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Procter & Gamble's Turnaround Supports Strong Dividend

In business since 1837, Procter & Gamble (PG) has grown into one of the world’s largest consumer goods manufacturers, advertisers, and distributors. It currently sells 65 product brands in more than 180 countries.

Some of its leading brands are Luvs, Pampers, Tampax, Charmin, Downy, Tide, Cascade, Dawn, Febreze, Head & Shoulders, Old Spice, Pantene, Gillette, Braun, Crest, and Oral-B.
Source: Procter & Gamble
Here’s a look at Procter & Gamble’s segments. Over 70% of its earnings are accounted for by Fabric & Home Care (27%); Baby, Feminine & Family Care (23%), and Beauty (23%). 
Source: Procter & Gamble, Simply Safe Dividends

Procter & Gamble's business is very diversified geographically. North America accounted for 44% of sales in fiscal 2018, followed by Europe (24%), Asia Pacific (9%), Greater China (9%), Latin America (7%), and India, Middle East and Africa (7%). Emerging markets generate approximately 35% of company-wide sales.

With 62 consecutive years of dividend growth, P&G is a dividend king. The company has also paid uninterrupted dividends for 128 years (since 1890).

Business Analysis
At first glance, it looks like Procter & Gamble could be in some trouble thanks to sales declines each year from fiscal 2013 to 2017. However, the company's top line decline was largely a direct result of management’s long-term growth plan.

Specifically, management sold off over 100 non-core brands (roughly 15% of total revenue) to refocus R&D and ad budgets on the company’s most important cash cows, which offer stronger profitability and better growth prospects.

Prior to the slim down, Procter & Gamble had about 170 brands. However, the company's 65 most successful brands, including its 21 mega-brands which each had annual sales of over $1 billion, accounted for 85% and 95% of revenue and profits, respectively.

In 2016 the company completed the first phase of its long-term growth plan with the sale of its last 43 ancillary brands to Coty (COTY) for $12.5 billion. In total, the firm reduced its number of brands and categories by 70% and 60%, respectively. Of its remaining 65 brands, half of them generate at least $500 million in annual sales or more.
Source: Procter & Gamble Investor Presentation
P&G believes its more focused approach will allow it to increase its long-term annual sales growth rate by 1 percentage point and expand its  margins by 200 basis points, which in a slow growth industry such as this is a meaningful benefit to shareholders.

The company has now ended its shrinking phase and in April 2018 acquired Merck's (MRK) consumer healthcare operations for $4.2 billion. That business sells a variety of vitamins and over-the-counter medications that generate $1 billion in stable annual revenue. It also has a meaningful presence in emerging markets, which have above-average growth potential compared to the consumer staples landscape in most developed countries.

However, while the consumer staples industry might be slow growing as whole, it's still large ($470 billion per year) and expected to expand 3.5% annually to exceed $540 billion by 2022 according to P&G.

The sector's global growth is expected to be fueled by a combination of a rising world population (7.6 billion people expected by 2028, up from 7 billion in 2017) and a 50% increase in the number of middle-class households by 2028. As a result, demand for many consumer staples products will rise.

While 2018 was hardly a gangbuster year for most large consumer staples companies, Procter & Gamble's long-term strategic shift does appear to be paying off.

For example, in its first quarter of fiscal 2019 (three-month period ending  9/30/18) P&G delivered 4% organic growth, which was far superior to rivals like Kimberly-Clark's (KMB) 1% growth rate and an improvement compared to recent years. Nine of its 10 categories posted positive organic sales growth.
Source: Procter & Gamble Investor Presentation

Another bright spot for Procter & Gamble is China (9% of total sales). After several years of refocusing its product portfolio, in fiscal 2018 the firm recorded 7% organic growth in that country. Organic sales growth in China steadily  accelerated throughout fiscal 2018 and even hit 10% in the fourth quarter.

