Analyzing Procter & Gamble’s (PG) Quarter

By Yaser Anwar, CSC of Equity Investment Ideas

• P&G reported 2Q results which were up 17% YoY with EPS of $0.84 ahead of Street estimates. The key driver appears to once again be strong top-line growth, which were aided by moderating input costs, favorable FX conditions, Gillette integration and robust product activity. Investors should expect a strong year for the industry bellwether and sustained sales and margin expansion.

• Total sales for the quarter increased 7.6%, with organic growth up 5%. Organic growth came in below Street expectations due to slightly worse than expected trends in Baby and Family Care and Duracell, but Fabric and Home Care business continued to outperform ahead of US laundry detergent compaction in September. Developing markets grew more than 10%, with broad-based growth across the developing regions, led by China and Russia.
• Snacks sales slowed down to +2% because of share losses by Pringles and in pet food, which is growing at 5+% due to strong brands Iams and Eukanuba. Management believes it has competitive innovation as for Pringles and pet food to regain traction.
• Management also noted that although commodity costs are expected to increase once again in 07, the impact on gross margin should be below the 100+ bps of downward pressure exerted in both 05 and 06. While the environment is clearly improving, the full impact of moderating commodity costs is likely to take several quarters to flow through in the cost of goods line.
• Interest expense of $340 million was up 13% from year ago levels, on higher debt levels and increased share repurchases subsequent to the merger with Gillette. Average shares outstanding in 2nd Q to $3.4 billion.
  

  "Both P&G and Colgate said revenue growth was affected by intense competition and aggressive pricing from rivals as they fought to defend the market share of some product mainstays. P&G noted the competition its Pampers and Luvs diapers faced against private-label brands that have resisted raising prices despite high pulp prices. Meanwhile, Colgate highlighted its intention to continue to defend its Total toothpaste against P&G’s new Crest Pro-Health brand." (S: WSJ)

• Duracell’s problem with the distribution center was temporary and the issue is whether the price increases in alkaline batteries gain traction as to offset higher zinc costs. The 6% price increase is in place since early January and going forward, the level of promotions and changes in market share are key for sustainability.
• The demographics are favorable as markets such as Central and Eastern Europe, China, Southeaster and Southern Asia and Latin America have the highest birth rates and growth in household formation, per capita consumption and disposable income.
• Management noted that 1 billion consumers bought a PG product for the first time over the last six to seven years and that it expects to reach another 1 billion in the next three to five. Sales momentum in emerging markets will likely determine whether P&G comes at the upper end of or exceeds its top-line targets.
• The Street expects that price increases to recover commodities and the Gillete integration could have weighed on these trends and given the solid macros across most key emerging markets, I expect sales to accelerate.
• P&G also raised its 07 guidance, with EPS now expected in the range of $2.99-$3.03. Contributing to this upward guidance revision is continued top line momentum, as well as progress on the Gillette integration, with dilution trending toward the low end of guidance in the $0.12-$0.18 range.

According to Prudential: There are risks to our PG investment thesis. Though the integration of Gillette almost complete, there is still some risk, remote, we believe, that P&G does not generate the revenue synergies that would have justified the purchase price of 17 times EV/EBITDA (or the 14.5 times “synergized” EBITDA that P&G likes to use).

In addition, falling commodity costs could translate into falling prices on store shelves and an increase in promotional activity as competitors vie more for market share gains than profitability. Finally, the “compaction” of liquid laundry detergent could lead to uneven quarterly earnings growth in FY08 as the new industry standard is implemented.

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