Procter & Gamble Stock: Increasing Prices Is Not Strategic Growth (NYSE:PG)

A little background foundation for an article is helpful, and let’s add a touch of investment thesis for the Procter & Gamble (NYSE:PG) investors.

Founded in 1837, P&G is a global business with products used by people in 180 countries. Sitting at #25 on Fortune’s 50, P&G garnered $80 billion in revenues over the past 12 months.

P&G business segment sales by dollars, percentages and key products are:

• Fabric & home care = $27.6B, 35% (Tide, Bounce, Downy, Swifter, Gain, Dawn, Cascade, Febreze)
• Baby, feminine and family care = $19.7B, 25% (Pampers, Charmin, Puffs)
• Beauty = $14.7B, 18% (Old Spice, Head and Shoulders, Pantene, Secret, Olay)
• Healthcare = $10.8B, 14% (Crest, Oral-B, Pepto Bismol, Vicks)
• Grooming = $6.6B, 8% (Gillette, Venus, Braun)

P&G sales by geography shows a clear reliance on the US consumer, with the breakdown as follows: North America 49% (up 7% post Great Recession), Europe 21%, Greater China, 10%; Asia-Pacific, 8%; Latin America, 6%; and India-Middle East-Africa, 6%.

P&G’s share price is down 4.67% YOY versus the S&P down 14.39%. P&G’s five-year return is 65.71%, for the S&P it is 28.71%. Over ten years, P&G has a 127.28% return versus 188.1% for the S&P. P&G’s four-year dividend return has been 2.46%.

Since 2010, P&G has doubled the number of billion-dollar brands from ten to twenty. An advertising and marketing machine, P&G has consistently been judged one of the best managed companies, with a high-performance culture; one that finds other companies seeking to poach their management talent.

The investment thesis has been simple. This is a company the investor can expect to receive a consistent return over the long term and there is little about P&G to suggest the company will be anything but successful in its attempts to gain greater global market share and increase both its revenues and its share price.

But as John Maynard Keynes once said, “In the long-term we are all dead!”

A Bit of Historical Perspective

If we look back to the Great Recession (2008-2009), P&G’s highest quarterly internal return on investment in the ensuing years was 20.93%, that in 2017, with an average over the post-recession years of about 16.5%. Those numbers are in sharp contrast to P&G’s 25.97% average return over the past ten quarters.

In fact, going into the Covid pandemic, P&G’s net income as a percent of revenues had been averaging 14.6%. Although operating expenses have increased over the past three years, like many firms, P&G has expressed concern about costs impacting its revenues and profit. While this seems to justify its number of repeated price increases, it remains that net income as a percentage of revenues has jumped over those same years. In 2020 it was 18.4%, in 2021 it was 18.9%, and in 2022 it was 18.4%. Further, Q1 2023 is starting off strongly with net income 19.2% of Q1 revenues.

A Brief Macroenvironmental Perspective

In 2021, seemingly everyone, from President Joe Biden to Treasury Secretary Janet Yellen to Federal Reserve Board Chair Jerome Powell, said inflation was transitory. Ah, but how things have changed.

In the face of global inflation, P&G has continued to raise prices claiming the need to meet the challenges of higher supplier costs. And it had decided its customers were willing to accept repeated product price increases.

In fact, in April 2022, P&G announced its fourth round of price hikes in 12 months.

Then late the next quarter they had another. If counting at home, that is five price increases in 15 months. Problematically, according to the CEO Jon Moeller…

We continue to believe that the majority of growth will be price driven with a negative volume component, as you would expect given the inflationary pressure.

P&G is projecting 3-5% organic revenue growth in 2023. But with shrinking volumes there is only one way to achieve that – price increases.

In April 2022, pointing to the 7% organic growth in revenues, P&G CEO Jon Mueller said the company’s customers are unaffected by the company raising prices, as they are continuing to buy P&G products (this notwithstanding the 3% decline in volume the company also admitted).

