Investors Stand to Clean Up With This Wide-Moat Firm

We believe  Procter & Gamble (PG) represents an attractive investment opportunity in a sector where discounts are few and far between. The firm has faced its share of challenges over the past several years. Even beyond the tough macro environment, where consumer spending has been ratcheted back and the competitive landscape has intensified, lackluster innovation and an attempt to overextend its geographic reach plagued P&G's financial performance and subsequently its share price. However, we now believe that recent investments behind new products, a more disciplined expansion plan, and efforts to rightsize the brand mix while improving the efficiency of operations appear to be gaining traction. As such, we contend that P&G is poised to post accelerating top-line growth as well as improving profitability metrics over the next several years.

We've long regarded P&G as a wide-moat giant that enjoys the benefits of scale with an extensive global manufacturing and distribution network and unprecedented brand reach. P&G is the leading consumer product manufacturer in the world, with more than $80 billion in annual sales. Its wide economic moat derives from the economies of scale that result from its portfolio of leading brands, 23 of which generate more than $1 billion in revenue per year and another 14 of which generate between $500 million and $1 billion in sales annually. Given the dominant market positions in its categories (the company cites it maintains over 30% of baby care, 70% of blades and razors, more than 30% of feminine protection, and in excess of 25% of fabric care), P&G is an important partner for retailers to drive traffic in their stores. Further, the size and scale P&G has amassed over many years enable the firm to develop meaningful cost advantages, resulting in a lower unit cost than its smaller peers. Overall, we forecast returns on invested capital (including goodwill but excluding excess cash) to average 16% over our 10-year explicit forecast, well in excess of our 7.4% cost of capital, solidifying our wide Morningstar Economic Moat Rating.

From our perspective, P&G supports its brand intangible assets by investing in research and development ($2 billion annually, or 2.5% of sales) and marketing ($9 billion each year, or 11% of sales). Wide-moat peers Colgate (CL) and Unilever (UL) spend approximately 2% and 11%-13% of sales on R&D and marketing, respectively. However, we note that on average over the past three years, P&G failed to realize a sufficient return on this spending, as evidence by its lagging organic volume growth, which we suspect reflects the disparity of its efforts (trying to overextend its product and geographic reach). Given the firm's renewed focus on improving the effectiveness of its brand investments, combined with the strategic rationalization of its portfolio, we expect organic volume growth will trend higher over the next several years as recent innovations begin to show up on store shelves, building upon recent gains.

By Shrinking Brand Mix, P&G Stands to Reinforce Competitive Edge
P&G's recent announcement that it intends to shed 90-100 brands--more than half of its existing brand portfolio, which in aggregate posted a 3% sales decline and a 16% profit reduction the past three years--indicates it is parting ways with its former self, looking to become a more nimble and responsive player in the global consumer product arena. We view this as a particularly important trait given the stagnant growth emanating from developed markets and the slowing prospects from emerging regions. Even a slimmed-down version of the leading global household- and personal-care firm will still carry significant clout with retailers, and we think these actions will support P&G's brand intangible asset and improve its scale advantages. The 70-80 brands it will keep already account for 90% of the firm's top line and 95% of its profits. As such, we don't anticipate P&G will sacrifice its scale edge (particularly in its largest markets of the United States, Greater China, United Kingdom/Ireland, Russia, Germany, and Japan), but will be able to better focus its resources (both personnel and financial) on its highest-return opportunities.

Most recently, the $4.7 billion sale of Duracell to wide-moat Berkshire Hathaway in exchange for its P&G shares (52.8 million shares, a transaction that is slated to take place in the second half of calendar 2015) strikes us as a sound divestment. P&G expects to incur $0.28 per share in a goodwill-impairment charge and is set to inject $1.8 billion of cash into the battery business before the close, which lowers the deal value to $2.9 billion, or 1.3 times fiscal 2014 sales and 7 times fiscal 2014 adjusted EBITDA. Despite the lower valuation relative to other deals in consumer products (which tend to approximate low-double-digit EBITDA multiples), we think the price received seems fair, as price is more important to consumers than brands in a commodity category like batteries, with R&D spending critical just to stay ahead of the competition. In addition, the growth prospects for Duracell's core battery business are limited longer term, given the growth of electronic devices with their own rechargeable batteries.

Beyond the sale of its battery business, P&G disclosed at its recent analyst day that 28 brands (including the pet-care business earlier this year) have been sold or discontinued or will be consolidated, out of the 90-100 it plans to shed. Prospective buyers are also conducting due diligence on another 10 brands; however, management refrained from offering much in regards to other specifics surrounding the brands that have been cut or any price received for the assets.

