Procter & Gamble (PG): A Dividend King Poised for Faster Dividend Growth

Many investors think that the only way to build truly substantial long-term wealth is to buy the next high-flying tech stock such as Facebook (FB), Amazon (AMZN), or Alphabet (GOOG).

 

However, as you can see below, boring but slow and steady growing blue chip dividend stocks, especially the dividend aristocrats and dividend kings such as Procter & Gamble (PG), are also great ways to meet your financial goals over the long run.

 

While these types of businesses don’t have the lofty growth rates boasted by some companies, their predictability has clearly benefited dividend growth investors over time.

 

 

In fact, over the past 21 years, including dividend reinvestment, Procter & Gamble has crushed the S&P 500 701% to 464%, respectively.

 

While the last few years’ worth of growth troubles for P&G may have many investors concerned that the best days are behind this venerable consumer products behemoth, when you actually dig down into the company’s business model and future growth plans, a different story comes to the surface.

 

Let’s take a look at why Procter & Gamble’s future dividend growth could accelerate and if today’s valuation makes it a solid long-term core holding for any diversified dividend growth portfolio, such as our Conservative Retirees dividend portfolio.

 

Business Description

Founded in 1837, Procter & Gamble has grown into one of the world’s largest consumer goods manufacturers, advertisers, and distributors. It currently sells 65 products in over 180 countries, including some of the world’s most well-known brands.

 

Here’s a look at Procter & Gamble’s segments. Over 70% of earnings are accounted for by Fabric & Home Care (27%); Baby, Feminine & Family Care (26%), and Beauty (20%). Some of its leading brands in these categories are Luvs, Pampers, Tampax, Charmin, Downy, Tide, Cascade, Dawn, Swiffer, Febreze, Head & Shoulders, Old Spice, and Pantene.

 

Source: Procter & Gamble

 

Thanks to its global reach Procter & Gamble is a great way of achieving easy worldwide diversification, including into emerging markets, which generated 35% of the company’s sales in fiscal 2016.

 

 

Business Analysis

At first glance it looks like Procter & Gamble is in deep trouble thanks to four straight years of declining sales and falling revenue in seven of the last eight quarters.

 

 

But actually this top line decline is largely a direct result of management’s long-term growth plan, which involves selling off over 100 non-core brands (roughly 15% of total revenue) to refocus R&D and ad budgets on the company’s most important cash cows.

 

For example, prior to the brand slim down, Procter & Gamble had about 165 brands. However, the 65 most successful, including its 21 mega-brands, which had annual sales of over $1 billion each, account for 90% and 95% of revenue and profits, respectively.

 

The company has now completed phase one of the growth plan, thanks to the sale of its last 41 ancillary brands to Coty Inc (COTY).

 

The company believes the more focused approach will allow it to deliver 1% higher long-term annual sales growth and deliver margins that are 2 higher, which in a slow growth industry such as this is a huge benefit to shareholders. First quarter results were certainly encouraging with low-to-mid single digits organic volume growth across each segment.

 

Source: Procter & Gamble Investor Presentation

 

Better yet, with fewer products to make, management has spent the last five years finding ways of squeezing $7.2 billion in inefficiencies out of its manufacturing, and supply chains. However, management is just getting started.

 

 

In fact, Procter & Gamble thinks that its new leaner business model will allow it to, thanks to advances in manufacturing automation, cut another $10 billion in savings from its production costs over the next five years.

 

 

That is part of the reason that management has made an impressive goal to return up to $70 billion in cash to shareholders over the next three years. This will mostly be in the form of buybacks.

 

However, over the long-term, a vastly reduced share count will make growing the dividend easier (via a lower payout ratio), and thus help the company continue to hopefully generate market-beating total returns in the future.

 

 

Business transformation aside, there are numerous reasons to like Procter & Gamble’s business. The company’s strengths begin with its deep understanding and constant adaptation to evolving consumer trends. P&G spends close to $2 billion each year on R&D, carrying out thousands of studies to gain consumer insights and develop relevant product technologies.

 

With the right products under its wings, P&G cranks up its advertising budget, which regularly exceeds $7 billion per year. It’s no wonder why consumers are so familiar with most of the company’s brands.

