Friday, 4 September 2015

Procter and Gamble Redux

I've revisited my initial analysis of Procter and Gamble having worked my way through my in-progress Greenwald model, based on Bruce Greenwald's book, Value Investing, from Graham to Buffet and Beyond.  This exercise is purely demonstrative and is not buy/sell advice.  It is purely theoretical.

I believe my model now gives me enough of an anchor in order to determine viability of future investment considerations.

Why Procter and Gamble?

It's a large cap, multinational, dividend payer, and is widely-held.  It is a favourite go to stock for dividend growth investors, and it's been weak over the last year (along with the rest of the market). It's also a great company to use as a work through for my model, which consists of the following:
  • Greenwald Earnings Power Value (EPV) and Balance Sheet Reproduction analysis
  • Michael Price sum of the parts analysis
  • Mario Gabelli Private Market Valuation (PMV) analysis 
  • Paul Sonkin cap rate analysis 
  • My own PE Payback analysis
  •  My own PEG vs PE analysis
  • A comparative analysis amongst peers 
  • A qualitative analysis along the lines of Porter's competition model   
  • A long term analysis of the trend in price (monthly)
In the dividend growth blogosphere/universe, there seems to be a prevailing idea in the face of weakness, that the weaker a stock gets, the more appealing it should get.   i.e., if a dividend growth investor loved P&G at $92, he/she should be tickled pink at $70!  But this line of reasoning is only half correct in my opinion.

The right questions to ask are, how cheap is it now, and how much of a margin of safety does it provide right here, at $70.

To attempt to answer this, I worked through my PG model and came up with the following results:

EPV Analysis

I used the last 10 years of financial results to determine theoretical earnings power value.  In accordance with Greenwald's teachings, EPV is sustainable adjusted earnings before interest and other non-operating expenses under a zero future growth scenario.  Certain adjustments are made starting from EBIT, including, capitalization of a portion of SG&A and R&D (in theory, the value of SG&A and R&D should produce an intangible asset not recognized under GAAP, but which should translate into future sales) , and normalization for special charges.  In Greenwald's case, he capitalized 25% of SG&A and R&D in his book, so I've done the same.

Next, adjusted EBIT is taxed at the average tax rate, depreciation is added back, and capx is deducted.  The end result is closer to a free cash flow sustainable earnings amount, before interest and other expense.

Greenwald suggests using a range of WACCs to capitalize the result, which I've done.  As I've written previously, this takes some of the guesswork out of trying to determine the appropriate discount rate.  The beauty is, you don't need to guess or even pretend that you know!  You simply take a range of WACC's between 7.5% and 10% (in the case of an extremely speculative situation, you would probably want to extend the range up to 12 or 15%, but I only think this would be necessary in the case of VC type ideas, which sort of defeats the purpose of evaluating no growth scenarios in th first place).

The capitalized result is then adjusted to get from an enterprise value type result back to a market capitalization result by adding back cash and deducting the debt.  The resulting adjusted EPV is then divided by shares o/s to get an EPV/share under a range of different discount rates, which is then compared to current price.  If EPV/share under all WACC scenarios exceeds current price, there's a theoretical margin of safety.  If current price exceeds EPV/share, a theoerertical margin  of safety is not there.

Here are my results (again):

