Don't Overthink How Cheap Procter & Gamble Is

By: SumZero Staff | Published: June 25, 2012 | Be the First to Comment

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

Contributor: Anthony Abbate.
Firm: Granite Value Capital. Hedge Fund.
Location: Hanover, NH.

Recommendation: Long Shares of Procter & Gamble (NYSE: PG).
Timeframe: 2 Years and Beyond
Recent Price: $60.00
Target Price: $87.83
Strategy: Value

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

Quick Thesis:
Generally the purpose of the SumZero site is to present obscure companies trading at significant discounts to their underlying intrinsic values. However, periodically "Mr. Market" undervalues large, well-known, blue-chip, high quality companies. I believe Procter & Gamble is in this category.

The company recently announced lower earnings guidance for FY 2013 and its stock price is approaching a 10 month week low. Investors are focusing too much on the short-term decline in earnings. It is difficult to have unusual insights into such a widely-followed company. However, my valuation analysis indicates investors are making a mistake in undervaluing this wide moat, predictable business.

Business Risk--Low
*Most of its products have relatively inelastic demand when compared to changes in the economy.
*About one-third of P&G's sales are in emerging markets. These markets have consumers with expanding incomes and tastes. These markets also do not have direct exposure to the negative effects of deleveraging that many developed economies are experiencing.
*The business should perform better than most businesses in what I expect to be a 5 to 7 year tepid period of economic growth.
*The company has consistently grown its intrinsic value over time. They have grown their intrinsic value in 21 of the past 24 fiscal years. The three years in which they did not grow their intrinsic value, the company saw declines of 1.6% in 2006, 8.3% in 2001 and -2.6% in 2000. Even in 2009 the company grew its intrinsic value by 0.9%.
*The minimum 10 year annualized growth rate in intrinsic value since 1987 is 8.3%. (This was achieved from 1992 to 2002.)

Balance Sheet Risk - Low
*Debt to 34% of the company's capital structure. Given the stability of its business, this is more than adequate.
*Operating Income to Interest Expense Ratio is 17.2. This is very favorable.
*Company's debt is rated AA by Morningstar.

Valuation Risk - Low
*The company sells at a very favorable EV/Free Cash Flow ratio of 15.8.
*This is just above the two 25 year EV/FCF trough valuation levels achieved in March 2009 (15.1) and August 1988 (13.8).
*The company's average EV/FCF valuation over the past 25 years is 25.9.
*The current valuation is in the lowest 5 percentile of its 25 year valuation range.
*There have been seven consumer product companies that have received buyout offers over the past decade that have comparable consumer product business to P&G. These companies include Clorox, Dial and Alberto Culver. The EV/FCF multiple of these seven consumer product companies were between a range of 18x to 33x. The average of these comparables is 27x.
*A relatively conservative multiple of an EV/FCF multiple of 22x implies a stock price for P&G of $87.83.

Other positive factors:
*Management tends to be shareholder friendly due to their desire to cut costs and return money to shareholders via stock buybacks and dividend increases.
*The company has increased its dividend for 54 consecutive years.

Return Potential/Assumptions:
Assume a growth rate in its intrinsic value of 6%
Dividend Yield of 3.7%
7 Years to close the gap between its current stock price and a 22x EV/FCF multiple
Potential annualized return is 15.2%

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