Brands and Scale Should Help P&G Hold Off Competition


Our Wide Economic Moat Rating for Procter & Gamble (PG) is intact after the company's second-quarter update revealed that product innovations helped to accelerate volume across several categories as the quarter progressed, positioning the company for volume growth and market share gains in the back half of the year. There were pockets of weakness, notably the beauty category, and we have some concerns about the industry's promotional activity; still, we believe management's full-year expectations of 3%-4% organic top-line growth (1%-2% excluding foreign currency) and 5%-7% core earnings growth are realistic--but also contingent on second-half productivity and cost-saving initiatives. Second-quarter results were generally in line with our estimates, and there are no material changes to our long-term valuation assumptions.

Second-quarter organic sales rose 3% year over year, driven entirely by higher volume. Price rollbacks to narrow the price gap with competitors in certain categories are still a concern, but we were comforted by management's comments about innovations in fabric care, oral care, and grooming for the back half of the year. We've long held the view that product innovation is a more sustainable plan to drive volumes than promotions and will lead to more consistent cash flow over a longer horizon.

The adjusted gross margin fell 90 basis points to 50% because of ongoing beauty-care weakness and emerging-market investments, but this was neutralized by cost-cutting efforts, resulting in a 10-basis-point increase in the operating margin to 20.4%. We still think a healthy dose of research and development and marketing investments will be needed to drive momentum across all categories, but P&G's innovation pipeline gives us confidence in our longer-term assumptions, including 4% average annual top-line growth and operating margins improving to 22% by fiscal 2020.

Improving Position Through Cost Saving and Innovation
Procter & Gamble has stumbled over the past several years. The firm entered too many new markets (particularly emerging markets, where its competitors already have a leg up) too quickly, and the new products it brought to market have failed to resonate with consumers, as evidenced by the fact that its market share subsequently suffered. While management has been talking the talk with regards to product innovation, including plans to sell its successful Tide Pods line across the pond, the true test--and what we believe will ultimately turn the tide at this 800-pound gorilla--will be ensuring that its new products resonate with consumers.

To improve its competitive positioning, P&G implemented a $10 billion cost-saving initiative designed to lower costs through reduced overhead, lower material costs from product design and formulation efficiencies, and increased manufacturing and marketing productivity. For example, P&G expects to realize a 20% reduction in its footprint of technical centers by 2014, while building out its network and providing for enhanced scale in faster-growing emerging markets, where it intends to double its presence with new facilities in China, Brazil, Nigeria, and Indonesia. Despite this renewed emphasis on driving productivity while creating value for customers and shareholders, we expect these initiatives are likely to play out over the next few years rather than a couple of months. We also still think a healthy dose of reinvestment in research and development and marketing will be needed to truly turn the corner.

We wouldn't be surprised to see P&G pursue selling some of its noncore businesses. This strategic approach is similar from what we've seen recently at other leading consumer product firms, like Unilever (UL)/(UN) and Nestle (NSRGY). Given the firm's vast portfolio, we think it's essential that its resources (both financial and personnel-related) are focused on the highest-return opportunities. Although the company has been vague regarding which brands may be culled, we think its pet-care business--which has struggled recently--could be on the docket.

Size and Scale Keep the Moat Wide
P&G is the leading consumer product manufacturer in the world, with more than $80 billion in annual sales. Its wide moat derives from the economies of scale that result from its portfolio of leading brands, 25 of which generate more than $1 billion in revenue per year and another 20 of which generate more than $500 million in sales annually. Given the dominant market positions P&G maintains in its categories (35% of baby care, 70% of blades and razors, 30% of feminine protection, and 25% of fabric care), we contend that retailers rely on P&G's products to drive traffic in their stores. Further, the size and scale P&G has amassed over many years enable it to realize a lower unit cost than its smaller peers, resulting in a cost advantage. From our perspective, P&G supports its competitive advantages by investing in research and development ($2 billion annually or 2.5% of sales) and marketing ($10 billion each year or 11.5% of sales) for core brands. After perfecting the practice of trading consumers up to premium products, the firm has switched gears as consumers have been increasingly focused on value over the past several years. We think this should ensure it provides enough product diversity in its categories to keep consumers buying P&G brands rather than losing out to other branded players or lower-priced private-label offerings.

Consumer Spending and Inflation Are Risks
Like others, P&G has fallen victim to weak and volatile consumer spending combined with persistent cost inflation that has yet to fully abate. At the same time, promotional spending over the past several years has conditioned consumers to expect lower prices. Although P&G has raised prices to offset the higher costs it is incurring, competitors have failed to follow suit in some cases, which has hindered volume and constrained profitability. Further, with nearly 65% of its sales derived outside the United States, P&G is exposed to foreign exchange rate fluctuations, which could have a negative impact on sales and profitability.

Slowing growth rates around the world, competitive pricing, and unfavorable foreign exchange trends have played a part in Procter & Gamble's woes, but we think the problems run deeper, as the firm might have overextended itself in its endeavors to build out its product portfolio and geographic footprint. While P&G was slow to react, management has responded with a massive $10 billion cost-saving plan to dramatically reduce head count and ultimately free up funds to reinvest in its business. This overhaul is sizable but necessary, although we're not entirely convinced the firm can pull it off.

We also harbor some concerns regarding P&G's intentions for additional head count reductions. P&G lowered its employee base by 7,000 individuals (about 5%-6% of its consolidated base) and anticipates cutting another 2%-4% annually between fiscal 2014 and 2016. When we asked former CEO Bob McDonald last year whether these reductions were concentrated in any one segment of the business, he told us that they inherently skewed more to brand-building, which had gotten too bloated. We intend to continue to monitor these initiatives, because we think reductions in R&D could leave P&G standing flat-footed in this highly competitive operating environment. However, given the stability of its profitability and cash flows, we assign P&G a low fair value uncertainty rating.

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