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Stocks  | January 29, 2019

The Procter & Gamble Company (NYSE:PG) spiked to a new all-time high price last week after a slightly better than expected earnings report. It has also survived the general market sell-off since the autumn surprising well. In fact, P&G was one of the top performing consumer staples in 2018. I know investors consider the company a defensive name, a blue-chip like few others, recession-proof (maybe, maybe not), holding super brand names and headed by top-notch managers. However, some contrarian analysis says the whole bull/buy story may not be as rosy as advertised.

P&G has always looked for ways to squeeze costs and grow leverage on its balance sheet, a little more, each year for the 33 years I have observed the stock market closely. Equity buybacks have put a small tailwind to the company's per share reported numbers since 2006. But here's the rub. During early 2019, I find Procter continues to owe excessive liabilities, wrapped in a negative tangible book value, restraining organic growth. The company has weaker expected sales and income prospects than the average S&P 500 company as ranked by Wall Street analyst consensus. P&G is priced by investors at a super-high valuation. Plus, the common equity is showing many signs of technical distribution, including a substantial drop in upside momentum the last several months.

The Operating Company Is Getting Smaller Every Year, and Leverage Is Growing

Let's start with some startling facts for newbies to Procter & Gamble. Total revenues peaked in 2008 at $83.5 billion vs. the $67.5 billion reported in the past four quarters. Minor, less important non-core units have been sold off. Some unprofitable product lines have been closed, and the company has focused its capital expenditures on its best brands since the 2005-06 merger with Gillette. Overall, since 2006, the company has become dramatically smaller in total size. Not only have revenues and volumes fallen, but the employee count has declined from 140,000 globally twelve years ago to a little over 90,000 today.

The table below is taken from the fiscal 2008 annual report highlighting some important 2006-08 numbers, including the peak in revenues ten years ago. We will talk about the Trump reduction in the corporate tax rate and its accounting gimmick effect on the rise in profit margins a little later. Plus, we can visually see the higher sales growth rate and much lower dividend payout as a percent of earnings a decade ago vs. today's experience.

Image Source: 2008 Annual Report

Bulls will argue the company achieved an amazingly high net profit margin of 15% in 2018. However, as the table above notes, the 30% tax expense rate of fiscal 2006 is dramatically higher than the 18% reported in calendar 2018. Trump's corporate tax cut to a 20% maximum in the U.S. means the current P&G 15% profit margin is basically the same as a 13% net return on sales, using the much higher tax rate schedule of 2006. Sorry, Procter is no more profitable on sales today than a decade ago, despite cost-cutting and belt-tightening efforts.

Another issue I have with Procter, as I do with most companies in America during 2018-19, is the use of excessive financial leverage. Procter has decided to keep financial leverage sky-high by reducing outstanding shares nearly every year since the 2006 Gillette merger. All told, the company has "spent" $99.5 billion on buybacks the last several decades (Treasury stock), a sum nearly equal to the $101.2 billion in retained earnings generated over the entire life of the business.

Since the Gillette merger, the company has held a large negative tangible book value from the acquired goodwill and intangibles involved. I have railed against such a balance sheet design as counterproductive and restrictive to honest business growth for decades. Most brand name consumer and food giants have run their business balance sheets this way. The group has also underperformed the S&P 500 averages, year after year, especially those with honest tangible book values. Procter's long-term success has waned just the same. Today, P&G holds just $50 billion in real-world assets like property, equipment, cash, and inventories, against $69 billion in total debt and liabilities. On top of a stock market capitalization of $235 billion, shareholders also OWE another $19 billion in net liabilities, in theory.

Versus the 30-40% dividend coverage from cash earnings a decade ago, P&G now spends 65% of earnings and free cash flow on its common dividend. The company is less able to grow the operating business or reduce debt levels when it sends out most income as a dividend. Let's review some numbers. During calendar 2018, P&G generated $11.4 billion in free cash flow, defined as operating cash flow minus capital expenditures. Against a $7.4 billion common dividend payout, the corporation was left with a tiny $4 billion in cash generation to increase the value of a $235 billion market cap value.

