Procter & Gamble Earnings Show Stock Is Not A Safe Place To Hide

Turning around a company like Procter & Gamble (NYSE:PG) is like turning around a battleship. The performance of the consumer staples giant over the past decade proves the truth of that aphorism.

Procter & Gamble has turned itself around but hasn't done so quickly—or easily. A process that started in 2012 took years to bear fruit. The shares closed at $161.25 on Friday.

When it did, P&G finally got back to being the powerhouse it had been in the past. And PG stock turned from being a laggard to a leader. It pays a significant dividend, distributing $3.65 per share annual dividend for a yield of 2.33%.

However, the problem at the moment, precisely, is that the turnaround is complete. There's little, if anything, left in the way of operational improvements or cost-cutting. Yet, PG stock is trading at historic highs, highs which seem to price in a continuation of the admittedly impressive growth over the past few years.

That outlook appears far too optimistic. Significant challenges loom. Broad market trading has become increasingly volatile.

Some investors are, no doubt, looking to PG stock as a place to hide from that volatility—but there's a good chance those investors will wind up disappointed.

The Turnaround Finally Hits/h2

It took time and effort for the P&G turnaround to work. It began in 2012 with a $10 billion 27x earnings for essentially zero profit growth quite obviously is not an attractive fundamental combination. Even the dividend yield looks far less attractive now that the 10-year Treasury bond is heading toward 3%.

The PG stock chart seems to highlight valuation worries as well, with the stock repeatedly stalling out at the $165 level going back to late December—and doing so again last week.

There's no doubt that this is a great business. But it's priced as such—to say the least. And investors who think that simply owning a great business is a way to avoid market volatility need only to look at PG stock in the past. Even when the company was performing well in 2008-2009—and, again, raising its dividend 10% annually—the stock still dropped by more than one-third from the beginning of 2008 to March 2009 lows.

Taking The Broader View/h2

To be fair, the valuation worries cited here are perhaps a bit misleading. It's true that P&G's earnings growth is going to be rather modest in FY22. But, as the company pointed out on its post-earnings conference call last week, the problem is higher costs. Chief financial officer Andre Schulten said on the call that higher prices for commodities and freight, plus foreign exchange effects, would total a $3.2 billion headwind for the company this fiscal year.

That figure is after-tax, and works out to about $1.26 per share—more than 20% of the guided core EPS of about $5.85. Some of that pressure is being offset by higher pricing—but not all of it.

So, the underlying business is performing better than EPS guidance might suggest. Total profit won't be flat year-over-year because P&G isn't selling enough; it will be flat year-over-year because inflation has spiked worldwide. In fact, as Schulten pointed out, since the fiscal year began, P&G has raised its estimate of these impacts by 56 cents. Yet, guidance has stayed intact. Excluding those external pressures, the business is performing better than even the company expected it would nine months ago.

The problem, however, is that those pressures don't seem likely to change any time soon. There's no sign commodity pressures are going to ease. Labor and freight inflation remain elevated.

The stronger dollar is perhaps the biggest issue. One of the big problems for P&G last decade was a sharp rise in the dollar. A stronger dollar means that international revenue—56% of last year's total sales—is less profitable, since local currency sales turn into fewer US dollars. That problem is only amplified by the fact that rivals in those countries can undercut P&G on pricing, since they don't face currency pressures at all.

The same Federal Reserve rate hikes driving the 10-year yield higher are likely to strengthen the dollar, since they increase potential returns in dollars on capital from around the world.

To be sure, P&G isn't likely to face another $3 billion-plus in headwinds in FY23. Nor is a stronger dollar alone likely to send the company and the stock back to the dark days of 2015-2018.

But those downside scenarios aren't what is priced in at 27x earnings. Continued growth is. And as well as P&G has performed over the past few years—and even in the most recent quarter—there are an awful lot of stumbling blocks to that growth going forward. Nervous investors are unlikely to ignore those challenges, which means a falling broad market is likely to bring PG stock down with it.

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Disclaimer: As of this writing, Vince Martin has no positions in any securities mentioned.

Written By: Vincent Martin