Procter and Gamble: Can They Cope With Compensating Consumer Behavior?

The emergence of frugality as a popular trend amongst consumers should continue to affect consumer spending, which, as we recall, represents some ~70% of the US economy. Our venue of choice for gleaning insight into this trend is the earnings, statements, and behavior of Procter and Gamble (the company responsible for every brand of household necessity that you see on the store shelf). At an investor conference last week, the CEO of P&G, A.G. Lafley, made the following statement:

"In every recession there are hosts of compensating consumer behaviors as they manage a more modest budget. We have to expand our portfolios to serve the needs of those consumers. I think a lot of that is going to last"

P&G is one of the fortunate ones-their products are actually needed by consumers, and they have a broad enough product mix (Gain v Tide, Pampers v Luvs) to emphasize "trade down" products in a recessionary environment. Even they are not immune however, as the Company's most recent 10-Q indicates that Q1 earnings were bolstered largely through the combination of a one time gain from the divestiture of its Folgers coffee business, aggressive cost-cutting, and lower interest expense.

Based on the Company’s most recent 10-Q, Net Sales and Operating Income, when compared to the prior year's period, declined 8% and 7% respectively. However, these factors were offset by a 13% decline in the Company's Selling, General and Administrative Expense. Additionally, the Company indicated an 8% decline in interest expense for the quarter, "driven mainly by a reduction in US interest rates". Furthermore, $0.63/share or 19.6% of the $3.46/share earned by the Company in the nine months ending March 31st is attributable to the sale of Folgers.

We would tend to agree with Mr. Lafley’s assertion that a majority of consumer’s compensating behavior will remain in place, even as Washington and the media pronounce an end to the economic gloom. This trend is most exemplified by the average US savings rate which, after steadily climbing for all of 2009, has now eclipsed the 5% mark. This trend does not bode well for P&G, as it is our view that consumers will increasingly turn to the private label “store brand” products as part of attempt to squeeze extra savings out of strained grocery budgets. In fact, P&G will be fighting a two-front war on this issue, as grocery stores have begun aggressively negotiating costs downwards, in some instances threatening to or actually removing a particular company’s products from its shelves.

Ultimately, barring a substantial departure from the current trend, we predict a continued decline in P&G’s sales. Given that the company has already cut costs significantly, we doubt that further cost-cuts will be able to keep pace with sales declines. Additionally, US interest rates continued to rise throughout April and May, putting further pressure on the Company’s bottom line. We expect the Company’s Q2 earnings to reflect the above realities in disappointing fashion.

Disclosure: No position in PG, however I own SPY puts

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