Renewed Focus on Innovation Steadies P&G's Competitive Positioning
While we've been of the opinion that P&G's pricing and brand power have come under pressure following a period of lackluster innovation, we now think the reignited focus on winning with innovation could be gaining some traction. For instance, P&G has operated as the number-two player in the U.S. diaper market for the past 20 years, following Kimberly-Clark's (KMB) launch of Pull-Ups training pants into the market. However, as a result of new product launches and efforts to get in front of new moms early on with increased sampling in hospitals, Pampers (P&G's largest brand with $10 billion in annual sales) has overtaken Huggies (a Kimberly-Clark brand) and now controls around 38% share of the U.S. diaper market, about 300 basis points above the level held by its leading competitor.

The success of its recent innovation has been particularly evident in its Swaddlers product line, which now is sold in sizes 1-6, up from just 1-3 previously; it accounts for more than $600 million in annual sales, up from less than $200 million 10 years ago and equating to a 10% value share of the category. The extension into larger-size diapers has proved to be a particular hit with cash-conscious consumers over the past several years. Kimberly-Clark management has repeatedly mentioned that sales of Pull-Ups training pants have come under pressure, given the price premium to traditional diapers (which we estimate to be around 45%, depending on the retailer). And now with the leading brands offering larger-size diapers, we question whether developed-market consumers will revert to training pants even when the economic environment improves.

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The firm is also realizing an improved share position in the U.S. laundry category; it now controls about 62% of the market, up from less than 60% during the past several years. Tide, P&G's second-largest brand with sales of nearly $9 billion each year (which includes international counterpart Ariel), has been a beneficiary, garnering 42% of the market, up from less than 40% over the past few years.

We think this reflects the success of its single-dose laundry pod launch. Single-dose laundry now makes up about 12% of the overall U.S. laundry space, with P&G maintaining 75% of this niche (accounting for $750 million in annual sales). Management has said single-dose laundry is even winning with dollar store consumers, despite selling at a 20% premium to base Tide, given the convenience it affords--it is easier to take a pod or two to the laundromat than a jug of liquid detergent. We think this showcases that consumers are willing to pay up for a product when they perceive added value. And we don't believe the benefits from this innovation are limited to the laundry aisle. From our vantage point, the fact that this technology can be extended to other parts of the firm's product set (like dishwashing liquids) further displays the leverage that can be realized from on-trend, value-added new products.

We also like that P&G isn't just letting new products speak for themselves. Even value-added new products can fail if consumers don't know about them. As such, we've been encouraged by a recent disclosure that marketing spending for Tide and Pampers is up 60 basis points and 230 basis points, respectively, in fiscal 2014 versus fiscal 2013. As the firm shrinks the breadth of its brand mix, we ultimately believe it stands to realize enhanced returns on this spending, which should ultimately aid both sales and profit growth over our explicit forecast.

Efforts to remove costs from its operations (including the firm's $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) and leverage its scale are also stabilizing PG&'s competitive position. For one, the extension of common manufacturing platforms globally is proving advantageous for its diaper business, a product that had been manufactured in a disparate form using different materials around the world, which inherently limited negotiating leverage over suppliers. However, by streamlining its manufacturing and using the same inputs on a global basis, we expect P&G to exploit its purchasing leverage and ultimately enhance its cost edge. The firm is also implementing these opportunities throughout a number of its large businesses, including blades and razors. Partly as a result of these efforts, we forecast gross margins will expand around 200 basis points over the next 10 years to 51%, about 100 basis points above its average gross margin over the past five years.

Poised for Improved Execution
Overall, we contend that the decision to shed more than half of its brands over the next two years stands to enhance the firm's focus on the highest-return opportunities. Deteriorating economic conditions in the U.S. and Europe combined with moderating growth in emerging markets like China will constrain P&G's growth prospects over the near term, which is reflected in our sales growth forecast of less than 2% in fiscal 2015 and just north of 3% in fiscal 2016. Over the long term, we continue to expect top-line growth above 4% on average annually. Globally, P&G's categories grow roughly 3% annually, so to reach the 4% annual sales growth pace we've modeled, the company would have to grow 1%-2% faster than the markets and categories in which it competes, which we think is achievable, particularly in light of recent strategic efforts. While sales growth in the U.S. and Europe may be flat or up only 1%, the company's sales in developing markets are growing 6%-8% annually. The firm has growth opportunities for its brands in many overseas markets, and in developed markets it remains the share leader in many of its categories.

From a category perspective, we anticipate that growth prospects for the beauty and grooming segments, which have continued to be plagued by lackluster innovation and intense competitive dynamics, will lag the firm's fabric- and home-care, health-care, and baby- and family-care segments over the near term. Conversely, we expect the latter segments will benefit from the success of new products particularly in the diaper and fabric-care spaces. However, we ultimately believe that the learnings derived from recent product wins and the firm's focus on ensuring its products are meeting consumer needs, rather than merely responding to competitive threats, will drive broad-based top-line growth across P&G's categories, with segment sales ranging from 4% to 5% annually.

