Is Procter & Gamble Co. Making a $3 Billion Mistake?

By Markets Fool.com

Image source: P&G.

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Procter & Gamble couldn't make it two-for-two. After an encouraging uptick in organic sales, the consumer goods titan just posted a growth slowdown (from 2% in fiscal Q2 to 1% in fiscal Q3). It was the seventh time in the last eight quarters that sales gains have either been flat or declined from one quarter to the next.

Rising profitability and new funds from the sale of its battery business still helped earnings jump 28% to $2.8 billion. Yet P&G's management spent more than that total, or about $3 billion, on dividends and stock repurchases.

Is the company being too aggressive by returning over 100% of earnings to shareholders while the core business is shrinking? Let's take a closer look.

Long-term problem
The first thing to note is that this isn't a single-quarter blip for the consumer-staples giant. Over the last nine months, in fact, P&G has sent out $9 billion to its shareholders, beating the $8.6 billion of net earnings it has generated. And in the last fiscal year, its dividend alone accounted for more than 100% of profits.

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PG Payout Ratio (TTM) data by YCharts

While higher cash returns are partly to blame (dividend payments are up 30% in the last five years), the real driver is a plunging earnings figure: Net profit dove 40% in fiscal 2015 and is on track to drop again this year as growth stays stubbornly low and foreign currency swings eat at P&G's bottom line.

What P&G is doing about it
Management's strategic response to this rough financial environment has been to sell off underperforming brands while at the same time cutting costs so that the parts that are left are more profitable. P&G has made good progress on both of these goals: It's portfolio is down to about 65 brands from 165 two years ago -- and it has removed billions of dollars out of its cost structure.

Investors can see the financial benefits of these changes, but they'll have to look beyond reported earnings figures to metrics like core profitability and cash flow. P&G's core gross margin, which strips out the effects of exchange rate shifts and brand divestments, jumped higher by 3 percentage points last quarter. Its cash flow productivity, or the percentage of earnings that the company converts into free cash, is surging -- and cash flow is at a 5-year high despite the smaller sales footprint.

Quarterly cash flow trends. Image source: P&G investor presentation.

Prioritizing investing in the business
Thanks to that strong cash flow, (with some help from brand divestments) executives have the funds they need to keep investing cash into the business. For P&G, that means spending on innovations around its most dominant brands like Tide, Pampers, and Gillette. Just as important, though, is hefty advertising spending in support of these global franchises.

The good news for investors is that the company is directing plenty of resources to these priorities, demonstrating that it isn't willing to short-change the business just to keep shareholder returns marching higher. On one hand, the weak operating trends helped produce P&G's smallest dividend hike in decades. However, that slow payout boost is happening in the context of a fast-growing broader capital return program.

Ideally, the cash to fund increasing returns to investors would be coming from profitable sales growth rather than a mix of cost cuts and brand divestments. But P&G still has the financial firepower to keep delivering billions to shareholders while making major investments into growing the business.

The article Is Procter & Gamble Co. Making a $3 Billion Mistake? originally appeared on Fool.com.

Demitrios Kalogeropoulos has no position in any stocks mentioned. The Motley Fool recommends Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.