EBIT %18.45%19.42%20.20%20.35%20.05%20.30%19.11%15.88%17.35%18.41%16.90%18.28%
Avg EBIT000000000014,855
Add special charges00000001,5763080973
EBIT before special charges10,46913,24915,45016,63715,37416,02115,49514,86814,63815,28815,8284.22%
Special charges as % of sales0.00%0.00%0.00%0.00%0.00%0.00%0.00%1.88%0.37%0.00%1.20%0.31%
Deduct avg special charges-286-286-286-286-286-286-286-286-286-286-286
EBIT after avg special charges10,18312,96315,16416,35115,08815,73515,20914,58214,35215,00215,5424.32%
SG&A as % of sales32.43%32.02%31.83%31.29%29.51%31.67%31.75%31.57%32.15%30.48%30.57%31.39%
R&D as % of sales0.00%0.00%0.00%0.00%0.00%0.00%0.00%0.00%0.00%0.00%0.00%0.00%
Add back 25% of SG&A4,6005,4626,0856,3945,6586,2506,4386,6056,6386,3296,210
Add back 25% of R&D00000000000
Adjusted EBIT14,78318,42521,24922,74520,74621,98521,64721,18820,99021,33121,7523.94%
Tax rate25.00%25.00%25.00%25.00%25.00%25.00%25.00%25.00%25.00%25.00%25.00%
EBIT AT11,08713,81915,93717,05915,55916,48916,23515,89115,74315,99816,314
+ Dep'n1,8842,6273,1303,1663,0823,1082,8383,2042,9823,1413,150
Adj EBIT AT10,79013,77916,12217,17915,40316,53015,76715,13114,71715,29115,7613.86%
NI per F/S6,9238,68410,34012,07513,43612,73611,92710,90411,40211,7859,2262.91%
$ Diff3,8675,0955,7825,1041,9673,7943,8404,2273,3153,5066,535
% Diff35.84%36.98%35.86%29.71%12.77%22.95%24.36%27.93%22.52%22.93%41.46%
Cost of capital rates:EPVAdj for Debt & Excess CashAdj EPVO/S sharesEPV / shareBVPS / shareExcess EPVCurrent pricePrice / EPVPrem/Discount vs EPV
Upper bound - VC15%105,071.75-2172283,349.75288328.9124.41.1869.822.42141.50%
Arbitrary 2 <10% - 12 %>10.00%157,607.62-21722135,885.62288347.1324.41.9369.821.4848.13%
Per GF8.46%186,297.43-21722164,575.43288357.0824.42.3469.821.2222.31%
LT equity return; 2014 - 19288.16%193,049.48-21722171,327.48288359.4324.42.4469.821.1717.49%
Arbitrary 17.50%210,143.50-21722188,421.50288365.3624.42.6869.821.076.83%
Combined NI & Div growth4.67%337,699.31-21722315,977.312883109.6024.44.4969.820.64-36.30%
Adj BetaRfRisk Premium%D%EAT Int cost

As you can see, none of my WACC scenarios produced a theoretical margin of safety as current price exceeded EPV/share at discount rates ranging from 7.5% to 10%.  In order for me to be interested in purcashing P&G, I would like to see current price less than EPV of at least -15% to -20%.

Balance Sheet Reproduction Cost

AssetsAs reportedAdjustmentReproduction cost
Deferred tax assets8200%0
Prepaid expenses3,067100%3,067
Assets held for sale3,6320%0
Total current31,56226,861
3 yrs SG&A and R&D74,514100%74,514
Equity method investments0100%0
Other investments0100%0
Other assets5,568100%5,568
Total LT173,889173,889
Total assets205,451200,750
Non-interest bearing liab's-15,691
Excess cash-12,348
Equals total net reproduction cost172,711
O/S shares2,883Greenwald Three States
Reproduction cost/sh60State One:
EPV/sh (avg)57AV > EPVAV = EPVAV < EPV
EPV less Reproduction cost/sh-3No franchiseEquilibrium Franchise
Bank advances0100%0
ST debt15,075100%15,075
A/P and accruals15,691100%15,691
Tax payable0100%0
Other liab's1,115100%1,115
Defd rev0100%0
Total current31,88131,881

I'm not going to say much more about Balance Sheet Reproduction Cost vs. what I noted in a previous post.  It makes sense that EPV/share would not definitively exceed Reproduction Cost/share given the competitive operating environment for P&G's business lines, but, this analysis is still cursory, and perhaps the shedding of certain non-core segements or businesses will allow the company to focus on those segments or businesses which are franchise worthy.

Michael Price Sum of the Parts

In Greenwald's book, there is a whole chapter devoted to Michael Price's sum of the parts approach.  Price takes the perspetive of an acquirer of an enterprise in its entirety, and looks at recent deal based multiples (EV/EBITDA, or EV/EBIT) in order to ascribe multiples to individual segments.  In order to determine margin of safety, the total of all multiples by segment should exceed current EV.  I did the following analysis based on P&G's segments for the calendar year ended June 30, 2014:

PG by segment analysisEBITEBITEBITEBITEBITEBIT multipleWeighted Avg EBIT multipleValue
Global financing00000120204,627
Mkt cap ($B's)185,940192,128179,401225,610198,49611.8897.00%Prem/Discount vs. mkt cap
Add: Debt29,00032,00030,00032,00020,300
Less: Cash-2,900-2,768-4,436-5,947-11,612
EV212,040221,360204,965251,663207,18412.40101.25%Prem/Discount vs. EV
Global financing000009.60.000188,574
EV212,040221,360204,965251,663207,18410.68109.87%Prem/Discount vs. EV
EV / EBITDA10.6511.5711.1213.1310.68

In both cases, I found no margin of safety on a multiples based approach.  FYI, apparently, Price looks for a 40% discount.