Even though we're encouraged that P&G is realizing some margin improvement from its ambitious initiative to shave $10 billion from its cost structure, we ultimately think the firm will need to reinvest a portion of these savings to maintain its competitive positioning. Our forecast calls for operating margins of 20.1% in fiscal 2015 (compared with 19.4% in fiscal 2014), and we expect operating margins to improve to nearly 23%% by the end of our 10-year explicit forecast.

We think the potential for efficiency improvements over the medium to longer term is particularly notable in the firm's developing markets. Relative to peers like Unilever and Colgate, which have played in some developing regions for nearly 100 years, P&G is a newer entrant. However, the firm has been investing behind localized manufacturing, which should ultimately lower its cost of operating in these markets. For instance, P&G has plans in place to reduce its footprint of technical centers by around 20%, while at the same time 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.

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Growth prospects in several emerging regions, which in the aggregate account for around 40% of annual sales, have slowed over the past several quarters. However, we still believe that populations will grow exponentially, urbanization and private investment will create favorable disposable income tailwinds, and a younger consumer base will offer the potential for a lifetime of transactions ahead. We think as P&G builds out its scale, improves its distribution, and familiarizes itself with local market consumers, enriched profits in these markets should ensue. If we assume that P&G merely maintains its 52% and 23% gross and operating margins in developed markets (and continues to generate around 60% of its sales from these locations), this implies that profitability in developing regions will approximate the firm's consolidated margins of 51% and 23% by the end of our 10-year explicit forecast, which seems reasonable particularly in light of emerging-market consumers' penchant for premium-priced products, which tend to carry higher margins than those positioned at the value end.

Given the stability of its profitability and cash flows, we assign P&G a low fair value uncertainty rating. The biggest risk to our valuation is whether the firm can offset intense competitive pressures and generate significant cost savings to enhance its competitive positioning.

If investments behind research and development as well as marketing support fail to resonate with consumers, sales growth could lag our base forecast. Further, if commodity cost pressures accelerate and competitive pressures intensify, P&G could be forced to invest even more resources behind its brands. Cost savings would fall short of management's--and our--expectations, and profitability could be constrained. Taking into account this set of assumptions, sales growth would amount to just 3% on average through fiscal 2024 while operating margins would approximate 21.2% at the end of our 10-year explicit forecast. The valuation for this downside scenario is $79 (or about 15% below our $94 fair value estimate). However, we note that even under these more bearish assumptions, the firm would still outearn its cost of capital each year of our 10-year explicit forecast, generating average ROICs of more than 14% through fiscal 2024.

Standard Stewardship of Shareholder Capital Firmly in Place
P&G takes a fairly conservative approach to its capital structure, keeping its focus on maintaining investment-grade credit to be able to cost-effectively deploy capital as it sees fit. Overall, we view P&G's stewardship of shareholder capital as standard. We've been encouraged by the renewed emphasis on driving productivity while also reinvesting behind core brands.

The firm maintains a healthy amount of cash on its balance sheet (nearly $9 billion), but given management's commitment to stepping up investment in the business during the next several years, we doubt there is much appetite to raid the piggy bank for a large acquisition. Beyond reinvesting in the business, we expect dividend payments will remain a top priority of cash (the firm has paid a dividend to its shareholders consistently for more than 120 years), and we forecast mid- to high-single-digit dividend increases during the next 10 years. P&G's dividend yields around 3% annually. On average, we also forecast that the company will buy back around 2% of shares each year over our 10-year explicit forecast.

Reinvesting in Business, Returning Cash to Shareholders Take Top Priority

Potential Headwinds Unlikely to Derail P&G's Competitive Prowess
While P&G faces a number of internal and external headwinds, we continue to believe the strength of its brands and the diversity of its product set will ensure its wide economic moat remains intact. 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, and lackluster innovation has, in some instances, failed to prompt consumers to pay up for its new products. Further, with more than 60% of its sales derived outside the U.S., 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 ran deeper, as the firm overextended itself in its endeavors to build out its product portfolio and geographic footprint. While P&G was slow to react, management has now responded with a massive $10 billion cost-saving initiative to dramatically reduce head count and ultimately free up funds to reinvest in its business. More recently, the firm has followed these cost cuts with plans to halve its brand portfolio to better focus its resources, which we view positively.

From a category perspective, despite some of the gains the firm is realizing in the U.S. diaper and laundry categories, beauty remains a challenge, as organic sales remain flat with a year ago. Management has noted that Olay (which accounts for a robust $5 billion in annual sales) in particular continues to struggle, although Pantene (which generates $3 billion-$4 billion in annual sales) appears to be gaining some traction, posting mid-single-digit organic sales in the first three months of its fiscal year. But we suspect performance in this category could prove lumpy, given the fierce competitive dynamics of the U.S. hair-care space, and it will take a few more quarters until we can get a sense whether it can sustain this improvement.