P&G's Pullback Is Investors' Potential Gain

We think the pullback in

Top-line growth across the industry remains elusive. Despite the market’s seeming lack of confidence, we believe the benefits of P&G’s more focused investments should yield improvements across its product mix, bolster sales and volume growth, and subsequently strengthen the brand intangible asset source of its wide economic moat. We believe P&G is poised to increase underlying sales at a 4% clip longer term, with nearly two thirds of its annual growth from increased volume and the remainder from higher prices and improved mix. But we don’t think these top-line gains will come at all costs; rather, we think P&G is working to reignite sales while also beefing up its profitability. We expect its current $10 billion cost-saving effort will lead to 500 basis points of operating margin gains, yielding a 24% margin over the next 10 years, and fuel spending behind product innovation and marketing to combat competitive pressures.

Focus on Highest-Return Opportunities Following a multiyear effort to cull around 100 brands from its mix, leaving it with 65 brands, P&G appears poised to benefit from an enhanced focus on its highest-return opportunities. Recent results, which have included a return to low-single-digit sales growth, suggest the company is beginning to realize the fruits of these efforts. More-targeted brand spending should also enable P&G to more effectively respond to evolving consumer trends, which we view as key in light of the ultracompetitive landscape and sluggish growth prospects around the world.

We believe even a slimmed-down version of the leading global household and personal-care company will carry clout with retailers, maintaining its scale edge. The 65 brands P&G continues to operate include 21 that generate $1 billion-$10 billion in annual sales and another 11 that account for $500 million-$1 billion in sales each year. We think that by supplying products across multiple categories, including fabric care, baby care, feminine care, and grooming, trusted manufacturers like P&G are critical to retailers looking to drive traffic, both into physical stores and onto e-commerce platforms.

We believe P&G is looking to drive sustainable and profitable growth over the long term, which we view as prudent. The company is working to extract another $10 billion in costs, aiming to reduce overhead, lower material costs, and increase manufacturing and marketing productivity. In our view, P&G is unlikely to let the entirety of these savings fall to the bottom line; instead, we expect these funds will fuel brand investment to prop up sales and support the intangible assets (entrenched retail relationships and leading brands) that underlie our wide economic moat. We forecast margin expansion at the gross as well as operating income lines.

Valued Retail Partner We assign Procter & Gamble a wide economic moat resulting from its intangible assets and cost edge. With its leading market shares (more than 25% of baby care, about 65% of blades and razors, over 25% of feminine protection, and more than 25% of fabric care), we think P&G is a valued partner for retailers, supporting its intangible asset moat source. We believe the company maintains the resources to bring new products to market (spending nearly 3% of sales or $2 billion on R&D annually) and tout that fare in front of consumers (spending around 11% of sales or $7 billion annually) to drive traffic into stores and onto e-commerce platforms, subsequently enhancing the stickiness of its retailer relationships. In our view, trusted manufacturers like P&G, which operate with a product set that spans the grocery store, are critical to retailers that are reluctant to risk costly out-of-stocks with unproven suppliers. Despite the bargaining power garnered by a consolidating base of retailers, leading brands like P&G's still drive store traffic. Bolstering its competitive position is the size and scale P&G has amassed over many years, which enables the company to realize a lower unit cost than its smaller peers, resulting in a cost advantage.

P&G’s slimmed-down portfolio still carries significant clout with retailers, and we think its enhanced focus supports the company’s brand intangible asset and cost advantage. The 65 brands it continues to operate had already accounted for more than 85% of its top line and 95% of its profits. As such, we didn’t anticipate P&G would sacrifice its scale edge but would be able to better focus its resources (both personnel and financial) on its highest-return opportunities. Returns on invested capital including goodwill have averaged more than 11% annually over the past 10 years, exceeding our 7% cost of capital estimate, and we think the company can continue to outearn its cost of capital over the next 20 years, supporting our take that P&G maintains a wide moat.

Subject to Consumer Spending Like others, P&G has fallen victim to muted consumer spending and persistent cost inflation that has yet to fully abate. Promotional spending the past few years has conditioned some consumers to expect lower prices, and lackluster innovation has in some instances failed to prompt consumers to pay up for new, higher-priced products. Further, with around 60% of its sales derived outside the United States, P&G is exposed to changes in foreign exchange rates, which could have a negative impact on its financial performance, as the company isn't always manufacturing in the locations where it's selling, a challenge that is unlikely to fully abate.

We don’t think P&G’s issues are limited to slowing global growth, competitive pricing, and unfavorable foreign exchange. We think the problems have run deeper, as the company overextended itself in the past to build out its product mix and geographic footprint. While P&G was slow to react, management has responded with another cost-saving effort to reduce head count and overhead, improve manufacturing efficiency, and free up funds to reinvest in its business. We also view the pruning of the brand portfolio as a positive.

From a category perspective, grooming remains a challenge, as consistent organic sales growth has proved elusive. Competition from lower-priced upstarts as well as demographic trends favoring facial hair the past few years are partly to blame, but we think this underperformance is also attributable to lackluster offerings. The company is working to recalibrate its pricing, investing in on-trend new products, launching its own subscription-based sales model, and driving trials by sending razors to 18-year-old U.S. males, but competition is unlikely to subside following Unilever’s deal to acquire Dollar Shave Club. As such, we expect low-single-digit sales growth will persist.