In 1837 William Procter, a candlemaker, and James Gamble, a soapmaker, became business partners at the suggestion of their father-in-law, Alexander Norris. By this unlikely turn of events, Procter & Gamble (NYSE: PG ) was born. Since then, Procter & Gamble has grown to become a massive conglomerate home to brands such as Head & Shoulders, Gillette, Crest, and Pampers.
Sporting a market capitalization of nearly $210 billion, the company has been able to survive multiple severe economic downturns throughout history. This is due primarily to the large diversification the company promotes in its brands and the fact that many of its products are deemed so necessary to society (like soap, diapers, toothpaste, and razor blades) that it should be borderline impossible for the company to fail unless it undergoes a prolonged period of severe financial mismanagement. As such, the company holds a large appeal to investors who are looking for a safe investment opportunity and also desire attractive fundamentals, which are demonstrated in the table below:
As shown above, we can see that Procter & Gamble has relatively attractive margins. On top of a five-year average return on equity of 18.6%, the company boasts a net profit margin over the same time horizon of 14.9%, a long-term debt/equity ratio of 0.32, and a hefty free cash flow margin of 13.6%.
The only metric that is somewhat disconcerting is its average current ratio (current assets divided by its current liabilities) of 0.79. Though this metric has shown steady improvement over the past five years, it suggests that the company could have at least temporary difficulties in meeting its short-term financial obligations should its earnings or free cash flow falter significantly.
Beyond that, though, the company appears rather healthy, right? Well, not necessarily. Aside from the current ratio, the company has very attractive metrics, but there is one concern; its profitability as measured by its return on equity, net profit margin and free cash flow margin seems to be on the decline. At first glance, this may send up a red flag in a current or prospective investor's head. Declining profitability could be a sign that a company's future may be in doubt. To be perfectly honest, that's what crossed my mind at first glance. Upon looking closer into the company's numbers, the opposite actually appears to be the case.
Starting with the company's net profit margin, we see an almost annual decline from 17.5% in 2009 to 13.4% in 2013. Although a net profit margin above 10% could generally be considered attractive, the trajectory of Procter & Gamble's margin suggests that it may soon dip below this level. However, upon further examination, I found that the company's margins aren't necessarily decreasing from the historical average. Rather, they appear to be reverting to the mean.
You see, following the 2007-2008 financial crisis, Procter & Gamble began restructuring itself to focus on what it deemed to be its core business. The company began divesting certain assets that it deemed not to fall in line with its operational goals. The largest impact from these discontinued operations was seen in 2009 when the company divested itself from its Folgers Coffee brand and netted more than $2.1 billion of its $2.76 billion in income from discontinued operations. Likewise, the company divested its global pharmaceutical business in 2010, which added $1.79 billion to its bottom line ($1.46 billion net of taxes).
In an effort to reinvent itself, the company continued to engage in divestitures of its assets through the end of its 2012 fiscal year. While these are benefits received by the company, it makes things a bit harder when trying to compare the company from one year to the next since each transaction is a one-time gig. By removing these transactions from Procter & Gamble's net profit margin, we come up with a more comparable measurement of the company's ability to generate a profit over time.
Looking at the revised metrics above, we notice that after said adjustments the company's net profit margin is smoother and shows virtually no signs of change. The only exception to this is in 2012 when the company took a significant impairment charge which had a negative impact on its earnings.
Following suit, we see that the change had similar impacts on the company's return on equity and its free cash flow margin. While each of these metrics show more earnings consistency, the return on equity has been on a general decline since 2010. Though this may be disconcerting, it's actually nothing to worry about. The cause can be chalked up to the company's retained earnings growing faster than its purchases of treasury shares (which are shares purchased by the company but instead of being retired they are held for the possibility of future issuance if the company needs or wants to raise cash).
After analyzing the causes behind the company's recent decline in earnings and cash flow relative to revenue and its book value of equity, we see that what may appear to be a major risk for the Foolish investor is nothing more than a reversion to the company's mean. Absent any major divestitures or impairments, it would be logical for the Foolish investor to expect more normalized net profit and free cash flow margins in the range of 13.5% to 14% and 11% to 12%, respectively. However, as the company continues to experience earnings that outpace its ability or willingness to buy back shares, it's not out of the question for it to exhibit a declining (though not necessarily dangerous) return on equity.
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