In 2019 management expects 2% to 3% company-wide organic sales growth which would still be the firm's fastest growth rate in years. With more of Procter & Gamble's most important product categories and countries growing or holding market share, that seems like a reasonable growth target. 
Source: Procter & Gamble Investor Presentation

Besides a return to stronger organic sales growth rates, management remains focused on making the business more efficient. As part of the company's turnaround plan, for example, P&G reduced its number of SKUs by 24% and cut its manufacturing platforms by 50%. 

With fewer products to make, over the last five years the company has squeezed more than $7 billion in inefficiencies out of its manufacturing and supply chains. By 2016, when it completed its last multi-year cost-cutting plan, the company hit its target of reducing annual costs across the entire business by $10 billion. However, management has plenty of runway left.
Source: Procter & Gamble Investor Presentation

In fact, Procter & Gamble believes that its leaner business model can still cut another $10 billion from its production costs between fiscal 2017 and 2021 (about a 15% total cost reduction). 

Some of the expected savings will come from greater manufacturing automation, moderate workforce downsizing (employee count is already down more than 20% since 2013), and supply chain technology investments.
Source: Procter & Gamble Investor Presentation

Thanks to these cost-cutting efforts, Procter & Gamble's operating margin has increased from 18% in fiscal 2012 to 22% today, placing it among the highest in the industry.
Source: Simply Safe Dividends

Business transformation aside, there are numerous reasons to be attracted to Procter & Gamble’s business. The company’s strengths begin with the firm's deep understanding of and continuous adaptation to evolving consumer trends.

For example, P&G spends close to $2 billion each year on R&D, carrying out thousands of studies to gain consumer insights and develop relevant product technologies. While parts of its business such as Gillette struggled in recent years due largely to a lack of innovation, the firm's improving market share momentum across various categories suggest management is successfully righting the ship. 

With the right products under its wings, P&G cranks up its advertising budget, which regularly exceeds $7 billion per year (more than 10% of sales). It’s no wonder why consumers are so familiar with most of the company’s brands.

As a result, P&G’s products have dominated the shelves at many retailers. Most of the company’s 21 billion-dollar brands boast No. 1 or No. 2 positions in their category or segment, and P&G is No. 1 in seven of its 10 categories. Incredibly, P&G’s products touch approximately 5 billion consumers daily!
Source: 2017 Procter & Gamble Investor Presentation

The company also boasts the largest amount of e-commerce sales in its industry. In fiscal 2018 online sales grew 30% to reach $4.5 billion (7% of total revenue). Many of its brands have leading positions among Millennials as well.

Procter & Gamble's success in e-commerce (its products are easily shippable by the likes of Amazon) is thanks in large part to its shift in advertising. In 2007 just 8% of its ad budget went to online marketing, a figure that hit 42% in 2018 and is expected to exceed 50% within a few years.

Besides investing in the right brands and marketing channels, P&G is an enduring business due to the very nature of its industry. Simply put, non-food consumer products have historically been very sticky, resulting in a relatively slow pace of change.

In fact, roughly 85% of households in America are constantly filled with the same 150 items, according to IRI Market Advantage. Furthermore, 60% to 80% of all new product launches fail. This makes it all the more difficult for smaller rivals to break into P&G’s market share (though the firm must still contend with private label and giant rivals' brands).

Over the long term, management targets low to mid-single-digit sales growth and modest margin expansion. Combined with steady buybacks, that's expected to drive mid- to high single-digit growth in earnings and cash flow per share. As a result, P&G's dividend has potential to grow at a mid-single-digit annual pace, somewhat faster than it has in recent years.

Overall, P&G is an absolute giant in the consumer staples sector and appears to have strong staying power. With nearly $10 billion of spending on R&D and advertising each year, extensive global distribution networks, recession-resistant products, plans to drive significant productivity savings, and a more focused portfolio of brands, Procter & Gamble should continue generating reliable cash flow for many years to come.

Key Risks
Over the short term, input cost inflation and currency exchange rate volatility (60% of sales come from overseas) can hurt the firm's reported sales and earnings growth. However, they shouldn't threaten P&G's long-term outlook.