(A quick note about the source of multiples used.  I borrowed the most recent EV/EBITDA from Professor Aswath Damodaran's website.  In order to be conservative, I took 75% of published EV/EBITDA mutliples for each of the Household Products and Healthcare Products industries.  The source of the data is here

Gabelli PMV

In Greenwald's book, there is a whole chapter devoted to Mario Gabelli's approach, who analyzes return on capital by business segment in order to determine potential catalysts for unlocking value.  If the results of one or two of a company's strongest segments are being obscured by the performance of the other segments, Gabelli's thesis seems to focus on buying companies in which the total results are being obscured by weaker segments at a sufficient discount, and waiting for an eventual catalyst in order to unlock value.

I performed the following analysis by segment for P&G:

I note the following:

  • Currently, the pretax cap rate (EBITDA - less capx) / EV is only about 5% for the company as a whole (using 2015 results)
  • Looking at the individual segments, Beauty, Fabric, and Baby had returns on assets of about 40%
  • The overall return on assets for all segments + corporate is about 11%, and my initial thoughts are, is there potential here for righting the ship?  Could the company restructure to scale down and/or sell off redundant corporate assets not actively related to the business of these three segments in order to improve results and/or unlock value?  Perhaps this is where the eventual value proposition is?

Income Stmt6/30/20116/30/20126/30/20136/30/20146/30/2015CAGR 1CAGR 2CAGR 3CAGR 4Comments
COGS %49.15%50.66%50.12%51.12%51.33%
GM %50.85%49.34%49.88%48.88%48.67%-2.97%-0.96%-1.31%-1.09%
Other 01,5763080973
EBIT15,49513,29214,33015,28813,732-14.22%-3.83%-0.45%-2.97%X item in 2012 reduced EBIT by $1.6B
EBIT %19.11%15.88%17.35%18.41%16.90%
Interest Income07787100130
Interest Expense-831-769-667-709-656
Other Income (Expense)333185942206231
Minority Interest00000
EBT14,99712,78514,69214,88513,437-14.75%-1.02%-0.25%-2.71%X item in 2012 reduced EBT by $1.6B
EBT %18.49%15.28%17.79%17.92%16.54%
Tax Provision-3,299-3,468-3,391-3,178-3,039
Tax Rate %22.00%27.13%23.08%21.35%22.62%
Net Income Con11,6989,31711,30111,70710,398-20.35%-1.71%0.03%-2.90%X item in 2012 reduced NI by $1.6B
Net Income Disc2291,58710178-1,172
Cash Flow
+ Dep'n2,8383,2042,9823,1413,150
EBITDA less CAPX15,02712,53213,30414,58113,179
LT Debt22,03321,08019,11119,81117,364
ST Debt9,9818,69812,43215,60615,075
Surplus Cash2,7684,4365,94710,68613,160
D + E - Cash212,074216,737211,067259,073262,797
CAP Rate7.09%5.78%6.30%5.63%5.01%
Segment Analysis 2014BeautyGroomingHealthFabricBabyCorporateTotalComments
Net Sales19,5078,0097,79826,06020,95073883,062
% of total23.48%9.64%9.39%31.37%25.22%0.89%100.00%Beauty, Fabric and Baby account for 80% of sales
+ Net Intx & Other00000403403
EBIT3,5302,5891,5974,6784,310-1,41615,288Segment EBIT before corporate = 16.7B vs 15.288B
% of total23.09%16.93%10.45%30.60%28.19%-9.26%100.00%
Total Assets8,57623,7675,87911,38410,94683,714144,266
Return on Assets41.16%10.89%27.16%41.09%39.38%-1.69%10.60%

P/E vs Payback in Years

This is my own rudimentary attempt at determining the required growth rate an investor would need to earn on initial earnings in order to get repaid his/her initial purchase price in terms of earnings in 10 years.

Currently, P&G's adjusted P/E (I'm excluding ongoing restructuring charges) is about 18x.  For a company exhibiting minimal to deteriorating growth, I think this P/E is too high.  On a simplistic basis, by paying 18x normalized earnings today, an investor will get repaid his/her purchase price in between 15 and 18 years (almost 4% of total return is dividend yield, so part of total return required is reduced by the dividend yield).

If an investor wanted to be repaid in 10 years, I'd hazard a rough guess that the P/E should be no more than 14 or 15 times normalized earnings.  This would put the target price at between $54 and $58.

Here's my analysis:

TickerPriceEPS yr 2015P/E

PEG Analysis

Another one of my overly simplistic tools, but which has a place in my toolbox.  I've looked at the historical PEG relative to PE over time.  My margin of safety is achieved by buying at the average of the lowest PEG mutiples over the last 15 years.  I get a target price of $62.34.

