Beyond the Brands at P&G

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor of Morningstar's OptionInvestor. Today it's my great pleasure to welcome Lauren DeSanto, who is a stock analyst covering consumer products companies for Morningstar. Thanks for coming.

Lauren DeSanto: Thanks for having me, Erik.

Kobayashi-Solomon: So, I just wrote a bullish article on a company that you cover, Procter & Gamble, P&G, and wanted to ask you a little bit about this firm. When I think about P&G, what I think of is just the marketing power. But you make a good point that it's also – their story is about economies of scale, also distribution scale. Can you just talk about how those things make a moat for P&G?

DeSanto: Sure. Well, I would say one leads to the other. So, while P&G has really been very focused on brands and consumer understanding, and that's really what they excel at. They are the best in the business at understanding consumers. They have then been able to build this portfolio of billion dollar brands and brands that achieve more than half a billion dollars in sales. As you get these brands, it gives you some leverage with retailers. So they're able to go to the retailers with a great portfolio of brands, and say, 'You know, if you want these on your shelves, here is the terms we like.' And they're able to negotiate.

Kobayashi-Solomon: So in other words, they can say, 'Look, we want to sell this kind of minor brand.'

DeSanto: Possibly, right.

Kobayashi-Solomon: 'If you want to sell our major brand, you're going to have to pick up this minor brand.' Is that part of it?

DeSanto: Exactly. That's part of it. Also they can say, 'We understand this category extremely well. We can segment it. We know the consumers that are in it. So you're going to want these different kinds of brands in here. Oh, we offer all those kinds.' So, they do segment categories very well.

Kobayashi-Solomon: So really providing retailers kind of a pull for the consumers to pull people into the stores.

DeSanto: Exactly, that's what strong brand equities essentially do. And so, as they – and it kind of creates a self-fulfilling cycle because as they get more sales for these brands, and learn more about the consumer from these brands, they're able to develop new products, expand overseas, expand their brands into new markets, where they again learn about consumers.

Kobayashi-Solomon: And I guess, they can also start pushing on suppliers a little bit as well, right?

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DeSanto: Certainly these – they have the scale to do it. When you've got billion dollar brands, suppliers want to partner with you, they want – wherever you are around the world and P&G has certainly done that. They have expanded their global footprint of their manufacturing facilities in other markets.

Kobayashi-Solomon: You know what surprised me when I was first researching P&G is a little snippet saying that they sold to about 4 billion people, and I think, there are only about 6 billion people on the earth, so they are selling to like two-thirds of the people on the planet.

DeSanto: They sell to a lot of people on the planet, and in a lot of their markets, though, they are underpenetrated with some of their brands. In some of the new markets they may go in with, say, maybe a paper towel or toilet paper or diapers, and then later on bring in toothpaste or detergents. So they…

Kobayashi-Solomon: I see. Kind of learning about the market first and then working their way up.

DeSanto: Exactly. And they're able to definitely kind of bring those into the markets as they go along.

Kobayashi-Solomon: Got you. Now right now in the news, of course, there is Europe.

DeSanto: Yes.

Kobayashi-Solomon: Everybody is worried about Europe, and Europe is imploding or exploding or falling apart, I don't know what any of those mean, but people are worried about Europe.

DeSanto: Sure.

Kobayashi-Solomon: What do we have to worry about with P&G? They must have a lot of exposure in Europe.

DeSanto: They do; about 20% of the sales or so come from Europe. Now what I would say is that if we hadn't just come out of a very recessionary environment in the U.S., I'd be more concerned, but I think, the company has really learned a great deal over the past year and a half about where consumers are. So that's one thing I would say.

Kobayashi-Solomon: Right.

DeSanto: The second thing I would say is that they are very used to dealing with the European markets, and European consumers are already very different from U.S. consumers. And German consumer is already a very frugal consumer. P&G and other multinational consumer products firms have adapted to work with hard discounters in Europe, such as ALDI and Lidl. So, they are really used to consumers many of whom, and especially in Germany don't really care about brands.

Kobayashi-Solomon: I see.

DeSanto: So, they've already really worked to understand how to adapt to these markets. So while it's not an insignificant concern, they're fairly well positioned and there has been a lot of learning the past year.

Kobayashi-Solomon: Yeah. That's what I was thinking that they've really kind of battened down the hatches as the U.S. consumer was having problems a couple years – for the last couple of years.

DeSanto: Right. And what they've done is they have said, there has been this trend for multinational CPG firms to \try to push consumers up to more value-add products, higher margins products, which are better for the company, but what they found was consumer said, we can't afford some of these products, trading back down to lower margin value products. And so P&G has kind of repositioned some of its portfolio and it's kind of beefed up some of its value brand, so from that standpoint, I would say, they are better positioned now to cope with the consumer with a smaller wallet than they were two years ago.

Kobayashi-Solomon: I see. So right now, P&G is trading at a pretty significant discount to your fair value estimate.

DeSanto: Yes.

Kobayashi-Solomon: What kind of assumptions, valuation assumptions have you made in terms of sales growth and profitability and so forth?

DeSanto: Sure. I think they have a target generally speaking of about 4% to 6% longer-term sales growth, and I think that's very achievable. That's pretty much about a 100 basis point above most of the category growth that they are – of the categories they are in.

Kobayashi-Solomon: Right, yes.

DeSanto: So, I think, they're able to do that.

Kobayashi-Solomon: So, inflation plus a little bit?

DeSanto: Exactly, exactly. So, they're able to do that. I think, I have operating profits growing a little bit faster. I think, there are opportunities for cost savings in their cost structure. They have a new CEO, who's very focused on improving productivity.

And again, they have the scale advantage. So, I think they can, as they get – you know, they can take in new products into new products, there is a scalable factor there.

Kobayashi-Solomon: That's what I was just thinking, maybe that process of – as they penetrate the new markets and start to sell more, maybe higher value-added products and…

DeSanto: You know, they've already got the infrastructure there, so let's bring on products X, Y, and Z and it's just added profits for them. So, I think, there is some opportunity for that.

They've have enjoyed some savings from advertising rates over the past year, so that's a little bit of…

Kobayashi-Solomon: Oh, because the advertising rates have been weaker.

DeSanto: Right. And they're coming back up. So, I think, there is a bit of a headwind there that they'll be facing. At the same time, you've got input cost declining. So while I think longer term the trend isn't necessarily the best for commodities, that's very longer term, I think right now they're going to see some breaks on the commodity front. So, that could provide a benefit to gross margins.

Kobayashi-Solomon: I see. Some offsets.

DeSanto: Exactly. So, longer term, their earnings growth target is mid single digits, 5% to 6%.

Kobayashi-Solomon: So, certainly not heroic assumptions?

DeSanto: No. Right.

Kobayashi-Solomon: It's not like you're assuming that they're growing in the mid-teens.

DeSanto: No, it's a very solid company, very safe company, strong credit rating from Morningstar. So, there's just a lot to like about it. Right now, obviously, the market kind of thinks maybe they are too much of a behemoth to cope with some of these problems. I would say that they are better suited than they were even a year ago, and I would say that they have experience coping with things like what's happening in Europe right now.

Kobayashi-Solomon: Sure. It seems like a good bullish bet to me.

DeSanto: Yeah. I think so.

Kobayashi-Solomon: Lauren, thanks for coming. I appreciate it.

DeSanto: Thanks for having me.

Kobayashi-Solomon: And thank you for joining us. Please stop by the Morningstar OptionInvestor website, where we have many more option investment ideas based on Morningstar's fundamental research.