I have to admit, that Procter and Gamble (PG) is sort of my white whale, in terms of classic DGI companies that I can never seem to find the right opportunity to buy. This company, like so many other consumers packaged goods plays, is known for its strong brand portfolio, defensive cash flows, and generous treatment of shareholders. P&G has a 64-year annual dividend increase streak. 64 years! That’s more than twice as long as I’ve been alive. So, as someone who prioritizes reliably increasing passive income when making investment decisions, obviously I would find this company appealing. But, quality is only half of the equation when accumulating shares (at least, for my portfolio, anyway). The other half is based upon the underlying fundamentals and valuation metrics. And, this is where my issues with PG have usually arose. So, with that in mind, I wanted to provide a Q3 update on PG shares. The company recently reported a great quarter. Yet, were the numbers strong enough to justify the current valuation premium, or better yet, create a margin of safety for conservative value investors? Let’s find out!
Fiscal Q1 2021 Highlights
P&G announced Q1 revenue of $19.32b, which was up 8.5% year-over-year. The company’s organic sales also increased by 9%, which was more than double the Street’s organic growth estimate of 4.1%.
PG saw sales volumes increase across all of its operating segments. Forex was a slight headwind across the board, but price increases helped to make up for the strong dollar, which allowed PG to generate organic sales growth across all segments as well. Organic sales were up during the quarter in 9 out of the company’s 10 product categories.
What’s more, the company’s reported gross margin figures also increased, rising 170 basis points, y/y. This meant that PG’s bottom-line numbers were even more impressive than its sales results.
The company’s Q1 GAAP EPS came in at $1.63. This beat the consensus analyst estimate by $0.20/share. This $1.63/share GAAP EPS figure represents 20% growth, year-over-year. And, from a non-GAAP perspective, the numbers were equally as impressive, with core EPS posting 19% y/y growth (without forex impacts, core EPS growth would have been 22%).
As you can see on the chart below, this was the company’s best first quarter earnings growth rate in years.
Management noted that operating cash flows were $4.7b. The company returned $4b to shareholders, $2b in the form of dividend payments and $2b in the form of share buybacks.
And potentially most important, due to the strength of the first quarter and strong demand that the company sees for its products in today’s marketplace, management increased its full-year fiscal guidance.
PG now expects to see fiscal year sales growth in the 4%-5% range. This implies a bit of a slowdown in the coming quarters, but still reliable top-line growth.
Source: PG Q121 ER Presentation, page 22
The company said that it now expects to see GAAP EPS growth of 4%-9% for fiscal 21. With regard to non-GAAP EPS, management raised its guidance from a range of 3%-7% to 5%-8%.
Source: PG Q121 ER Presentation, page 23
PG also raised its shareholder returns guidance as well. With expectations for larger cash flows on the horizon, management now expects to buy back $7b-$9b of shares in 2021, compared to prior guidance of $6b-$8b. The full-year dividend guidance remained the same at roughly $8b.
Source: PG Q121 ER Presentation, page 24
PG now has ~$13.4b of cash/cash equivalents on the balance sheet. This was up nicely from the $9.3b in cash/cash equivalents that the company had on the balance sheet one year ago. The company’s long-term debt load was $23.9b, which remains fairly conservative relative to the company’s cash flows, especially in today’s low rate environment. PG carries AA- credit rating, showing the strength of its balance sheet.
All in all, I think it’s safe to say that this was a fantastic quarter.
A Defensive Blue Chip
While this was a great quarter without a doubt, it’s also important to mention that PG has been chugging along at an attractive pace for awhile now. The company’s organic sales figures for the 2019 calendar year were 6%. PG continued that strong growth pace throughout the first-half of the calendar year in 2020 as well. 6% organic sales growth during the pandemic period shows that this company is built to last and can perform well during some of the worst and more unprecedented economic environments that we’ve seen in recent memory. Management noted that there were continued risks, with regard to the uncertainties surrounding high unemployment, which can harm demand, and social unrest, which can raise operating costs, but all in all, PG’s strong Q1 performance is exactly why investors sleep well at night owning their PG shares.
I already mentioned that PG has an annual dividend growth streak of 64-years. Taking a look at Justin Law’s CCC List, there are only 2 other companies with longer active annual increase streaks (American States Water (AWR) with a 66-year streak and Dover Corp (DOV) with a 65-year streak). While length of this streak is obviously unique, PG’s dividend growth levels have been less impressive. PG’s 3, 5, and 10-year dividend growth rates are 3.4%, 3.1%, and 5.6%, respectively. PG’s most recent dividend increase came in April, at 6%. This uptick to the mid-single digit range does make the stock more attractive in my opinion. However, the recent strong share price performance that the stock has seen throughout 2019 and 2020 has pushed its dividend yield down to just 2.21%, meaning that certain dividend growth investors may still view PG’s dividend growth prospects, relative to its yield, as sub-par. Generally speaking, I look for a minimum Chowder Number in the 10% area, with a target of 12% or more. PG’s 2.21% dividend yield plus its 3.1% 5-year DGR results in a disappointing Chowder Number of just 5.31%. While I continue to believe that PG’s dividend is quite safe, I don’t expect to see double digit dividend growth needed to propel that Chowder number notably higher in the short-term. I do, however, expect to see PG’s annual dividend growth continue to beat out inflation by an acceptable margin, meaning that if you’re content with a 2.2% dividend yield, this is one of the safest options that I’m aware of in the equity space with regard to generating a passive income with reliable growth that helps to avoid one’s purchasing power being eroded away.
Unfortunately, this is where I turn bearish.
While I believe that PG’s operations are really solid and this is a wonderful company, I don’t believe that the stock is very wonderful these days, due to an elevated premium that is difficult to justify when looking at recent purchase and future growth expectations.
Right now, PG trades with a blended price-to-earnings ratio of 27.3x. This is well above the company’s 10 and 20-year average P/E ratios of 19.6x and 19.9x, respectively. Yet, as you can see on the F.A.S.T. Graph below, the company’s forward looking EPS growth expectations in the 7-8% range appear to be essentially in-line with the long-term average.
In other words, future growth potentially does not appear to be elevated and therefore, I believe it is irrational for the market to be placing an abnormally high valuation premium on shares as well.
To me, a ~20x multiple is probably fair for a company of PG’s caliber. This would still represent a fairly high PEG ratio, but I do believe that a premium is warranted on these shares. I believe that an attractive margin of safety would appear in the 17-18x range. Unfortunately, as you can see on the F.A.S.T. Graph above, the company rarely trades with such a discount.
So, with that in mind, I’m certainly not going to hold my breath as I wait to see a sub-20x multiple on PG shares. The low-rate T.I.N.A. environment (there is no alternative) coupled with the very reliable sales/earnings outlook that this company projects in today’s uncertain economic times is likely to help support high multiples in the short-term. But, if like me, you believe in mean reversion over the longer-term, it’s easy to see how an investment at today’s high valuation could underperform moving forward.
Even accounting for PG’s safe dividends, reliable dividend growth in the mid-single digit range, and the forward looking EPS growth that analysts expect to see in the coming years, an investor buying shares of PG today trading for 27.3x would be looking at annualized total returns of -2.4% through the end of PG’s fiscal calendar in June, 2023 if we saw mean reversion back towards that long-term average in the 19.9x range (which is highlighted by the pink line on the chart below).
Safe dividend income is great, but I have to imagine that most investors are looking for better returns than that. I know I am. And, this is why, no matter how much I respect the company’s recent operational performance and would love to have exposure to its defensive cash flows, I am not willing to knowingly overpay for shares, because doing so would put my invested capital at undue risk, relative to the rest of the market.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.