By: Steve Smith
Friday’s weak jobs data caused a recalibration in the probability and pace of additional rate hikes this year. This in turn caused a weakening of the dollar, which in turn provided a boost to shares multinationals. While the shelving of an increase in interest rates has tempered my negativity, I think consumer staples, which had been beneficiaries as investors sought shelter in defensive names, still look overpriced and likely to sell-off in coming months.
One name looking particularly vulnerable is Procter & Gamble (PG), maker of everyday household items such as detergent, toilet paper and toothpaste under brand names such as Tide, Charmin, and Crest. Full disclosure, I currently own and use all three products. So the following bearish take on the stock is a bit self-contradictory. Especially given one of my main points is consumers increasing reluctance to pay a premium for packaged goods.
But here we go with some of my bearish bullet points:
- Valuation: The shares trade at a historically high 28.3x forward p/e, but are expected to have a 3.5% and 15% decline in revenue and profits in 2016. Estimates for 2017 look for low to mid single digit growth in each. I think PG should trade at the same valuations as its 20 year average of 19.5 level. Granted, if no rate hike comes P&G’s 2.9% dividend yield once again looks very attractive.
- Competition: Ever since the financial crisis, extending through to more savvy shoppers, consumers have become less willing to pay a premium for brands, especially for packaged goods such as detergent in which the private label is essentially the same. All big box retailers from COST, Target and Walmart, offer and feature their own private labels that compete with PGs. All told P&G gets some 40% of its sales from the 6 largest retailers – those same retailers are now its competitors.
There is also increasing online competitive pressure. Amazon is entering the fray with its own brands. Amazon has history of crushing competition, even large and seemingly impregnable brands. Procter’s Gillette brand is losing share to online offering such as Dollar Shave Club and Harry’s.
- Shrinking Stable of Products: For decades, PG either developed new products internally or bought them to achieve impressive gains as it was able to use its size as a leverage to get more shelf space and the best shelf location in stores. Now, it is selling brands such as Pringles, Vicks, Crisco, Duracell, Jif, Folgers and Clairol to whittle down its product lines to about 80 from over 150. But that makes it totally dependent on in increasing market share which will be difficult. The shrink to grow strategy may not work.
- Currency: This is where the recent jobs data has thrown a bit of kink into my thesis. The dollar had been rebounding in recent weeks and would have surely climbed higher if the Fed bumped rates in June or July. But in light of Friday’s employment report, it now seems off the table. Given that PG generates some 50% of its revenue from overseas a stronger dollar would be drag on profit. So that potential headwind seems to have been neutralized for the time being.
- Chart: it recently failed to take out the high and is still in longer term downtrend. Albeit threatening an important resistance near the $84 level.
Prognosis for Proctor? Bearish
I’ve established a bearish position through the purchase of vertical put spread. Specifically;
-Buy August 80 Puts
-Sell contracts August 75 Puts
For $1.20 net Debit
These options expire August 19, which gives time to get a look at 2nd quarter earnings due on August 2. I expect the results to disappoint and the stock to sink.
This is what the risk graph of the put spread looks like. Note, it would only take around a 6.8% move down to below $75 share to push the spread fully in-the-money allowing us to realize (depending on time) a nearly maximum profit of over 220% gain.