P&G stated in the Q1 2023 analyst call that they fully expect more volatility in costs, currencies, and consumer dynamics, as they move through the fiscal year. This includes raw and packaging material costs inclusive of commodities and supplier inflation that have remained high since they gave an initial outlook for the year in late July 2022.

It seems the mantra is “blame costs” and while P&G costs did go up in 2021, 2022 saw the same operating expenses as 2020. In FY 2022, P&G took price on 80% of its products and in Q1 2023 it was on 85% of its products.

Since costs are pretty much the only reason customers will accept for price increases, P&G is taking a page from the past to blame input costs. Still, the truth is probably closer to this sentence – P&G will raise prices so they can make more profit because they believe their customers are willing to pay more for their products.

P&G said they would continue to invest in “irresistible superiority” to compete. To a business executive, suggesting investments in “irresistible superiority” can only come in two basic flavors – actual R&D or advertising/marketing. But here’s the rub… Advertising spending was down in 2022 to $7.9 B (10% of revenues) v. 2021 $8.2 B (10.3% of revenues) and it trended down through the pandemic. But that hardly supports P&G’s argument they have invested in “irresistible superiority” through R&D because – How would the consumer really know?

Recognizing the macroeconomic and market level consumer challenges, P&G is maintaining guidance for FY2023 of 3-5%. While they believe this is a rough patch for growth, they say they remain committed to driving productivity improvements to fund growth investments, mitigate input cost challenges and maintain balanced top and bottom-line growth.

Markets, Inflation and Consumer Demand

Given their expectations, P&G has risk exposure when considering its revenue breakdown by geography. North America accounts for a robust 49% of its revenues, while the European consumer accounts for 21% of P&G’s revenues, which might be notably less elastic than the North American consumers given energy prices, the coming winter, and the ongoing Russia-Ukraine war.

Regarding that war and the decision by many global firms to withdraw completely from Russia, P&G said it has significantly reduced its product portfolio and discontinued all new capital investments, media or promotional spend. If anyone is noticing, that means reducing costs. But that does not mean they are not doing business in Russia. In fact, they remain focused on continuing to sell basic health, hygiene, and personal care products in Russia (i.e., most products).

While P&G seems to diminish Russia’s contribution to the bottom line, it operates two plants there, with 2,400 employees producing products that account for about $1.6 billion, which is not nothing given P&G’s prospect of 2023 revenue growth of 3-5% and Q1 2023 starting off at a paltry 1.3%.

This is not to ignore China, which accounts for 10% of P&G revenues (~$8 billion) and remains in a Covid two-step that has significantly reduced economic growth. Yet, China still refuses Western medicines and with the recent internal “re-opening” portends increased infections, the likely development of additional Covid variances and, with 17.8% of the population 60 years or older and millions of elderly people across China still not fully vaccinated, this is raising concerns that the virus may kill these most vulnerable citizens in huge numbers.

In the US, our consumer society is a 20th-century construct of the American Dream that has become synonymous with buying material goods such as cars, houses, furniture or electronics; as the spending habits of American households make up roughly 70% of the US gross domestic product.

Today, the US consumer is facing continued inflation, a potential recession and, for some, concerns for a possible job loss. During a recession, the entire economy is down and everyone feels the impact in one way or another. Interest rate hikes are used to slow down the economy due to rising inflation and, with less money in circulation, the unemployment numbers increase. Without work, people reduce spending.

For many, the worst-case scenario of a recession is that they could lose their job, since high unemployment numbers signify and correlate with a shrinking economy. When consumer spending goes down, it forces businesses to adjust and, in some cases, reduce operations. So they may have to lay off staff to match the decrease in consumer spending.

In the Great Recession, the US saw unemployment more than double, forcing millions of Americans out of work. Those who didn’t lose their jobs worried about wage cuts, reduced hours, and the possibility that companies won’t be as willing to offer bonuses and other financial incentives.

As we’ve seen in 2022, the prices of everything around us have increased, and people are spending ever more on essentials (e.g., rent, electricity, food), that means money does not go as far and people are unable to maintain the same quality of life.

