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Why Procter & Gamble Is a Buy at $68


The full effect of P&G's recently announced cost-cutting plan will not be felt until 2016, but the size is correct and will give the company a clear edge over competitors.

Procter & Gamble (PG) has finally done what no other consumer staples company has done since the 2008 recession and consumer retrenchment. It has come up with a credible plan to get its prices in line with the present reality. About six weeks ago, I argued that P&G cost cuts laid out in its recent second-quarter EPS release were too little to make much difference:

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 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 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 back then. Now the business mix tends to approach that of a consumer discretionary stock in it leverage to GDP changes. Finally, I am almost sure that the pricing vs. its competition was not as high then as it is now.

(See Fourth Quarter Numbers Show Troubled Consumer -- Why P&G Needs to Adjust.)
But P&G management recently announced a huge $10 billion cost-cutting program that will take its selling, general, and adminstrative expenses to sales ratio down to about the average of its competitors (which, given P&G's greater scale, still leaves it with relatively more SG&A spending per business).

The full effect will not be felt until 2016, but the size is correct in my opinion. Looking at 2014, if I take $53.7 billion of 2011 North American and Western European sales and apply a 2% compound growth rate, I get $57 billion. Ten billion of cost saves does not all go into lower pricing, supposedly, as ad spending will be increased, but as time goes on I can believe that all of it will go into pricing, as a constrained consumer is not particularly interested in new higher margined products if she cannot afford the ones she used to buy.

Ten billion of price cuts on a $57 billion sales base is a 17.5% price cut. Applying an average 17.5% price cut to P&G's average 80% premium to private label leaves the company's product average at 49% over private label in these developed markets. That should be all P&G has to do. It still has the best products, pretty much overall. And this takes its pricing down to equal the level of its categories. So P&G should start taking quite a bit of market share from its branded competitors. Then the company will have a defensible base earnings level and growth rate.

The downside is for its competitors who do not have any excess overhead to cut, and who will then have to cut their prices, assuming that there is no strong growth in the economy in the next five years, which is the consensus view. So Reckitt Benckiser (LSE: RB), SC Johnson, Clorox (CLX), L'Oreal (Euronext: OR), Kimberly-Clark (KMB), Colgate-Palmolive (CL), Unilever (UN), and Church and Dwight (CHD) all stand to lose in varying degrees from this.

The rapidity of P&G's management changing its mind about the depth of cost cuts is surprising to me. It does give me confidence that it might go further in cost cuts a few years from now if it doesn't get the intended results. Another $3 billion in SG&A cuts could bring pricing down to 40% over private label, which is below the category average pricing and probably about gets the SG&A in line with the competition on an economics-of-scale-adjusted basis.

My biggest potential downside to this buy recommendation is that I'm too early and the stock is dead money. P&G will still be losing share over the next few quarters. Then as some of the price cuts kick in, the rate of market share decline should start to lessen. But I believe that the market knows that P&G got out of trouble this way twice before and will quickly believe that it will happen again.

Also, because this price cutting will be seen to be coming, investors will shy away from all other cosmetics and household products stocks for fear of it. P&G will also have a normalizable earnings base that investors will have some faith in, even if they wonder about a growth rate. If nothing else, investors who have to own staples will be pushed in P&G's direction. To be sure, it is possible that there will be some very uncharacteristic price wars coming in some classically oligopolistic industry segments, but I see P&G as an eventual winner. If the economy does take off strongly, earnings leverage in P&G's relatively premium product line should make the stock outperform.

While consensus EPS of $4.04 and $4.40, respectively, for fiscal years '12 and '13 could still be under pressure until the price cutting takes hold, I'm willing to use them as an earnings base. The present $68 price discounts a 2% five-year growth rate. A 6% growth rate, which is achievable, justifies $83, or 23% upside, and 7%, probably the top rate when the "dust clears" implies $88, or 29% appreciation.
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