Last spring and summer many VIC members contributed ideas to a thread entitled, “Best positioned companies at any price.”  The challenge put forth was to pick stocks that one would be willing to buy at 15X normalized earnings with the caveats of investing a substantial portion of one’s net worth and a holding period of 15-20 years.  Procter & Gamble was not mentioned in this thread.  I think it definitely merits inclusion on this list. Furthermore, at just over 15X trailing EPS, P&G now trades at its lowest multiple for decades save for a short period in early 2009. With a free cash flow yield of 7%, which I think can grow in high single digits for years and probably decades into the future, Procter is a compounding machine that should provide highly attractive returns--especially adjusting for very low business risk.

Corporate History/Balance Sheet/Returns:

Founded in 1837, P&G has paid dividends each year since its incorporation in 1890, or 121 years.  Impressively, the company has increased dividends each year since 1956, or 54 straight years, at a rate of 9.5%/year. The current dividend is $1.92 (a yield of 3.1%) and should be increased in late April--I would guess by 8% to $2.08--which would bring the yield almost exactly to the current 10 year Treasury rate.  Perhaps even more impressively, since 1930, or for eight decades, net income has compounded at 9%/year.

P&G is a very international company, operating in over 180 countries.  Only 42% of sales last year (6/30/10) were in North America.  Importantly, 34% of sales (against just 20% in 2000) are in developing markets:  Emerging Asia, Latin America, Central and Eastern Europe, and the Middle East and Africa.  More on this and its ramifications below.

As one would expect, the company is a paragon of financial strength (EBIT interest coverage of 17X) and has very clean accounting.  While an ROE under 20% appears unimpressive, recall that P&G made three (two big and one huge) acquisitions over the last decade:  Wella, Clairol and Gillette.  Stripping out intangibles, return on capital employed is extremely impressive (over 55% pre-tax).  The major investments made by the company--product development and enhancement, marketing/sales force and advertising--are expensed through the income statement. My sense is that the current  management team has very little appetite for major acquisitions and understands that the company’s greatest opportunity lies in exploiting its current brands (23 have over $1 billion in sales and another 20 have over $500 million--together these represent 95% of corporate profitability.) Hence, free cash productivity is very high and a key corporate goal (over 90% of net earnings, which has actually been exceeded in each of the past 5 years) which is one of the key criteria driving management incentives.

The Emerging Market Opportunity:

At its Investor Day last December (http://media.corporate-ir.net/media_files/irol/10/104574/HANDOUT-ANALYSTMEETING2010.pdf), management highlighted three keys to growth:  product innovation, integration (operating as one company instead of a series of brands) and, I think most importantly, capitalizing on developing markets.  Here, the major driver is underlying market growth or, in Coke parlance, per caps.  As an example, in Greater China, the diaper market has grown over 10-fold in the last decade (over 25%/year) to exceed $2 billion.  The Goldman analyst estimates emerging market category sales can grow for 8%/year for decades to come.  Is this likely?  Of course, no one really knows.  But it is actually lower than the rate of the last few years and, if one looks at the very low penetration rates in many huge markets (for instance, Mexico per capita P&G spending is over 6X China levels and 20X Indonesia and Indian levels.

Beyond simply rapid underlying market growth, P&G has great potential to expand category/country combinations--taking existing brands into new geographies.  One quick example:  only a few months ago Olay was introduced into South Korea, which is the 7th largest skin care market.   Overall, if one looks at just the top 50 markets across P&G’s 38 product categories (1900 possible combinations), half are unfilled.  Management plans to enter 250 of these opportunities over the next five years.

Some analysts have observed, of course correctly, that just because these are “white space” opportunities for P&G doesn’t mean that they are altogether unserved.  And it will be a challenge to enter competitive markets. Nonetheless, Procter brings a number of important strengths that should lead to success:  strong brands, an existing base of operations, leading advertising spender and overall scale.  So while the company will undoubtedly stumble with certain brands in some markets, I believe the overall strategy is sound and low-risk.  

Long-Term Assumptions

1. Sales growth of 5%/year.  This is actually in-line with current trends.  I think mature markets should grow 2-3%/year and emerging markets 8-10%.  At this pace, emerging markets will be close to half of the company in 10 years.  Note that the corporate organic sales goal is 1-2% above global market growth.

 2. Very modest operating margin expansion.  Management goes into great detail in the Analyst Day presentation outlining the up to 200 bp improvement they see as possible through “simplification, productivity and cost breakthroughs” as well as an additional 250 bp over the next five years through “cost discipline and sales leverage.”  I do think that there is ample room for cost savings, or, to use P&G jargon, “simplification opportunity” but think that the vast majority of what is realized will be reinvested back in the business. Note: Some question the margin potential in emerging markets, as the product mix is less rich, but P&G points out that margins in Chin a and the Philippines have exceeded the corporate average in recent years.  I model 30 basis points of margin improvement over the next 5 years.  This is slightly magnified on the pre-tax line through a small reduction in interest expenses as a percentage of operating income

 3.  Continued aggressive share repurchases.  By the end of the current FY P&G will have bought back over 300MM shares, or roundly 10% of its going in share base, over the last 3 years.  Management clearly understands the power of shrinking the share base over time.  I model a 2.5% annual shrinkage in the net share base.  Effectively, therefore, P&G would divide its free cash flow (almost synonymous with EPS) between dividends and share buybacks.

This model produces EPS (and dividend) gains of 8-9%/year, or very consistent with the long-term results which Procter has generated.  It is at the low end of the corporate long-term goals of high single-low double digit EPS growth. Without any multiple expansion (which I believe is very possible if the company achieves these results), P&G should be a very rewarding investment.  

Jim Grant made a compelling case several months ago for what he called cast-off blue chips:  “Big, stable, dividend paying adaptive corporations can survive in most monetary and fiscal settings.”  P&G is so big and operates in so many categories and markets that any one country or business development (Egyptian upheaval, for example, or a slight market share loss in the US to a competitor) really can’t move the needle much up or down.  I don’t know anything about the company that isn’t widely known.  But, in conclusion, when one steps back and looks at its portfolio of businesses and cash generating prowess over generations, it is a value hiding in plain sight.