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P&G's 'Surprise' CEO Change Signals Cuts May Happen Sooner Than Expected


A stock that already had very little downside risk just became even more attractive.

The decision at Procter & Gamble (NYSE:PG) to bring back former CEO A.G. Lafley to replace Bob McDonald, effective immediately, is being reported in many business pages as a "surprise."

But it is no real surprise to those closely watching the stock since something had to be done, as I said in my May 22 note (see below) reiterating that Procter & Gamble was still a buy and had very little downside risk.

Because Lafley engineered one of the two former major overhead cuts referred to in my previous note, I believe that the chances of faster and greater SG&A cuts has been increased significantly.

My $88 - $92 price target is likely to be attained sooner, which the market seems to recognize, given that the stock is up 4% as I write this.

When I first recommended Procter & Gamble stock in March of last year at $68, I expected that there would be a large cut in corporate overhead followed by significantly needed price-cutting. That would spur, as it had twice in approximately the last two decades, significant increases in sales and operating income. The stock would then rise, I thought, from the $68 that reflected a 2% five-year growth rate to the $83-$88 area, reflective of a 6-7% rate. That 6-7% would have been reflective of a 3.5-5% sales growth rate.

PG gave investors the big cost cuts -- sort of. A $10 billion SG&A cut on a $57 billion sales base in the developed world would have been a 17.5% price overhead cut, and would have gotten sales growth and the stock price up in a hurry. But management instead gave a $10 million cut that would not be fully felt until 2016, i.e. not as big a cut as it looked, and slower to take effect. So, over the past year, cost cuts have been falling to the bottom line, and while there have been some price cuts, they have not been anywhere near the magnitude needed. Investors have been somewhat mollified as market shares have turned somewhat positive in the developed world, where PG earnings are about two-thirds of its operating income. But investors have rightly concentrated on sales growth.

The third fiscal quarter reported in late April was $.99 versus a consensus of $.96, as SG&A to sales improved, but gross margin did not, though operating margin rose 10 bps to 18.8%. Emerging market sales growth was 7%, and developed markets grew 1%.

Market shares have improved in the developed world, although total value share, using a build-up of the different operating divisions, has been declining 32 to 38 bps year-over-year for the last four quarters. Management expects that some degree of new product activity, which has helped developed world shares so far, will help emerging market shares when the worldwide rollouts of these products are completed. Also, P&G has been especially lacking in traction against competition in beauty by L'Oreal (OTCMKTS:LRLCY), Estee Lauder (NYSE:EL), and Unilever (NYSE:UL), especially in hair care. Organic sales growth has only been .5% over the last two years. That has been going on for some years now and most investors will be loath to discount increased sales here until they see them come though. As I look at the totality of the new products, I see no potential home runs, mostly "new and improved" and line extension-type stuff.

Sales do not look to get back to and stay in management's 3-4% growth range soon. Beauty industry sales growth is slowing in the developed world now. Europe is still likely weakening and growth in emerging markets -- including Brazil and China -- has been slowing recently. Cost cuts will support some EPS growth, and the price cuts are bringing PG's prices toward competitiveness, but only very slowly.

The solution is simple: There must be greater overhead cuts and they must come faster. Consumers in the developed world are under financial pressure, and the best way to get sales up is to give them lower prices, rather than new products, when they are financially pressured to afford the older ones. Procter's core SG&A ratio is 17% vs. 14% for a group of four competitors, the majority of whom have smaller businesses than P&G. The incremental sales would, in my opinion, allow for growth nearer 4-5%. Increased operating leverage on that sales level would get a five-year EPS compound growth rate into the 6-7% range, implying a $87- $92 stock.

While that sort of price appreciation is not the 20% I would like for a "buy," it is more than you would be able to get from the great majority of consumer staples at this time. The downside for Procter is a continuation of the status quo, which is to say very little downside risk operationally. That status quo is a $79 stock that reflects an expectation of a 4% long term growth rate on 2.5% sales growth, which I believe is unacceptable to management as well as shareholders. The more quarters that pass with only marginal sales and EPS growth acceleration, the higher the likelihood of incremental overhead cuts and price cuts soon after. So, I characterize Procter as an investment that has very little downside now, especially versus its peers, and has a probability of about 15% upside that is increasingly likely over time. Again that looks a lot better than the consumer staples group, and really looks better versus much of the consumer discretionaries as well, given Procter's leverage to an improving economy, and given its very upscale product positioning compared to competitors.

Also see:

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