gamble is a classic dividend growth stock. Here are its positives:
• Very high-quality company.
• Dividend Champion.
• Recent price weakness makes its yield a historically high 3.5%. PG is rarely available with such a high yield.
• Forward estimates are for improved earnings growth compared to past few years.
• Fair valuation.
And here are its negatives:
• Earnings weakness for the past few years.
• Slowing dividend growth rate, with 2015’s increase being only 3%.
• Highly competitive environment.
• Needs to turn itself around a little and carry out its long-term program to focus on core, profitable products and markets.
I like to purchase stocks when they have yields of 2.7% or more, so PG is well above that cut-off line.
In my Dividend Growth Portfolio, I will be reinvesting dividends in August. I began a position in PG in 2014, and while I was disappointed by the company’s lame 3% dividend increase this year, it is not often that you get to purchase a dividend growth company of PG’s quality at a 3.5% yield. I will strongly consider adding shares of PG to my portfolio later this month. Another stock I am considering is T. Rowe Price Group (TROW), which was May’s Dividend Growth Stock of the Month.
– Dave Van Knapp