In 2022, Procter & Gamble (PG +0.23%) stock did exactly what it is supposed to do when the market is down: outperform. The consumer staples behemoth posted a -5% total return, compared to an -18.1% total return for the S&P 500.
P&G has a recession-proof product mix and an industry-leading position across most of its categories. Although the old faithful dividend stock remains a staple for income investors and retirees, there is one glaring question that needs to be answered before the stock can be a screaming buy in 2023.
Let's start with the basic investment thesis for P&G and then go into why that thesis is being put to the test.
Image source: Getty Images.
The investment thesis for P&G
Innovative companies use capital to reinvest in the business and accelerate growth. That's why you don't see a company like Tesla or Amazon buy back its own stock or pay a dividend. But there's only so much innovating a mature 185-year-old company like P&G can do before it becomes excessive.
Instead, P&G returns value to shareholders through its dividend and share buybacks. P&G is one of the longest-tenured Dividend Kings. It has paid a dividend for 132 years and raised it for 66 consecutive years. Its shares outstanding are down 13.9% in the past 10 years, which boosts value for existing shareholders.
This is all great news. However, the ability to continually raise the dividend and buy back stock is predicated on growing free cash flow (FCF). P&G can grow its FCF in several ways. It can develop or buy new products and expand its portfolio. It can grow sales volumes. And it can raise prices.
Long-term P&G shareholders may remember that overexpansion got the company in trouble and forced a restructuring between fiscal 2015 and 2017 that drastically reduced the number of products and streamlined the product categories. It paid off, but it's a painful reminder that growth must be purposeful to have long-term benefits.
Since the restructuring, P&G has boosted organic growth by relying mostly on increased sales volume and price hikes. The strategy has worked out well. But in the last 10 years, net income and FCF have grown at a slower rate than dividend and share buyback growth -- which signals that the pace of buybacks and dividend growth may be unsustainable.
PG Free Cash Flow (Annual) data by YCharts
P&G's shareholders expect the company to keep buying back stock and raising the dividend. That's the primary incentive for tolerating P&G's low growth rate. But if P&G has a low growth rate and it slows down the pace of dividend raises and buybacks, that could jeopardize its investment thesis.
Unsustainable organic growth
Last week, P&G reported earnings for its fiscal 2023 second quarter (ended Dec. 31, 2022). And although the stock initially only fell a couple of percentage points in response to the report, there were traces of a glaring problem that has been going on for a while.
The issue is that P&G is experiencing declining sales volumes and is using price increases to sustain organic growth. The table below summarizes this dynamic. It shows that sales volumes across all five company segments fell from Q2 fiscal 2022 to Q2 fiscal 2023. But prices rose significantly across all of its segments. The end result was 5% organic sales growth.
|
Segment |
Volume |
Price |
Product Mix |
Organic Sales |
|---|---|---|---|---|
|
Beauty |
(4%) |
9% |
(2%) |
3% |
|
Grooming |
(8%) |
11% |
(3%) |
0% |
|
Health Care |
(1%) |
5% |
4% |
8% |
|
Fabric & Home Care |
(7%) |
13% |
2% |
8% |
|
Baby, Feminine, & Family Care |
(6%) |
8% |
2% |
4% |
|
Total |
(6%) |
10% |
1% |
5% |
Data source: Procter & Gamble. All percent changes are year over year from Q2 2022 to Q2 2023.
To get organic growth, simply add together volume, price, and product mix. Volume and price changes are self-explanatory. And product mix just shows if there was a favorable change in the average cost of products sold in a category. For example, if customers had a net pivot from Gain to Tide laundry detergent, that would boost the product mix of fabric and home care because Tide is generally a higher price than Gain.
Out of the three ways to boost organic sales, a change in price is the least sustainable. Ideally, we would want to see P&G volumes grow, because that would signal more demand for its products, or product mix change, because a customer sees the value of paying more for a premium brand.
A 10% average price increase in just one year can do wonders to boost organic sales growth in the short term. And P&G deserves a lot of credit for pulling off this kind of price hike in such a short amount of time. But price hikes at this rate are simply unsustainable for a consumer staples company that only has so much brand power toward the cost-conscious consumer.
NYSE: PG
Key Data Points
P&G's stock is too expensive to buy now
The biggest question facing P&G in 2023 is whether its customers will comply with more price increases. And if P&G slows its rate of price hikes, will it be able to rely more on volume or product mix increases?
The answer remains to be seen. But over the long term, P&G has to figure out a better way to grow organic sales so it can boost FCF growth and do what shareholders expect it to do, which is to raise the dividend and buy back stock with FCF and not debt.
With a 24.4 forward price-to-earnings ratio and a dividend yield of 2.6%, P&G stock is simply too expensive to justify this level of uncertainty or its multiyear streak of low-to-mid-single-digit organic growth.
Investors are better off choosing other dividend stocks with better valuations or growth prospects -- or getting a 4.6% yield from a three-month risk-free Treasury bill.