Because of how inflation rates differ across goods and services, the lower the household’s income, the harder inflation hits. For middle-class households, the percentage of after-tax income spent on necessities jumped from 60% to 65%. For upper-class households, the shift was from 26% to 28%. Working-class households already needed 108% of their monthly income to cover the basics in 2021 and in 2022 it was 118%. This necessitates people either dip into savings, get help from relatives, access some safety-net programs, or go into debt.

Relatedly, it should be no surprise that inflation topped the list of voter issues this past election cycle. More Americans are finding that their middle-class aspirations are teetering and under such strain the consumer will inevitably look to purchase lower priced private label brands to meet their needs. And claiming product superiority does not matter when it comes down to dollars and sense (not a misspelling).

In the December 6, 2022 Morgan Stanley Retail Conference, analyst Dara Mohsenian pointed out to CFO Andre Schulten that for P&G, “Outsized pricing was driving better than expected revenue growth.” But there was also a concerning issue that volumes are down, with the result that P&G is selling fewer things but at a higher price. The CFO admitted volume was down 2-3% and that is a concern because growth through price increases is not sustainable.

Regarding consumer behavior in the US, at the same conference, Lauren Lieberman with Barclays noted, “Just the absolute sales growth that we see in tracked and untracked data does look like there’s (consumer product) category contraction going on.”

In response, CEO Jon Moeller said that P&G expected some volume reduction with price increases amidst inflationary pressures. Moeller goes on to say that tiered pricing with products – specifically fabric care and Pampers (at $7B, its largest selling product) – have helped ease concerns the consumer’s shrinking pocketbook might cause them to wander into private label products.

P&G claims to feel good where things are, but should they really?

The outlook for the global economy headed into 2023 has soured, according to a number of recent analyses, as the ongoing war in Ukraine continues to strain trade, particularly in Europe, as markets await a fuller reopening of the Chinese economy following months of disruptive COVID-19 lockdowns.

In an analysis recently released, the Institute of International Finance predicted global economic growth rate of just 1.2% in 2023, a level on par with 2009, when the world was only beginning its emergence from the financial crisis.

In the US, the Fed’s goal is to get inflation under control without plunging the economy into a damaging recession. And while a number of economic signs indicate that efforts to slow demand might be working, the threat of a recession looms.

Evidence released this week showed that business activity in the US contracted for a fifth consecutive month, as companies reacted to decreased consumer demand. Although the economy has continued to add jobs in recent months, applications for unemployment benefits are on the rise, suggesting a potential softening in the labor market.

According to the Conference Board, the economic outlook for the United States for 2023 has deteriorated under the weight of high inflation rates and rapid monetary tightening. Falling consumer and business confidence, softening consumption and investment, and geopolitics-induced energy “shocks” are likely to tip the economy into recession around the turn of the year. In 2024 and beyond, the US economy is likely to return to its slowing trend growth rate trajectory. Key risks around the longer-term US outlook are related to geopolitical frictions, environmental challenges, labor markets, and inflation.

Following a large drop in US gross GDP in 2020 due to the impact of the COVID-19 pandemic, the US economy experienced rapid growth for much of 2021. However, in 2022 this growth momentum began to sputter. The board expects inflation to remain above pre-pandemic trends for several years.

The US economy is currently grappling with a wave of high inflation driven by a confluence of supply and demand factors that the board does not expect to resolve quickly. Further, they do not expect interest rates to fall until 2024 or later. As a function of inflation, the Federal Reserve has rapidly tightened monetary policy and will continue to raise rates at least into early 2023. Following the expectation of near-zero growth in 2023, the board expects US real GDP growth to finally recover in 2024. However, over the next decade, the board expects growth will be somewhat muted relative to pre-pandemic trends.

Disruptions brought about from the pandemic will have lasting effects on the drivers of US growth ahead.

