Innovation, Not Sales Growth, Is Procter & Gamble's Challenge
- By Sangara Narayanan
Procter & Gamble's (PG) top management rewarded itself well after missing its own sales growth and profit growth targets.
As sales of the household goods maker kept tumbling for the last few years, the company blamed weak spending around the world and increased competition for its woes. The financial situation and the cash flow got so tight that the company, which boasts of 59 consecutive years of dividend raises, had to announce a mere 1% increase in dividends - a far cry from the near 7% increase the company has been doling out for the last 10 years.
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The intrinsic value of PG
To get out of this rut the company embarked on a restructuring mission, selling low-performance brands, focusing on higher-margin products and cutting costs to keep the bottom line from slipping too far down. As the company shifted focus on internal issues it smartly changed its compensation program to reward the management based on the effectiveness of its restructuring. I see that as a highly ineffective way to move things forward because it rewards people who fail the least.
However, it's obvious that the traditional methods of rewarding sales, growth, earnings and market share haven't been working for P&G so far so it took the easy way. What really irks me is that investors got a measly 1% dividend increase while senior management members walked away with bags of gold because they helped identify poor performers and cut out a few budget items.
Case in point: Procter & Gamble paid its new CEO, David Taylor, who took over last November, a $2.5 million bonus for fiscal 2016, bringing his total compensation for the year to $14.4 million.
According to the Wall Street Journal:
"The maker of Tide and Pampers has long awarded executives based on typical corporate metrics such as sales growth, market share and per-share earnings. Last year, P&G added a 'transformation factor' that rewards executives for initiatives that drive the Cincinnati company's restructuring , such as overhauling the supply chain, improving cybersecurity and streamlining the product portfolio.
"Mr. Taylor and his team received the highest possible marks in the transformation category with weaker scores on measures of the company's success in meeting sales and earnings targets."
On the other hand, I can understand where P&G is coming from. Compensation programs are always a sensitive issue to address, especially when you have a company that is underperforming. If you are not able to pay, then you won't be able to retain talent, but if you pay them well then investors and the market in general are not going to be happy. It's a tightrope walk, to say the least, and PG unfortunately had to pay as much as it could under the circumstances, and it is taking the flak for it.
Though things have improved internally within the company as operating margins rose this year to above 20% - much higher than the 15.6% the company achieved last year - P&G is still a long way away from being the company it once was. The company has been selling off brands at a furious pace, and nobody can clearly say how the brands they chose to retain will perform five years down the road. The composition of the product portfolio will be extremely important for the company, and the real effects of that can only be realized five or 10 years hence.
A consumer goods company such as Procter & Gamble needs durable brands that can live forever, brands that can show stable growth, keep up with inflation, retain their market share and be cash flow machines. Duracell, Gillette, Pampers, Tide and Head & Shoulders are perfect examples of that. But while it still has these brands (except for Duracell, which disappeared along with Warren Buffett (Trades, Portfolio)'s interest in the company), it needs to keep investing in research and development in order to keep its product pipeline full to the brim. In a way it's similar to the pharma industry but without the inherent risks of patent expiry, competition from generics, cheaper and more effective alternatives and so on.
R&D is the key part of its future promise; not just for finding the next billion-dollar brand but also for the top-performing brands, constant innovation is key.
Take Gillette, for example: it just can't stop innovating and although product prices have been going up every few years, as a buyer I never really bothered about the increase because the new product has always been better than the one before.
But those kinds of examples are now few and far between for P&G. Despite spending more than $10 billion in R&D over the last five years, the company didn't have a single new billion-dollar brand launched during that time - or even in the five years preceding that.
"P&G's philosophy is that scale matters. If they can build big brands, they believe they have an advantage in advertising, distribution, share, innovation, etc.," said Ali Dibadj, an analyst with Sanford Bernstein. "If a brand or innovation doesn't reach $1 billion, then it won't move the needle for the $85 billion company." - USA Today, July 2014
This is has been the biggest challenge for the company, and one that is the root cause for its problems. Unless it can fix that quickly, it's going to continue that tightrope walk well into the next decade.
Disclosure: I have no positions in any of the stocks mentioned above and no intention to initiate a position in the next 72 hours.
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This article first appeared on GuruFocus.
Warning! GuruFocus has detected 6 Warning Sign with PG. Click here to check it out.
The intrinsic value of PG