Subtracting $24 billion in current assets from $69 billion in total liabilities, we get $55 billion in net long-term liabilities. At first glance, the company maintains a relatively typical 5-year payoff period to theoretically cover net liabilities. To compare apples to apples between companies and industries, I first calculate annual free cash flow generation, excluding dividend payments, then divide the cash flow sum into my net liability total, all other variables staying the same. The average long-term liability payback ratio on the 150 mega-cap stocks I follow weekly, adjusted for current assets, is close to 4 years of cash flow in early 2019.

However, when factoring in the oversized dividend payout, P&G's total IOU payback estimate runs to 17 years. My point is Procter's high dividend payout is a form of financial leverage, just like excessive intangible assets or too much debt. P&G cannot afford a major downturn in sales or unexpected jump in labor costs, commodity expenses or interest rates on tens of billions in debt and pension/retirement benefit accounting. If P&G sees a downturn in its business, lowered financial flexibility could mean a dividend cut, assets sales or the issuance of new debt/equity that dilutes existing shareholder worth.

General Electric (GE) has been "the" poster child and real-world example of a "defensive" blue-chip conglomerate in America imploding from too much leverage and weakening operating results. I have written bearish articles on Seeking Alpha about GE since early 2017 when the stock was trading above $30 a share. While Procter's debt issues are not as dire as the GE situation, a slowing global economy WILL create problems for the company's bottom line soon, in my estimation.

Weak Long-Term Performance for Shareholders and a Questionable Future

Believe it or not, gold buried in your backyard 12 years ago has profited the same or more as an investment in Procter & Gamble shares. That's right - since the Gillette merger in 2006, $26 in dividends and a stock quote rise from $60 to $94 equals a rough 100% total return. Yet, gold has risen from $600 to $1,300 an ounce since 2006.

Haven't share buybacks been a boon for shareholder worth long term? Nope. P&G's bottom and top-line results "per ownership share" have lagged the S&P 500 average the past 12 years, and barely kept up with the general advance in the CPI price level. Earnings per share have risen from $2.79 in fiscal 2006 to $4.30 in calendar 2018, equal to a 54% gain. The S&P 500 has witnessed a rise in EPS from 87 in 2006 to an estimated 161 in 2018, for an 85% increase. Meanwhile, the Consumer Price Index has risen 26% from 2006, despite woefully understating actual inflation. Sales per share have performed even worse for P&G, as $22 in per share revenues during 2006 have only climbed to $26 in calendar 2018, an 18% gain. Underlying S&P 500 revenues have risen from 952 in 2006 to an estimated 1,300 in calendar 2018, a 36% increase and double P&G's result.

Business performance expectations going forward are no better. Wall Street analyst consensus is projecting low single-digit revenue growth and only mid-single digit earnings per share increases for fiscal 2019-20. Most all the profit "growth" is projected as a result of ongoing share buybacks at record equity prices, adding even greater financial leverage onto existing operations.

My biggest worries - any sales decline from a recession or a rising tax rate on income in the future [that may soon be required by credit ratings agencies to reduce America's out-of-control federal deficit situation] will likely lead to sharply lower reported P&G earnings after 2019. Since the company runs a tight ship, with extensive financial leverage, weaker sales and lower income levels could force a dividend cut, asset sales, or share issuance hurting long-term shareholder values. You can imagine what the stock price direction will be, given lower valuation ratios on falling sales and income, especially as current shareholders feel the brunt of dilutive debt/equity decisions.

Valuations are Extremely High

Against a 2.4x price to trailing sales ratio for its 12-year average, 3.5x sales at January's $94 quote is a modern record valuation for the P&G business! [The same can be said for the whole U.S. stock market, as September 2018 witnessed a record high price to trailing sales number over 2.2x.] Then, munch on the 1.6x price to sales recession low of early 2009. I can argue Procter & Gamble's fair value on sales is $65, with a potential low trade of $43 in a steep recession or business downturn specific to P&G's operations. Conclusion: downside may be 30-55% in 2019, given a deep economic contraction by year's end.