Adj EPS1.171.001.501.812.162.482.603.073.563.393.533.853.123.833.983.858.88%Compound
G = -14.53%50.00%20.67%19.34%14.81%4.84%18.08%15.96%-4.78%4.13%9.07%-18.96%22.76%3.92%-3.27%9.47%Average
Avg price28.4631.7144.6544.5954.4452.7555.6061.1960.8151.1059.9863.5761.2576.9978.5980.70
Avg P/E24.3231.7129.7724.6425.2021.2721.3819.9317.0815.0716.9916.5119.6320.1019.7520.9621.33Average
Prem/disc to historical PEG113.0%147.3%138.3%114.5%117.1%98.8%99.4%92.6%79.4%70.0%79.0%76.7%91.2%93.4%91.8%97.4%62.34

Comparative Analysis Amongst Peers

Ben Graham would conduct comparative analytics across companies across similar and completely different industries to get a feel for current valuation vs. comparables.  I've done the same comparing PG, KMB, UL, and CL:

Market Cap190,14538,583120,50056,627
Net (cash) / debt23,4357,69512,2666,188
Revenue (ttm)76,88518,43752,64816,736
EPS (ttm)3.455.191.892.49
P/E (ttm)19.9619.9520.7424.68
PE (09 low)10.5010.507.6015.38
P/E prem/disc to 09 low190.06%190.03%272.90%160.49%
EBITDA (ttm)17,7693,76910,1734,293
EBIT (ttm)13,9532,9418,6984,130
EV / EBITDA (ttm)12.0212.2813.0514.63
EV / EBITDA (09 low)9.917.126.0010.00
EV / EBITDA prem/disc to 09 low121.29%172.45%217.51%146.32%
EV / EBIT15.3115.7415.2615.21
EV / Sales2.782.512.523.75
Yield % 3.67%3.21%3.31%2.34%
EBIT Margin18.15%15.95%16.52%24.68%
EBITDA Margin23.11%20.44%19.32%25.65%
10 year rev g3.30%6.00%10.00%7.20%
10 year earnings g3.00%3.20%8.40%9.00%
5 year rev g0.90%3.10%2.00%5.50%
5 year earnings g-1.20%0.15.30%2.10%
Current ratio1.000.820.681.19
Interest coverage22.3210.2819.3331.77

On a simple comparative basis, I'd be more preferential to Kimberly Clark vs. P&G, why? Lower P/S, lower overall EV (perhaps an acquisition target?), similar yields, higher 10 year growth, similar P/E's.  None of the comparables appear super cheap at the moment.  I find it amazing that at the trough of the 08/09 crisis, these companies were trading at EV/EBITDA multiples of between 6x and 10x, vs. 12 to 15 now!

Monthly Chart

Lastly, an analysis of the monthly trend.  I like to do this last because I don't want to introduce bias into my fundamental analysis.  A monthly trend over a long enough time period should be sufficient to capture most of the major peaks and troughs over multiple business cycles:

My initial target for a cycle low is between $55 and $60.  Caveat! Trendlines break!  There's no reason why if long term support going back to 1990 doesn't hold on a test of say, $63, P&G can't chop around for a few years at anywhere between $49 and $63. 

Finally, my overall summary of target prices and qualitative analysis

Explain industry composition and characteristics; - Steady, mature, established industry, minimal growth
Assess potential barriers to entry;- Cost structure vs. potential new entrants, not likely lower
- Patent protection over its products vs. new entrants
- Minimal customer captavity (access to customer demand) that new entrants or competitors don't have
- Company's products are not habit forming (i.e., Coke, Cigarettes)
- Customers are not faced with high search or switching costs vs. staying with the incumbent (i.e. Microsoft)?
Assess potential Economies of Scale;- Does the company have economies of scale in combination with barriers to entry?Not necessarily
- How big is the potential market for new entrants?Large market
- Does the company concentrate its focus on one product area or does the company focus on multiple product areas?Multiple
- Does the company operate regionally or globally?Globally
Average target price all scenariosPaul SonkinGreenwald EPVBS ReproductionPrice Sum of the PartsGabelli PMVPE vs PaybackDDM PEG Monthly trend
AT Cap Rate4.80%
Target Cap Rate10%
Average prem/disc to EPV21.81%
Target disc to EPV-30%
Average EPV - Reproduction cost-3
Price EV/EBITDA prem/disc109.55%
Target EV/EBITDA prem/disc70%
Total return on assets10.60%
Highest divisional return on asset40.54%
Current PE req'd "g" 10 yrs15
Current PE req'd "g" 15 yrs6
Value of perpetual dividend only55.53
Prem/disc to perpetual dividend23.82%
Current prem/disc to historical PEG97.4%
Trough prem/disc to historical PEG70.0%
Target price54.6848.1356.265655.5362.3460

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