Wednesday, August 22, 2012

Procter & Gamble Equity Research

Another day, another lowering of guidance from the under performing Procter & Gamble (NYSE: PG).

The stock price is now below what it was five years ago and the company seems to have been hit with one issue after another. Most commentary focuses on management's inability or unwillingness to take decisive action, but I think the problem is a more subtle one. Every cycle is different and I think the last few years have significantly challenged the way PG traditionally runs its business.

My thesis is that the company has tended to hold its prices in a downturn in order to retain the value of its classic consumer brands and then tried to regain market share when the economy recovers. The problem is that this recovery has been a lot slower than in previous cycles. Consequently, PG now finds itself with prices that are too high, causing market share erosion. The obvious solution is to offer innovation, but this is proving thin on the ground.

Before developing this point further, I want to summarize the change to the guidance issued in the latest presentation.

April to June QuarterPrevious GuidanceCurrent Guidance
Organic Sales Growth      4 to 5%       2 to 3%
Net Sales Growth      1 to 2%      -1 to -2%
Core EPS    79 to 85c     75 to 79c
All in EPS  121 to 123c   117 to 126c
And for fiscal 2013.
Fiscal 2013Guidance
Organic Sales Growth 2 to 4%
Core EPSflat to mid single digits
Core EPS Growth Ex FXflat to mid-high single digits
The market did not like the lowering of guidance and it is seen as confirmation on tough ongoing conditions. It has been one thing after another for PG. Commodity cost increases have trimmed margins, the weakness in developed markets has held back revenue growth and now the slowdown in the emerging world is challenging its growth strategy.


Weaker Developed Markets Recovery and Now Emerging Markets Faltering

As discussed above, the weak recovery in developed markets has changed the way that consumers shop. Consumers are much more inclined to visit Dollar stores and purchase private label, value or discounted brands. Indeed, competitors like Church & Dwight (NYSE: CHD) have been grabbing market share in certain categories. Church & Dwight has 40% of its revenues in 'value' brands and is able to benefit from a weak mass consumer environment. The same cannot be said for PG's brands nor its strategy.

It isn't the only company experiencing these problems. I note that Johnson & Johnson (NYSE: JNJ) gave weak results on its consumer division in the last quarter. The difference is that JNJ's problems partly stem from some production issues whilst PG's are more fundamental. It is losing out to a company like Colgate Palmolive (NYSE: CL), which is more focused on soap and oral care. Colgate is able to innovate and defend market share much better than PG. In addition, its innovation is better because of a tighter focus on research and development.

The longer term plan for PG is to shift revenues toward the emerging markets and since 2000 emerging markets have grown from 20% of total sales to 37% today. This is a worthy idea and considering the populations and growth prospects in the emerging world, it is a no-brainer. However, it does bring about challenges. For example, a company like Yum Brands has seen its focus on generating emerging market growth lead to its dropping the ball in its existing marketplace. Fast moving consumer goods (FMCG) are so-called for a good reason. If you fail to retain brand value, are too highly priced or lack innovative ideas then consumers will punish you. And quickly.

Throw in the slowing emerging market growth and the perfect storm seems to be gathering for PG's business model.


What is the Latest Plan?

The plan outlined recently was not so much a fundamental overhaul as more a series of piecemeal adjustments wrapped up in management talk of a more focused and balanced approach. As such, PG spent a lot of time discussing what it was not going to do! There will be no buybacks, no exiting of existing investments, no pulling out of markets already entered and no stopping country/product expansions.

Instead, there will be an increased focus on its top brands and in its 10 most important emerging markets. Pricing will also be cut in certain brands. it all makes perfect sense but I get the impression that analysts and investors need more than this.


Will it Work?

Frankly, it smacks of a bit of tactical adjustment to tide the company over until the macro-economy hopefully improves. In a sense, this is all investors can really expect PG to do because its brands are not going to morph into value brands overnight. The company is structured for a different kind of economic cycle and its management is finding execution to be extremely difficult. That said, there is a huge amount of cash on the balance sheet and I think that it's time for PG to start thinking about purchasing some value brands to complement its existing portfolio. It could also buy some brands in faster growing segments of the consumer space like skin or eye care.

Dividend investors will value the chance to pick up he stock with a higher yield but growth investors will probably take a pass here. It is hard to see a quick turnaround. PG just wasn't made for this type of economy and restructuring a behemoth is not going to happen overnight.