 

As a result, P&G’s products dominate the shelves at many retailers. Most of the company’s 20+ billion-dollar brands boast #1 or #2 positions in their category or segment, and P&G is #1 in seven of its 10 categories. Incredibly, P&G’s products touch approximately 5 billion consumers daily!

 

Importantly, non-food consumer products are very sticky, resulting in a relatively slow pace of change. Roughly 85% of households in America are constantly filled with the same 150 items, according to IRI Market Advantage. Furthermore, 60-80% of all new product launches fail. This makes it all the more difficult for smaller rivals to break into P&G’s market share.

 

It’s no surprise why Warren Buffett’s dividend portfolio is filled with consumer staples stocks!

 

Key Risks

There are three main risks to consider before buying shares of Procter & Gamble.

 

First, while the consumer goods and healthcare industry is historically one that is very recession-resistant, that doesn’t mean that it isn’t rife with cut throat competition.

 

For example, Procter & Gamble must constantly be innovating in the form of new and improved versions of current hit brands in order to maintain and hopefully grow market share, which means taking on rivals such as Unilever (UL), Kimberly Clark (KMB), Clorox (CLX), and Colgate-Palmolive (CL).

 

In addition, while P&G invests billions each year (11% of sales) into advertising to maintain its brand equity and the pricing power that goes with it, we can’t forget that in times of economic hardship consumer’s might always choose to go with generic store brands that pretty much do the same thing but at much lower prices.

 

In other words, while Procter & Gamble’s recent brand culling and hyper focus on efficiency and cost cutting might mean that margins jump in the coming year, don’t forget that those high margins (gross margins are expected to hit 51% within the next decade versus 49.6% last year) need to be protected, behind high R&D and ad spending that totals 14% to 15% of total revenues.

 

This brings me to the second major risk: management’s ability to deliver on its promised efficiency initiatives.

 

While current CEO David Taylor, a 35-year veteran of the company, has done a great job continuing the previous management’s road map to cost cutting greatness, there is always the risk that the low hanging fruit has already been plucked.

 

In fact, if management gets too aggressive with cost cutting, including a 30% decrease in employee count, there is a risk that productivity and R&D innovation may suffer.

 

Or to put it another way, P&G might have become so fond of cost cutting to grow earnings that it might end up cutting too deep and getting rid of not just unnecessary fat, but also muscle or bone. This is essentially what has happened to IBM over the past decade (combined with financial engineering gimmicks).

 

Finally, we can’t forget that one of Procter & Gamble’s biggest strength could also become a major weakness.  That’s because Procter & Gamble derives about 60% of its sales from outside the US.

 

As you can see from the first quarter results, the negative currency effects of the strong and strengthening U.S. dollar are expected to be a big headwind for the company in 2017. In fact, earnings per share growth took a 7% hit, while operating margins were 1% lower due to the strong dollar.

 

 

With the probability rising that the Federal Reserve will raise interest rates several times next year, as well as long-term treasury yields increasing thanks to the pro growth/inflation effects of a Trump stimulus package, the strong dollar may be something P&G investors have to deal with for several years to come.

 

However, it shouldn’t have an impact on the company’s long-term earnings potential. By the far the biggest factors are management turning P&G back to profitable growth and executing on the cost savings targets.

 

Dividend Safety Analysis: Procter & Gamble

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

 

Procter & Gamble has a Dividend Safety Score of 99, indicating that Procter & Gamble has one of the safest dividends of any company in America.

 

In fact, Procter & Gamble’s dividend track record is the stuff of legend. For example, 2016 marked the 60th consecutive year of dividend growth for the company.

 

Even more impressive? Procter & Gamble has paid a dividend every year since 1890 (126 years).

 

This dividend reliability is a function of the low volatility (recession-resistant nature) of the consumer goods industry, as well as the company’s strong brand portfolio which gives it a wide moat and decent pricing power. These strengths helped P&G power through the last recession with just a 3% dip in revenue. The company’s stock also outperformed the S&P 500 by 23% in 2008.

 

 

Procter & Gamble’s wide moat and pricing power also results in industry-leading profitability. The company has reliably delivered operating margins near 20% for most of the past decade. Such stability is usually a good indicator that a company’s dividend is secure.

