P&G's Edge Unwavering

In fiscal 2015, sales ticked up 1% organically but 2% when excluding the brands that will be divested. Beauty remained a laggard, with segment sales off 1% versus last year. However, health care (up 4%) and baby, feminine, and family care (up 3%) were bright spots. We think the market share gains achieved in U.S. laundry, U.S. diapers, and adult incontinence signal the potential that can be realized across the firm's mix when innovation and marketing are on target, supporting P&G's brand intangible asset, although these investments take time to yield measurable gains. In addition, the firm's efforts to drive out excess costs are notable and ultimately should provide the fuel to reignite its brands. Excluding the impact of unfavorable foreign exchange, adjusted gross margins increased 80 basis points to nearly 50%, and adjusted operating margins rose 130 basis points to the high teens/low 20s.

We suspect the market fails to share our view that P&G can return to mid-single-digit annual sales growth and maintain its percentage of sales spent on research and development, which stands at roughly 2.5% of sales and is in line with peers. We think P&G's strategic endeavor to rightsize its brand mix is a wise course and shows that the firm aims to become a more nimble and responsive operator. Further, we think this should enable P&G to increase its focus (from both a financial and personnel perspective) on the highest-return opportunities, which is critical in the intensely competitive environment in which it plays. We've long thought these initiatives would play out over the next few years rather than a couple of months. As such, we don't expect to materially alter our $90 fair value estimate.

Globally, P&G's categories grow roughly 3% annually, so the firm would have to grow 1%-2% faster than the markets and categories in which it competes, which we view as achievable, particularly in light of recent strategic efforts. Further, we contend that the firm possesses growth opportunities for its brands in many overseas markets (such as the liquid laundry and diaper pant categories in China), as it works to tailor its mix to meet the preferences of local consumers. We're also encouraged that P&G is realizing some margin improvement from its ambitious initiative to shave $10 billion from its cost structure while investing behind its core brands, and we think more improvement is probably in the cards. Beyond reinvesting in the business, we expect dividends will remain a 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 over the next 10 years.

New CEO, but We Expect No Change in Strategic Focus More than two years after his return to the helm, A.G. Lafley will step down as CEO in November, and David Taylor--a 35-year company veteran who has headed the health-care business since 2013 and was recently tapped to bring beauty care and grooming into his fold--will assume the reins. Lafley will continue to serve as executive chairman to ensure a smooth transition.

We weren't surprised Lafley would look to step down from running the day-to-day operations as P&G closes the chapter on strategic efforts put in place a year ago to shed more than half of its brand portfolio. From an internal perspective, Taylor struck us as the heir apparent, given his grasp of P&G's vast product and geographic footprint.

We expect Taylor to continue implementing the playbook P&G has been operating under the past few years--maintaining a stringent eye on extracting costs from its operations, while fueling investments behind product innovation that resonates with consumers and marketing. Beyond articulating and implementing the firm's strategic efforts, we think the onus will be on him to ensure P&G's large global employee base remains engaged in its strategic direction (unlike a few years ago).

Despite its efforts to slim down, we don't think P&G will sacrifice its scale edge, maintaining around 90% of its sales base, or more than $70 billion in annual sales. However, we expect it will better focus its resources (personnel and financial) on its highest-return opportunities, enhancing its brand intangible asset and cost edge.

Righting the Ship by Jettisoning Brands Procter & Gamble previously entered too many new markets--particularly emerging markets, where competitors already have a leg up--too quickly, and new products failed to resonate with consumers, as evidenced by its languishing market share position. However, P&G's plan to shed around 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.

These actions build on 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. Overall, we think the combination of these efforts will enable P&G to up its core brand spending behind product innovation and marketing support, which is critical given the ultracompetitive landscape in which it plays, while at the same time driving improved profitability. We forecast margin expansion at the gross (up around 200 basis points to 51%) and operating income line (up 350 basis points to 23%) over our 10-year explicit forecast.

Economies of Scale Make a Wide Moat P&G is the leading consumer product manufacturer in the world, with around $80 billion in annual sales. Its wide 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 P&G maintains in its categories (over 30% of baby care, 70% of blades and razors, more than 30% of feminine protection, and in excess of 25% of fabric care), we think 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 ($9 billion each year, or 11% of sales) for core brands. This is comparable to the approximately 2% and 11%-13% of sales spent on research and development and marketing, respectively, by wide-moat peers Colgate CL and Unilever UL/UN.

Even a slimmed-down version of the leading global household- and personal-care firm will still carry significant clout with retailers, and we think P&G's actions will support its brand intangible asset and its cost advantage. We forecast returns on invested capital (including goodwill) to average 12% over the next five years, well in excess of our 7.1% cost of capital, solidifying our take that P&G maintains a wide economic moat.

Weak Consumer Spending Has Effect 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 fluctuations, which could have a negative impact on sales and profitability.

From a category perspective, despite some of the gains the firm is realizing within the U.S. diaper and laundry categories, beauty remains a challenge, as organic sales remain at the level of a year ago. Management has noted that Olay in particular continues to struggle, although Pantene appears to be gaining some traction, posting mid-single-digit organic sales and growing its share base over the past several months. Despite this, we suspect the 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 this improvement is sustainable.