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Commentary

Strong Dollar Weighs on P&G, But Wide Moat Intact

We’re lowering our fair value estimate for Procter & Gamble due to the negative impact of currencies, but the firm’s underlying business is gaining traction and shares look modestly undervalued.

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While  Procter & Gamble’s (PG) headline second-quarter results were bleak (with sales down 4% and earnings before tax off 8%), we haven’t swayed from our view that the firm’s underlying business is gaining traction. As such, P&G’s wide moat, which stems from its expansive scale and brand power, is firmly in place. However, in light of the negative impact foreign currency is having on current-year results, we’re taking our fair value estimate down to $90 per share, from $94. We now expect sales to slip 3.7% this year (which compares with 1.7% growth previously), and operating margins to approximate 19.4% (versus 20.1% previously). The profit impact is more pronounced, as the firm isn't manufacturing in the locations it is selling, a challenge that is unlikely to abate, but is not indicative of the firm’s fundamentals. Shares are off around 3%, and at a slightly larger discount, we’d contend that the stock would be an attractive investment in a sector where discounts are few and far between.

Excluding foreign currency rates and one-time charges (including a $0.26 per share impairment related to its battery business), sales ticked up 2%, driven by higher prices and favorable product and geographic mix, and operating margins contracted 60 basis points to 20.2%. We still believe efforts to bring new products to market that prove valuable to consumers are paying off. In fact,  Kimberly-Clark (KMB) recently noted that it suffered share losses at the hand of P&G in both U.S. diapers and adult incontinence. This commentary runs in line with P&G’s disclosure at its investor conference in November 2014 that Pampers (P&G’s largest brand, with $10 billion in annual sales) had overtaken Huggies and now controls around 38% share of the U.S. diaper market, about 300 basis points above the level held by Kimberly.

From a category perspective, fabric and home care and baby, feminine, and family care proved bright spots, with underlying sales up 3% and 4%, respectively. However, beauty remains a challenge; segment organic sales ticked down 1%. As such, we view the recent appointment of David Taylor to the helm of this business (while he also continues to run the global health and grooming operations) favorably--a fresh perspective might be just what is needed to put this business on more stable ground. Olay is still a struggle, though Pantene continues to improve, posting seven straight months of market share gains. We aren’t blind to the fact, though, that the performance in this category could prove lumpy given the fierce competitive dynamics of the U.S. hair care space.

P&G also disclosed that to date, 35 brands (including the pet-care and battery business) have been sold or discontinued or will be consolidated, out of the 90-100 it plans to shed. We continue to believe that P&G's efforts to focus on core brands will aid financial performance without sacrificing scale and negotiating leverage with retailers. 

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Erin Lash does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.