P&G: Growth r’us

The CFO says that P&G has always been able to add price to the growth equation. But what is past is not always prologue. The problem with P&G is that current senior management was not in place during the Great Recession and either discount or do not understand what P&G, like many firms, experienced during that time – A consumer willing to trade down.

Currently, we are seeing US consumers buying staples in smaller quantities, switching to cheaper, store-name brands and more rigorously hunting for deals, according to retailers and analysts. The shift is especially pronounced among lower-income consumers who splurged on household products during the height of the pandemic.

P&G’s CFO stated that the hope is consumers will have used up their pantry inventory and look to replenish the stock. However, he should be reminded that hope is not a strategy. Moreover, with a reduction in advertising spend that creates the consumer awareness about products that do not have empirical quality, the belief that P&G is building “irresistible superiority” is unrelatable for the consumer because, as was stated by Randy Burt, a managing director in the consumer-products practice at AlixPartners…

Consumers are starting to become more price sensitive in a lot of categories.

This is something that could become even more complicated as federal relief aid has gone away. This raises the key question – Will the consumer now look for lower priced substitutes?

BCG research noted that in the major markets they studied, in rich and poor nations alike, anywhere from 70% to 90% of consumers identify themselves as “value conscious” and they become more so in tough economic times. In truth, the rise of the value-conscious consumer has been a widely acknowledged phenomenon ever since it loomed large in the Great Recession of 2008, as large percentages of households traded down to lower-priced options in many product categories. BCG noted that it also observed a similar trend during the COVID-19 pandemic among lower and middle-income consumers.

A common refrain is that context matters, which resurrects the question – Will the consumer trade down, as before?

Concluding Thoughts

In 2010, coming out of the Great Recession, P&G organic sales growth for the year was 3%. In 2022, coming out of the Great Pandemic, organic sales for the year were 7% and unquestionably driven by price increases. With the consumer feeling pinched from inflation and a new recession brewing, P&G volumes are down. With a focus on margins disconnected from the consumer because of the belief in the “irresistible superiority” of its products, is there a point in the short term that P&G will see an end to its price hikes? With the 1.3% increase in organic sales growth for P&G in Q1 2023, this is a salient question.

According to CEO Jon Moeller…

While it’s relatively easy to envision many possible scenarios, steeper inflation, deep recession, further geopolitical disruption or commodity cost reversion easing inflation, and peaceful conflict resolution, it’s very difficult to assign probability to any single scenario. We remain committed to driving productivity improvements to fund growth investments, mitigate input cost challenges and to maintain balanced top and bottom-line growth.

That sounds like price increases in the future. In fact, according to CFO Andre Schulten…

We expect pricing to be the main driver in market growth with volumes slightly down. There’s no viable strategy to do anything but try to pass through the commodity cost pressures and inflation pressure. As we have taken pricing around the world and we have priced slightly ahead of the market, not significantly.

Okay… priced just “slightly ahead” rather than significantly ahead of the market. I guess it’s that “irresistible superiority” that P&G believes makes it worthwhile to the consumer. Or it just might be pure hubris.

For anyone familiar with leadership development, P&G hubris would be an unsurprising answer to why they continue to increase prices for consumers in the face of increasing profit margins.

Until most recently, the only avenue to P&G management was to be hired directly from an undergraduate or graduate business program. No management positions for “outsiders”. That means all those people in upper management today are P&G lifers who unquestionably see the world through the narrow P&G prism.

As previously noted, unlike all other P&G CEOs, Jon Moeller’s work experience is singularly grounded in numbers – accounting and finance. His resume is distinctive by its absence of business operations experience. Consequently, the concern is that Moeller brings a narrow finance “hit the numbers” perspective that would be in contradiction to P&G’s long held belief it is operationally driven and customer centric.

In the face of declining volumes, growth driven by price increases, and Q1 2023 only having a 1.3% organic sales growth, P&G’s projections of 2023 having 3-5% organic sales growth seems to suggest some people have been drinking the P&G Kool-Aid. This is a problem because Kool-Aid is a product of Kraft Heinz (KHC).