Procter & Gamble: Premium Valuation Is Not A Problem For Future Returns (NYSE:PG)

With short-dated treasury yields standing at around 5%, the case for high yielding and slow growth consumer staple businesses has waned. That is why it is hardly a surprise that even a high quality business, such as Procter & Gamble (NYSE:PG) has a solid Hold rating.

The current period is also quite an unusual one with the gap between PG’s free cash flow yield and the 10-year Treasury yield standing at one of its widest levels for the past 20 years.

The last time this happened was around the 2006-07 period and although PG wasn’t a very good investment in the following years relative to high grade fixed income, the stock did much better than the broader equity market on an absolute basis.

Of course, this time around the macroeconomic situation is rather different from the 2006-07 period and it is worth noting that in spite of the increasing gap between PG’s free cash flow yield and the yield on Treasuries, the stock has delivered a total return of nearly 90% over the past 5-year period and thus significantly outperforming most of its peers in the Consumer Staples sector.

With that in mind, it is worth taking the long-term view on Procter & Gamble and assessing the company’s business fundamentals through the lens of its valuation. This way, we could get a better understanding of what it would take for PG to continue to outperform its peers.

The Long-Term View

One of the most notable developments at Procter & Gamble for the past nearly 20-year period, is the fact that the company’s Return on Capital Employed has increased significantly following the pandemic and is now at its highest levels in the last 20 years.

In a similar fashion, both sales and earnings multiples of the stock reacted and are now at record highs on a historical basis.

Even though both sales and earnings multiples of PG have come down slightly in recent months, the company is still earning a record high return on its invested capital.

Therefore, provided that P&G could sustain its high ROCE over the coming years, the stock is in a very good position to continue to deliver satisfactory returns even in the case of the broader equity market declining.

But what caused P&G’s ROCE to increase at such a rapid pace and just how sustainable is that increase?

All About The Margins

Gross profitability is the usual suspect when it comes to improving return on capital for a slow-growth company like Procter & Gamble. Surprisingly, the company’s gross margin has actually been trending downwards over the past 20 years or so.

Tangible Asset Turnover (excluding goodwill and other intangible assets) has also been on a downward trajectory over the same period, even though it bottomed all the way back in fiscal year 2016.

Leverage has increased over the period we see above, albeit not by such a high amount to justify the notable increase in ROCE we saw above. This leaves, a much lower share of fixed costs relative to sales (operating margin improvement) as the chief culprit behind the record high return on capital for Procter & Gamble.

That is why, we observe a very strong relationship between PG’s operating margin (plotted on the x-axis on the graph below) and the stock’s price/sales multiples (on y-axis).

There were a number of factors contributing to Procter & Gamble’s operating margin improvement over the very long period we saw above.

• Organizational Structure & Portfolio Simplification

One of the most important ones and arguably the most sustainable one has been the strategy to simplify brand portfolio, by focusing on the largest and most international brands in each category.

This approach has been criticized to significantly reduce P&G’s growth profile by missing out on the newly emerging smaller brands that are often appealing to younger demographics. So far, this has not been the case and the company’s actually benefited by owning a portfolio of strong brands that could drive significant price premiums and thus to offset the rising costs of raw materials.

In conjunction with brand portfolio simplification, Procter & Gamble’s organizational structure has also undergone a significant change. The company’s design has been simplified which also allowed for further reduction in fixed costs relative to sales.

The role of exchange rates has also been significant over the reviewed period. Even though PG is a truly international organization, the company is still largely focused on its home market – the United States, with slightly less than half of its sales coming from its home market.

This is in stark contrast to major peers, such as Unilever (UL) and Colgate-Palmolive (CL), which have significantly higher international exposure.

This way, PG was not impacted by the rising U.S. dollar to the same extent that many of its large cap peers were.

Having said that, however, forecasting future exchange rates is a futile exercise and it is reasonable for investors to expect that changes in exchange rates tend to cancel each other out over the long run.

• Leadership In Each Category

Back in fiscal year 2013, when PG’s operating margin was near record lows (see above), the gap between the different segments in terms of profitability was significant. The Grooming business unit was by far the leading product category and Beauty was at the very bottom.

Through strategic acquisitions and divestments, in combination with the aforementioned portfolio simplification, however, management has managed to reduce this gap and the company is now in a leading position in each of its five business units.

The Role Of Pricing Power

The high margin and high asset turnover Beauty segment has been by far the biggest success for the company with the segment now growing at 11% and 5% during the Q4 2023 and Q1 2024 periods respectively.

As we see from the two graphs above, this outstanding growth has been achieved by significant pricing actions within the category which did not lead to a notable decline in volumes.

As a result of its strong brand portfolio in each of the five business units, Procter & Gamble’s management has been able to offset recent increases in input costs and continues to deliver organic net sales growth on the back of pricing initiatives, without sacrificing market share.

Nonetheless, the guidance for FY24 is for a significant slowdown in pricing and consequently organic net sales growth, which is expected to be within the 4% to 5% range.

The lower commodity prices, however, would allow for an improvement in gross profitability which would offset any of the risks for the operating margin I mentioned above.

(…) we estimate commodities will be a tailwind of around $800 million after tax in fiscal ‘24.

Source: PG Q1 2024 Earnings Transcript

As a result, I expect Procter & Gamble’s gross margin to slowly improve on a trailing 12-month basis and with that the risk for operating margin and valuation multiples will be significantly lower.

Conclusion

After outperforming its peers, Procter & Gamble remains an attractive long-term investment opportunity even after taking into account the attractive yields of U.S. Treasuries. The record-high operating margin has been the key driver of PG’s outperformance over its peers over the recent years. With that, the upside based on multiple expansion is now limited, unless gross margin is improved and there are no fixed cost headwinds. Having said all that, the downside risk for PG is very low and the company benefits heavily from its strong brand portfolio and pricing power.