Procter & Gamble: Strong Pricing Power, But Expensive

Dear readers,

Earlier this week August CPI missed expectations, increasing to 3.7% YoY, as a result of energy and gasoline prices increasing sharply, by 5.6% and 10.6% MoM, respectively.

Higher energy prices, as well as sticky shelter inflation which continues to be reported at 7.3% YoY, despite real-time housing data showing no inflation, have contributed to CPI decisively breaking the downtrend it's been on since October 2022.

If you've been following my research, you know that I'm currently bullish on a number of companies and that my base case calls for a decrease in interest rates sooner rather than later.

But that doesn't mean that my entire portfolio is positioned for a decrease in rates. That would be foolish and dangerous.

Earlier this week I published an article called 3 REITs For A Higher For Longer Scenario where I argued that investors should position themselves for multiple potential macroeconomic scenarios, including a higher for longer scenario. I also gave examples of three REITs that, despite common belief, are actually very well positioned for high interest rates and should outperform the market in such scenario.

In an effort to diversify and protect my own portfolio against the risk of sticky inflation and high interest rates for years to come, I've done a lot of research in sectors beyond REITs, Financials and Energy, which I usually invest in.

I was mainly looking for defensive dividend-paying stocks, with non-cyclical demand, low leverage and high ability to pass inflation on to the consumer. I found that consumer staples companies as well as some consumer discretionary companies such as fast-food restaurants satisfy this criteria rather well.

My thinking is that rather than holding a cash position of say 10-15% to be deployed in case of a market crash, I could buy defensive names today around a 3% dividend yield and "lock-in" an expected annual total return of somewhere between 7-10%.

If we get a soft landing, then these stocks will indeed do better than cash and if inflation stays high, the Fed pushes the economy into a recession and the market sells off, then these stocks which have a beta of 0.5-0.6x will for sure decline less than riskier technology stocks that I can then rotate into in anticipation of a higher total return than the 7-10%.

This is why I plan to start a series of articles on defensive companies from The Coca-Cola Company (KO), through McDonald's Corporation (MCD) and Starbucks Corporation (SBUX), to The Procter & Gamble Company (NYSE:PG) which I will start with today.

Procter & Gamble

Procter & Gamble is a global AA- rated consumer staples powerhouse which needs little introduction as it owns some of the most well-knows brands in beauty, grooming, home care and healthcare such as Gillette, Old Spice, Oral B, Pampers and many others.

I guarantee that you have at least a dozen products made by PG in your home and importantly, these are essential products to our everyday life. This means that we will buy them no matter what, which gives the companies making these products enormous pricing power, which is especially important in times of high inflation.

Recent results, reported by PG for their fiscal Q4 2023, confirm that indeed the company is able to pass inflation onto consumers. Organic growth has reached 7%, of which 9% was attributable to pricing and 1% to mix, while volume declined by 3%. Notably, the growth has been broad-based, across all of PG's segments.

Core earnings reached $5.90 per share, which is only 2% above last year numbers due to strong headwinds (of $1.38 per share) from higher material costs and FX. Keeping FX constant, core EPS increased by impressive 11% YoY.

As a result of strong results, the company has increased its dividend by 3% to $0.941 per quarter or a 2.4% dividend yield. In addition to paying out $9 Billion in dividends, the company also executed $7.4 Billion in share repurchases, confirming their shareholder friendly capital policy as evident from 66 years of consecutive dividend increases.

Going forward, management expects that pricing increases will slow and volumes will return closer to normalized levels, which should result in future market growth of about 4%. This assumption along with management's expectation to gradually capture market share worldwide leads to organic sales guidance of 4-5% for fiscal 2024.

In terms of earnings, guidance calls for fiscal 2024 EPS of $6.25-6.43 per share, which at mid-point represents annual growth of 7.5%. This still assumes a 3% headwind from FX so in neutral FX terms, guidance calls for EPS growth of 9-12% YoY.

In 2024, the expectation is for another $9 Billion in dividends and $5-6 Billion in share repurchases and beyond consensus calls for 6-8% core EPS growth until fiscal 2026.

Valuation

Procter & Gamble is a dividend king, which means that it pays one of the most reliable dividends out there, now at 2.4%.

Such high quality barely ever comes cheap, and today is not an exception. At 25.8x 2023 earnings and 24.4x forward earnings, the stock trades at a premium to its 10-year average P/E of 23.8x.

So we're paying about an 8% premium today, relative to historical valuation.

With that said, I think we can reasonably expect the following:

• 2.4% dividend almost guaranteed to grow by 2-4% per year
• 6-8% core EPS growth for the next three years
• potential downside from re-rating to 23.8x earnings of 8%

Combined, this yields a price target of $175 three years from now, which corresponds to an expected annual return of about 6.5%.

That's somewhat below the 7-10% total return I'm after as part of my strategy, and it's also below the average market return. As a result, I rate PG a HOLD here at $155 per share and will continue looking for other defensive companies with higher potential upside.

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