More importantly, organic sales growth has long been at the heart of P&G's struggles. The company has broadly lost market share over the past decade, driven by the continued rise of smaller brands (thanks in part to e-commerce), an overall lack of product innovation (until recently), and cost cuts that have helped boost short-term profits but perhaps at the expense of long-term growth.

Between 2015 and 2017, for example, P&G's cumulative organic sales growth (3%) significantly trailed the growth rates recorded by its large peers (6%) and the overall market (7%).
Source: Trian Presentation

Activist investor Nelson Peltz gained a seat on P&G's board in March 2018 (despite losing the proxy fight) in an effort to help the company reverse market share losses and create more value for shareholders.

Unlike what happens in many activist investor campaigns, P&G is not expected to take on substantial financial leverage, break up the company, or meaningfully slash spending on R&D and marketing.

Rather Peltz is merely expected to try to keep the company on track, with its tighter focus on core brands, new product development, cost-cutting, and returning cash to shareholders via dividends and buybacks.

However, Peltz and P&G certainly face a tall task, especially in the company's largest and most profitable market, North America.

Growth has been a big challenge as P&G's relatively high prices and general lack of innovation (until recently) opened the door for new and existing players to take market share.

Consumers are also getting smarter with how they shop, using their smartphones to compare prices and check out reviews on new, less expensive brands. Private label products continue closing the gap as well, with Costco's (COST) Kirkland brand one of the most visible examples across numerous categories.

Fortunately, in 2018 Procter & Gamble began regaining market share and reporting strong organic growth rates compared to peers which suggests that the firm's long-term strategic shift might be working.

Regardless, while the consumer goods and healthcare industries are defensive and enjoy a relatively slow pace of change, they are rife with cutthroat competition.

Procter & Gamble must constantly develop new and improved versions of current hit brands in order to maintain and hopefully grow market share. The firm has to square off against growth-hungry rivals such as Unilever (UL), Kimberly-Clark (KMB), Clorox (CLX), and Colgate-Palmolive (CL), as well as many new entrants such as Dollar Shave Club (now owned by Unilever).

While Procter & Gamble’s recent brand culling and hyper-focus on efficiency and cost-cutting might mean that margins jump in the short term, don’t forget that those high margins need to be protected by effective R&D and ad spending that routinely totals 14% to 15% of overall revenues.

Management’s ability to deliver on its promised efficiency initiatives are another risk. While current CEO David Taylor, a 35-year veteran of the company, has continued the previous management team’s roadmap to cost-cutting greatness, there is always the risk that the low hanging fruit has already been plucked.

In fact, if management gets too aggressive with cost-cutting, including a near 25% decrease in employee count over the last five years, there is risk that productivity and production innovation may ultimately begin to suffer.

Or to put it another way, P&G might have become so fond of cost-cutting to grow earnings that it might end up cutting too deep and getting rid of not only unnecessary fat but also muscle or bone. This is essentially what has happened to IBM over the past decade (combined with financial engineering gimmicks).

Closing Thoughts on Procter & Gamble
Procter & Gamble has long been a favorite dividend stock for conservative investors. With a track record of paying a dividend every year since 1890, including 62 consecutive years of payout increases, the company's reputation as a dependable income investment is well-earned.  

However, as with all mature businesses, P&G's sheer size has caused a number of growth and innovation challenges over the past decade. These issues do not seem insurmountable or likely to cause more pain than just a slow bleed at worst over time, but they need to be thoughtfully addressed if the company is to continue its rich history of profitable long-term growth. 

P&G's portfolio transformation and profit growth initiatives are still far from proven, but it's encouraging to see the firm's improving pace of organic sales growth and market share gains in recent quarters. Having an activist investor on the board to help bring in some fresh thinking seems like a positive as well. 
 
Overall, the company's strategic plans to improve organic growth and regain market share will take time to play out, but this blue-chip dividend king should continue delivering safe income and steady payout growth in the years ahead, in all economic environments.

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