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Fourth Quarter Numbers Show Troubled Consumer -- Why P&G Needs to Adjust


P&G is a stock worth reexamining when management decides to cut overhead or announce price cuts.

There's more evidence of the troubled consumer in the fourth quarter stats. It sets the background for Procter & Gamble (PG) here and some other stocks in future notes.

The retail price of food has gone up over the last two years and has been partially passed along by the supermarkets. In the fourth quarter of 2011, according to Nielsen data, food pricing was up 7-7.5% versus the year before and had accelerated from nearer 3% in the April year-to-date period. At the same time supermarket sales dollars, from a positive 1% in May, were declining at an accelerating rate, falling from negative 2.2% at 9/03 to negative 4.4% by year-end. At the same time, the savings rate, which was about 5.3% at the start of 2011, was generally falling throughout the year, ending at around 4.5%.

So, the consumer was spending more of his income, but, as far as food was concerned, the numbers imply that he was eating 3-4% less. That's astonishing!

Obviously there are other things happening, such as more shopping at lower priced food stores, like Costco (COST), and more private label shopping at lower prices. But these are still big numbers relative to those trends, which have been in place for years. There was probably some pantry deloading too. But my guess is that a lot of consumers are eating marginally less and/or have changed their diets significantly. How often does that happen? I've never seen it.

I know that gasoline was a problem as well. The pace of increasing prices for both food and gasoline are slowing, but this is still ugly in my opinion.

Procter & Gamble's pricing moves will be very interesting as they are, on pricing, one of the worst placed consumer companies I can think of. Before the just announced quarterly EPS disappointment, one sell-sider pointed out that PG's prices were on average 80% above private label and exceeded the weighted average of its categories by 43% in the US. I also suspect that there is a big, but somewhat smaller pricing premium in Western Europe and Japan.

I'm not sure if there's a way out of this that does not result in a huge earnings reset and decline in stock price. The current $63 stock price with new FY '12 and '13 estimates of $4.04 and $4.39 (that were previously the low estimates) discount a 2% five year EPS CAGR (Compound Average Growth Rate).

I have had a lot of market outperformance with P&G stock on two other occasions when the company had priced up too far vs. the competition. On both occasions the company took down prices in concert with cutting some of its huge Sales, General and Administration (SG&A) expense to sales relative to its competitors. The volumes increased and the operational leverage worked to get earnings going. But that was back when consumers were leveraging up, or at least not in retrenchment mode. And the company had a business mix that was more basic at that time. Now the business mix tends to approach that of a consumer discretionary stock in its leverage to GDP changes. Finally, I am almost sure that the pricing vs. its competition was not as high then as it is now.

Developed country sales are 65% of PG's total, or $54 billion. Assuming that a 10% price cut would not spur any particular short term revenue growth, operating profit, estimated at $16.5 billion, would decline by $5.4 billion or 33% before any SG&A offsets. The result, applied to a street low $4.00 FY 2012 estimate (that already incorporates some price adjustments that management had talked about on it quarterly call) results in adjusted EPS of $2.64. That implies a $52 stock price if P&G could revert back to being a 6% grower from that more solid level of earnings. While I do not think that a 10% price cut would necessarily get PG's prices in line for the new consumer reality in the developed nations (especially with Europe not having started to go through its coming economic wringer), that's probably a reasonable next 12 months worst case scenario possibility.

Before doing a 10% price cut, P&G would almost certainly address it high SG&A costs. Even though P&G has greater economies of scale vs. its competitors, one sell-sider's estimate of "Core SG&A" for its competitors is about 14.2% of sales vs. 16.8% for P&G. Netting that with the effect of a 10% price decrease in developed countries results in a $3.20 EPS number. If you assume a 6% 5 yr. EPS CAGR, which I believe is what the market will use for a good consumer company when the developed economies stabilize, the $3.20 EPS about justifies the present $63 stock price.

This developed counties consumer retrenchment is unprecedented and I cannot pretend that I know where the shakeout ends up. My expectation is that it will be worse than the market expects for P&G. But the market's P&G valuation looks to be fairly rational, based on its expectation that prices will still be too high for this environment after management makes its near-term adjustments, and the fact that management has always attacked overhead substantially when P&G has gotten into similar situations in the past. I would reexamine the stock for a possible buy recommendation when management decides to cut that overhead and/or announces another round of price cuts, absent a stronger growth rate of developed world economies.
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