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Procter & Gamble (PG) - Thesis

Procter & Gamble (PG)
Rating: Buy
Current Price: $81.63
Price Target: $99.79

Thesis:
Procter & Gamble’s stock price is depressed because of strong foreign currency headwinds and a variety of sub-optimal market ventures. The currency headwinds will likely subside as global monetary policies continue to normalize as the financial crises moves further into the rear-view mirror.  Additionally, the company’s current multi-year restructuring will increase profitability by increasing efficiency and by shedding sub-optimal market ventures.  Using a discounted cash flow model, Procter & Gamble is worth $99.79 per share, giving the stock more than 22% upside versus its current market price.

Foreign Currency Headwinds:
Approximately 61% of Procter & Gamble’s sales come from outside the United States.  This creates a variety of foreign currency challenges for the company, especially since the US dollar (the company’s reporting currency) has strengthened significantly in the last year.  In fact, the company expects to take an approximately $1.4 billion hit to earnings in 2015 because of the strong US dollar.  This is significant considering PG’s total earnings are only around $11.6 billion per year.  Foreign currencies have weakened versus the US dollar for a variety of reasons.  For example, the US economy is recovering from the global financial crisis quicker than other economies, and while the US is beginning to reduce accommodative monetary policies, non-US economies are still introducing more accommodative policies.  Regardless, recent currency volatility will eventually decline, and P&G will also tweak its foreign currency hedging programs.  The result will be less foreign currency challenges, and P&G’s earnings will pop up.  Also, there could be quarters and years in the future where PG’s earnings are helped by foreign currency moves in which case earnings will pop up even more.

Restructuring:
P&G is currently in the process of shedding a variety of less profitable brands.  According to CEO A.G. Lafley:

"P&G will become a simpler, more focused Company of 70 to 80 brands, organized into about a dozen businesses and four industry-based sectors. We will compete in businesses that are structurally attractive and best leverage our core capabilities.  Within these businesses, we will focus on leading brands or brands with leadership potential, marketed in the right countries where the size of prize and probability of winning is highest, with products that sell. We will discontinue or divest businesses, brands, product lines, and unproductive products that are structurally unattractive or that don’t fully play to our strengths… The 90 to 100 brands we plan to exit have declining sales of -3%, declining profits of -16% and half the average Company margin during the past three years."

In addition to shedding some 90 to 100 brands, P&G is also in the middle of a multi-year productivity and cost-savings plan.  Per the company’s annual report:

"In 2012, the Company initiated a productivity and cost savings plan to reduce costs and better leverage scale in the areas of supply chain, research and development, marketing and overheads. The plan was designed to accelerate cost reductions by streamlining management decision making, manufacturing and other work processes to fund the Company's growth strategy.  As part of this plan, the Company expects to incur in excess of $4.5 billion in before-tax restructuring costs over a five-year period (from fiscal 2012 through fiscal 2016).  Approximately 62% of the costs have been incurred through the end of fiscal 2014. Savings generated from the restructuring costs are difficult to estimate, given the nature of the activities, the corollary benefits achieved (e.g., enrollment reduction achieved via normal attrition), the timing of the execution and the degree of reinvestment.  Overall, the costs and other non-manufacturing enrollment reductions are expected to deliver in excess of $2.8 billion in annual gross savings (before-tax). The cumulative before-tax savings realized through 2014 were approximately $1.4 billion."

P&G’s profitability will increase as the multi-year restructuring is completed and as less profitable brands are exited.  This helps create the room for significant upside to the current stock price.

Growth Opportunities:
In addition to restructuring, P&G does have some growth opportunities.  To some extent, P&G will grow as the total global population grows.  Additionally, the secular trend in emerging markets whereby populations move from rural to more urbanized and suburbanized areas benefits P&G because these populations tend to use more P&G products.

Additionally, P&G spent $2.0 billion on research and development in 2012, 2013 and 2014.  Examples of recent product introductions include the Fusion ProGlide (introduced four years ago, priced at the higher end of the premium segment, grew global share for 31 consecutive quarters, and reached $1 billion in sales faster than any other P&G brand in history) and Crest 3D White (a premium oral care regimen, has grown market share for 17 consecutive quarters, is a billion-dollar business, and is an important driver of toothpaste market share growth in developing markets).

Valuation:
We value PG at $99.79 using a discounted cash flow valuation.  We assume 2014 free cash flow of $10.11 billion grows at 3.5% in the future (conservative estimate roughly equal to global economic growth), $1.0 billion of the estimated $1.4B negative 2015 currency impact returns to a more neutral level of negative $0.4B (remember if the US dollar weakens it could actually help P&G), P&G restructuring amounts to $1.4 billion of additional annual cash flow (conservative estimate, less than P&G’s own estimate) and the required rate of return is 8.5% (long-term capital market assumption):
 [($10.11B x 1.035 + $1.0B + $1.4B) / (0.085 – 0.035) + 13.16B of cash ] / 2.71B shares = $99.79 per share.

As a double check, a “Dividend + Share Repurchase” model suggests the company is worth around $100.06 per share.  This valuation technique is relevant for PG because the company is very stable and consistently pays increasing dividend and buys back shares.  Here is the calculation:  [($6000 of share repurchase + $6900 of dividends) / (8.5% required return – 3.5% growth) + $13160 cash] / 2710 shares = $100.06 per share.

Conclusion:
Procter & Gamble has underperformed the S&P 500 by roughly 14% year-to-date, and trades more than 22% below its intrinsic value per our discounted cash flow valuation model.  A “dividend + share repurchase” discount model also suggests the stock is significantly undervalued.  PG stock is depressed as the company has been hampered by severe foreign currency headwinds (the US dollar is strong) and a variety of (soon-to-be eliminated) sub-optimal market ventures.  PG currently trades around $81.63 per share, and we believe it is worth more.  Our price target is $99.79 per share.

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