 

 

High and stable operating margins and relatively low capital intensity are a recipe for great free cash flow generation, and P&G is no exception. The company has generated positive free cash flow for more than a decade, easily supporting its safe and growing dividend. Without free cash flow, companies must rely on fickle debt and equity markets to fund their businesses (and dividends).

 

 

A final key factor making Procter & Gamble’s dividend one of the safest in the market is the company’s fortress-like balance sheet, which has less leverage than most of its peers and sports an “AA-” credit rating from S&P. The company’s ability to borrow cheaply helps to lower its cost of capital, raise its overall profitability, and more easily cover the dividend with strong earnings and cash flow. P&G’s $15.9 billion cash pile alone more than doubles its dividends paid last year ($7.4 billion).

 

 

Despite all of the moving parts over the last year, P&G’s dividend remains extremely secure. The company’s payout ratios are reasonable considering its business stability, free cash flow generation is excellent, profit margins are resilient, and the balance sheet is very sturdy.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Procter & Gamble has a Dividend Growth Score of 48, which means its dividend growth prospects are about even with that of major U.S. corporations (median 6.1% CAGR since 1990).

 

Note that the company’s 20-year payout growth rate has been excellent, but P&G’s dividend growth rate has decelerated over the last decade. In fact, the company’s last dividend increase was a 1% raise in April 2016.

 

 

Thanks to the negative sales effects of the company’s brand streamlining, Procter & Gamble’s payout ratios, both on an EPS and free cash flow basis, have risen to levels that make future double-digit dividend growth unlikely.

 

As seen below, P&G’s dividend consumed 70% of reported EPS during the company’s most recently completed fiscal year. This is a much higher level compared to 10 years ago when P&G’s payout ratio sat closer to 40%.

 

 

PG’s free cash flow payout ratio is 63% over the last 12 months, indicating that management needs to first deliver on its margin improvements before it can return to more aggressive payout growth.

 

Once the dust finishes settling from its portfolio transformation and some of the company’s profit growth initiatives build momentum, an eventual return to mid-single digit dividend growth seems reasonable.

 

Valuation

In the last two months, rising long-term interest rates have helped to push PG’s stock down 6.5% compared to the market’s 4.3% rally.

 

That being said, shares of P&G still trade at a steep forward P/E multiple of 21.6 and offer a dividend yield of 3.2%, which is roughly in line with the company’s five-year average dividend yield of 3.15%.

 

With a 13-year dividend yield range of 1.77% to 3.82%, the shares might, in a worst case scenario (such as a 2008-2009 market crash) pull back to $70 or so (versus a price of $83.50 today, a drop of 16%).

 

Of course 50% market crashes are historically rare, and thanks to P&G’s rising dividend, strong payout growth prospects going forward, and relatively small downside risk (thanks to its low beta of 0.59), P&G seems to represent a reasonable core dividend growth choice for risk averse investors such as retirees.

 

From a total return perspective, Procter & Gamble targets low-to-mid single digits organic sales growth and mid-to-high single digits core earnings per share growth over the long term. With 60% fewer categories and 70% less brands to manage, plus the company’s solid first quarter results, there are several reasons to believe P&G can deliver on its guidance.

 

If the company hits these objectives, P&G’s stock has potential to deliver 8-11% annual returns (3.2% dividend yield plus 5-8% annual earnings growth). The stock’s current multiple doesn’t look cheap, especially if growth becomes a challenge again, but the safety and income growth components of P&G continue to make it an appealing holding for long-term dividend investors.

 

Conclusion

While no one knows if Procter & Gamble will beat the market in the coming two decades like it has in the past, the company’s current growth plan is encouraging. Management has thus far proven very good at delivering on its cost-cutting efforts, and the most recent quarter has shown that the company is once more experiencing accelerating, if still somewhat slow, organic volume growth.

 

Combined with the planned cost savings of the next five years, as well as likely increases in R&D and ad spending on its most lucrative brands, this blue chip dividend king should be set to continue delivering the kind of rock solid income and reasonable payout growth that should make long-term income investors happy in the years to come (especially those living off dividends in retirement).