Contrary Call: Shorting P&G on Loss of Innovation/Pricing Power

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: Uncited.
Firm: Undisclosed. Hedge Fund.
Location: New York, NY.

Recommendation: Short Shares of Procter & Gamble (NYSE: PG).
Timeframe: 1 to 2 Years
Recent Price: $61.50
Target Price: $47.10
Strategy: Value

Disclosure: The author of this report had an active position in this security at the time of its posting.

Quick Thesis:
The economics of Procter & Gamble have been so complex that only a few people actually understand them. The direction of the company is doubtful based on the current strategy and the speed of execution. Analysts and investors are unwilling to be patient because most of them still respect the 200-year old company. However, as a consumer, when you take a deeper look of the P&G’s products and the customer’s sentiments, it is not difficult to find out the competitive advantage of P&G is fading.

As of July 7, 2012, the stock is trading at $61.3. It has an intrinsic value of $47.1, representing a margin of safety of 23%. In Bull case scenario, the stock is worth $54.4 while in bear case the stock is worth $39.9.

Catalysts - Why is the high valuation unsustainable?

1. . Doubtful pricing strategy

P&G has maintained an increasing pricing strategy for premium products in the developed markets. In the first three month of 2012, the Beauty segment had bumped up the pricing by 5%, however, it caused a low single digit decline in volume in the developed markets, causing a 4% decrease in the mix. In the Gooming segment and Health Care Segment, the price had increased by 3%, however, it also caused a low single digit decline in volume in the developed markets, resulting in a 2% decrease in the mix.

The management team mistakenly assessed the loyalty of the customers towards P&G’s products, the price elasticity of demand is more elastic than the management’s estimation, especially in the premium product.

2. High exposure in Europe

P&G is an international organization and is not immune from the European Crisis. About 25% of the total sales came from Europe (Central, Eastern and Western Europe), the figure had been steady in the past three years.

3. Lower guidance for the second time within two months

In the April 2012 earnings call, P&G announced an EPS cut on the bottom line to the range of $3.82 to $3.88 for FY2012, comparing to a prior range of $3.93 to $4.03, which did not include the impact of pricing controls in Venezuela. In June 2012 Deutsche Bank Global Consumer Conference, CEO Bob McDonald cut the fourth quarter core EPS guidance again from the range of $0.79 to $0.85 to the range of $0.75 to $0.79. The net sales growth estimation was even cut from positive growth to negative growth. It all happened within two months. For a well structured company like P&G with about 200 years of history, $168Bn market cap and 129,000 employees, such a frequent lowering of the earnings bar isn’t common.

4. Problem more of innovation and complacency than execution

The problem at P&G is more on innovation and the complacency than execution. P&G used to differentiate themselves by a huge pool of innovative products, branding strategies and full analysis of consumer behavior. Those edges faded away in recent years, especially after the turmoil in 2000. Currently, P&G has been facing a similar dilemma – slowing sales growth, increasing headcount cost, delaying decision making process and weakening innovation. The management team is counting on the 5-year restructuring plan to save up to $10 billion from a projected cost pool of around $85 billion in fiscal year 2016. If the issue is merely a cost problem, the cost cutting campaign may help, however, the root causes are the product innovation and the identity of the company.

Valuation

The major competitors of P&G are trading at around 7x – 10x EV/EBITDA (2013E) forward multiple, however, P&G is trading at 11x. Specifically, the Beauty Care segment of the major competitors are growing organically from 6% to 10% but P&G is only growing at about 2%, This segment is the second most important segment of P&G but they are beaten down by Unilever, J&J and Kimberly. Colgate-Palmolive has done a tremendous job to differentiate their products and their focus strategy pays off, so they deserve a slightly higher multiple. The current situation of P&G only deserves a similar multiple as J&J which has similar market capitalization, revenue and net income. In fact, J&J has been running more efficient than P&G. The EBITDA margin of J&J is estimated at around 32.2% in 2013E compared to only 23% of P&G. J&J also has higher 2013E free cash flow per share, they will generate about $5.5 FCF/share compared to $3.4 FCF/share of P&G.

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