Against a low 2.0x accounting book value in 2009 or 3.0x 12-year average, the present 4.5x reading is similarly excessive. 23x peak economic earnings in early 2019 is quite expensive against an S&P 500 equivalent of 16x. On almost every financial valuation metric, P&G is at or near a record valuation in early 2019. Plus, if you include the extra $19 billion in negative tangible book value in your capitalization total, the stock is roughly 10% MORE expensive on all the metrics discussed. Versus businesses owning high tangible book values and a related margin of safety backstopping your investment in a downturn, excessive leverage is something to carefully contemplate at an economic peak. Ask yourself, are investors getting a bargain today, buying low to sell high later?

Trading Momentum Is Fading Fast

Early November's robust momentum has faded with little or no follow through the last two months. In a bullish move higher, prices usually continue to drift higher for months after a similar spike of upside volume and price momentum. Otherwise, a lack of follow-through can mark a top area. Below are some charts to review. You can see the big deceleration in buying enthusiasm the last few months. In many ways, buying excitement has been turning negative just like the late 2017 into January 2018 period pictured below.

As the chart above highlights, P&G has undergone a significant drop in momentum since November. We can compare similar instances and how they played out differently in Caterpillar (CAT) and Boeing (BA) stock action the past year. Caterpillar's spike in positive momentum buying proved a final peak in January 2018. Boeing's volume and price buying excitement propelled the stock higher the first instance pictured during late summer 2017, helped to form a meaningful top a few months later in early 2018, and may be pointing to another peak in January 2019.

Further, we can look at how Procter & Gamble has traded against large-cap defensive peers and competitors in the consumer staples space. The below charts compare the company to the S&P 500 index, the Consumer Staples SPDR (XLP), Colgate-Palmolive (CL), Kimberly-Clark (KMB), Unilever(UN), Johnson & Johnson (JNJ), Altria (MO), Coca-Cola (KO), General Mills (GIS), and Walmart (WMT) at different time intervals between three months and ten years. Basically, Procter has been a champion investment idea during the last year. Over extended time periods, however, its performance looks subpar at increasing rates.

Pulling It All Together

If you assumed Procter & Gamble was a larger and financially stronger company than 2007, at the start of the last recession, you would be wrong. In early 2019, Procter is actually a smaller, more leveraged, and indebted company than a decade ago. A high dividend payout and negative tangible book value have made earnings growth next to impossible, outside of share buyback or corporate tax rate cut gimmickry. Imagine how much more valuable the company would be if it had forgone a massive $100 billion in share buybacks? Reinvesting cash earnings for decades into stagnated consumer lines witnessing next to zero volume growth has proven a counterproductive strategy. If P&G's $100 billion Treasury stock sum was instead reinvested into accretive acquisitions and worldwide product development efforts, the stock price could easily be double the quote today. Higher earnings and revenues per share from organic growth may have translated into a better dividend payout and safer dividend coverage.

At $94 a share, Procter & Gamble holds a premium valuation compared to its long-term historical trading and current S&P 500 financial metrics. Is it worth such an expensive price as the U.S. economy brakes in 2019?

Almost all operating business progress has come from outside the U.S. the last three years. Foreign consumers accounted for 56% of total revenues in fiscal 2018. Trade war fears, rising interest rates, and a higher dollar value have slowed economic growth and projected economic expansion rates going forward for the globe. If we slip into recession, P&G revenue totals will likely decline. Lower sales will in turn pressure earnings to actually fall in the near future. Are bullish investors ready for this possibility?

Perhaps, the sharp drop in buying momentum since November is completely justified. Perhaps, the P&G business outlook is starting to sour. Perhaps, its ultra-expensive stock valuation is actually too extended, and a price trend movement lower is beginning.

From my vantage point, the probability of continued long-term underperformance vs. the S&P 500 looks almost certain. In addition, the increasing likelihood of a large equity price decline cannot be ignored as economic growth decelerates. Procter & Gamble is no longer recession-proof. I argue investors should be looking to sell Procter & Gamble shares. More aggressive accounts, especially diversified long/short portfolios may want to research the company further as a short hedge idea paired against better positioned long choices.

Short Sale Suggestions: Please consult a registered financial advisor if you are contemplating a Procter & Gamble short position. The unique risks of short selling, including the potential for unlimited losses, are different than holding a long-only position. Always short a diversified basket of stocks to reduce the risk of one equity creating oversized losses.

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