P&G’s earnings report was well received by the market last week. Currency-neutral earnings per share grew 12%, margins expanded nicely, and management’s expectations for improving organic sales growth trends were reaffirmed. After analyzing the report, we are happy to keep P&G in our Conservative Retirees dividend portfolio. However, many investors remain concerned about underlying volume trends across each of P&G’s segments.

Organic sales declined by 1% last quarter, driven by favorable price/mix benefits of 3% and a volume decline of 4%. Volume declines were seen across every segment: Beauty -4%, Grooming -3%, Health Care -6%, Fabric Care & Home Care -2%, and Baby / Feminine / Family Care -6%.

The primary fear is that organic sales growth built on price increases alone is unsustainable. While we agree with this idea, we do not think P&G’s true volume growth was as weak as the numbers suggested. We also believe that investors need to maintain a long-term view with where the company’s transformational efforts have the business headed over the next five years, not the next quarter. These are substantial initiatives that will not pay off overnight.

Starting with the quarter, P&G’s organic sales fell by 1%. During its conference call, the company estimated that its intentional efforts to exit less profitable product categories and SKUs attributed about 1% of the total sales growth decline. Another 1% came from inventory level adjustments and capacity constraints within US Baby Care. These non-core factors could explain some of the drop in sales volume and suggest true organic sales might have actually grown during the quarter. Still, there are many moving pieces at P&G right now, and it sounds like the company is only about halfway through reviewing its remaining product portfolio for less profitable areas to step away from.

Perhaps most importantly, P&G said it expects organic top line growth to resume in Q2, with further strengthening in the back half of its new fiscal year. While it’s a very short window, management even said that October organic sales growth was 3% so far and expects the price-volume gap to narrow as the next fiscal year progresses.

P&G is digesting a lot of change right now. When the dust settles, it will have exited 60% of its brands while retaining 94% of its pretax profit by the end of September 2016. Many are griping about lackluster volume growth, but few are analyzing why those trends have occurred in the first place. While P&G’s massive size, excessive number of brands, and lack of focus have almost certainly played a role, we think the rise of private label products and consumers’ changing preferences have contributed even more.

The recession and poor marketing efforts from big brand name players caused more consumers to purchase private label products. According to the Private Label Manufacturers Association, nearly one of every four products sold and $1 of every $5 of all sales in 2014 was credited to store brands. In supermarkets, unit and dollar shares now stand at 23.1% and 19.5%, respectively (up from about 14% of US dollar supermarket sales throughout the 1980s and 1990s). Across combined retail outlets, which include mass merchandisers and Walmart stores, shares came in at 21% in units and 17.7% in dollars. Growth in private label has doubled the growth rate in name brand products over the last three years.

In 2010, 57% of consumers also agreed with the statement “Brand names are not better quality,” according to Time Magazine. More recently, that figure was closer to 65%. Private label products are improving in quality, packaging, and promotion, taking market share, shelf space, and brand loyalty from old giants like P&G. After all, if brand names are not perceived to be of superior quality, why would a consumer pay a premium for them? For that reason, many consumers are not returning to higher-priced options.

While it is hard to argue with the adverse impact the private label trend has had on parts of P&G’s business, it’s equally important to remember that not all consumer goods are equally susceptible to the private label threat.

Once P&G’s portfolio transformation work concludes, Baby Care, Fabric Care, Hair Care and Grooming will represent about 60% of its sales and profits (the other six categories are Feminine Care, Family Care, Home Care, Skin Care & Personal Cleansing, Oral Care, and Personal Health Care). The following table is from The Integer Group and shows the percentage of shoppers who were “OK” with considering private label options for each of the categories below. The survey was taken in 2010 and 2013 to highlight any change in trends.

Most of P&G’s remaining brands are concentrated in categories where consumers have the least amount of interest in private label and the most dependence on brand names – laundry detergent (65% are not “OK” with private label), health & beauty products (66%), and shaving products (70%). Aside from health & beauty, the trend from 2010 to 2013 appears to be stable in these categories.

P&G Private Label

Source: The Integer Group

The million dollar question is what P&G’s organic sales growth will look like once its transformation is complete? Will sales volume grow again? If not, it’s hard to get excited about the stock, which trades at 20x forward earnings today.

We believe the company’s volume will show growth again, albeit at a low single-digit rate. Most of the company’s remaining 10 product categories are in areas where private label is less of a threat. The company is focusing more R&D and marketing dollars on fewer brands, driving more competitive product innovation and even greater consumer awareness. The company’s remaining brands have also exhibited healthy organic sales growth and profitability over the last three years and maintain #1 or #2 market share positions, suggesting P&G will continue playing from a position of relative strength.

We also like that fact that, according to IRI Market Advantage, 85% of American household needs are consistently filled with the same 150 items, and 60-80% of new product launches fail. In other words, P&G maintains a highly durable and sticky position with the 5 billion consumers they touch daily, and new entrants really struggle to win over consumers who are happy with incumbents’ offerings.

P&G’s annual investments of $2 billion in R&D and $8.3 billion in advertising further strengthen the company’s ability to take back market share with better products and promotion in coming years. On its earnings call, P&G noted that more than 10 major product innovations on its leading brands will be launched this year, and most are proprietary technologies that will be leveraged for multiple years. New product innovation will be a key for P&G to drive organic volume growth in future years, and hopefully it has found some magic with its most recent technologies coming to market. The company’s growing presence in developing markets (over 25% of total sales) will also help longer-term, although it has hurt recent results.

As expected, there will be bumps along the way on the path back to clean organic sales growth. Few things in life are truly linear. With over 60% of P&G’s sales coming from outside of the US, foreign currency fluctuations have been a major headwind the last couple of

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