How One Blue Chip Stock Fooled Every Investor

blue-chip-stockThere are stocks that fit legendary investor Peter Lynch’s category of “stalwarts” – companies that are growing earnings in the high single-digit percentage zone, pay a solid and reliable dividend, and are often great core holdings for retirement portfolios.
Many people consider Proctor & Gamble (NYSE:PG) to be one of those stocks. But I think that’s a terrible mistake.  The company’s recent earnings report spells out a number of deeply concerning issues.
The biggest concern is Proctor & Gamble’s lack of growth. Net company sales were only up 3% on a constant-dollar basis (60% of its business is outside of North America at this point).  By category, beauty rose 2%, grooming by 1%, fabric/home care by 6%, baby/feminine/family care by 2%, and health care was flat.
With slow sales growth, diluted EPS increased only 2%. Surprisingly, 50% of the company’s EPS growth was a direct result of share repurchases.
On the margin side, core gross margins fell 1.1%. This was offset by some reductions of selling, general and administrative expenses. The end result was operating margins that grew by a tiny 0.2%.
Those results are pretty unimpressive…This is not even close to stalwart territory. And it’s a sign that this is a globally moribund business.  It’s somewhat disconcerting considering the company’s reach (180 countries) and a portfolio of famous products, including Head & Shoulders, Olay, Pantene, Wella, Braun, Fusion, Gillette, Mach3, Always, Crest, Oral-B brands, Pringles, Ace, Ariel, Dawn, Downy, Duracell, Gain, Tide, Febreze, Bounty, Charmin and Pampers.
Even more unsettling is that these are considered consumer staples – the products that people use in their everyday lives.  The problem facing this blue chip stock is that all of these products now face stiff competition. With many stores now offering private-label brands – and more consumers looking to save money on everyday items – P&G appears to be taking a hit.
Additional competition is coming from “dollar stores” including Family Dollar Stores (NYSE: FDO). Although many dollar store products are branded, many aren’t. Dollar stores have been expanding over the past ten years, and shoppers who were paying higher prices at grocery stores have migrated to the dollar stores. Whether branded or not, the margins on the dollar products are small.
These are just a few of the factors contributing to P&G’s decline.
The bright spot for P&G is what most mature companies enjoy: robust cash flow.  Operating cash flow was $9.45 billion, and free cash flow was $6.84 billion. Of that free cash flow, $5.1 billion was returned to shareholders as a dividend.  Still, operation cash flow fell 10% and free cash flow was down 15%.
P&G clearly isn’t going out of business, and there’s more than enough free cash flow to keep paying (and increasing) its dividend in the near term.
But the real problem for investors is that the stock trades at $81. Analysts estimate that P&G will earn $4.21 in 2014 (a 4% YOY increase). Long-term earnings growth projections are at 8%.
But when I compared the share price to the EPS, it’s easy to see that  the stock trades at pricy 19x earnings. It’s a mistake to buy this expensive stock for its 3.1% yield, without recognizing that the stock is trading at two-times its fair value.
If P&G shares fall to $40, I would happily buy the stock. At that price, the current dividend would deliver a reasonable 6.2% yield.
Disclosure: Lawrence Meyers does not own P&G.


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