P&G Still Faces Uphill Battle

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Procter & Gamble’s third-quarter results arrived with little fanfare, as underlying sales rose modestly (up 3%, reflecting 2% higher volume and a 1% price increase) but profit expansion was more muted (underlying gross margins ticked up 20 basis points to 50.0%, and the core operating margin expanded just 10 basis points to 18.8%).

While the firm’s $10 billion cost-cutting efforts to reduce overhead, improve material costs from product design and formulation efficiencies, and increase manufacturing and marketing productivity appear to be taking hold, a large portion of these savings is front-end loaded–reflecting plans to trim the employee base about 10% this fiscal year–as supply chain and manufacturing improvements tend to take longer to implement.

Management narrowed its fiscal 2013 earnings per share guidance by raising the bottom end of the range by $0.02 to $3.96-$4.04, and while we intend to review the assumptions underlying our discounted cash flow model, our $70 fair value estimate remains in place for now, although we may bump it up slightly. We still regard P&G as a wide-moat giant that enjoys the benefits of scale and unprecedented brand reach, but a healthy dose of reinvestment (both in research and development and marketing) will be needed for the business to truly turn the corner.

Analysts were struck by management’s commentary regarding the heightened competitive landscape in hair care (overall organic beauty sales dropped a disappointing 1% year over year). This runs in contrast to recent remarks from L’Oreal, which alluded to realizing early traction in its recent premium hair-care launch in the United States under the L’Oreal Paris brand.

The hair-care aisle historically has been ultracompetitive and one in which P&G has stubbed its toe in the past; the Pantene reset just a few years ago left consumers dazed and confused. P&G is also looking to garner a larger slice of this segment–launching its line under the Pantene franchise, priced at a 200%-250% premium to the base Pantene line–and today’s announcement could indicate that its product set is falling short in the eyes of consumers, a topic analysts hope management addresses on its upcoming earnings call.

Despite some glimmers of hope, we contend the firm has a ways to go down the road of driving sustainable and profitable growth. For one, analysts question the degree to which recent revenue growth reflects the benefit of rolling back prices in some product segments to narrow the price gap with competitors and enhance competitive positioning. From our perspective, promotional spending isn’t a sustainable or profitable strategy over the long run, but rather product innovation that resonates with consumers is what will ultimately turn the tide at this 800-pound gorilla.

In addition, many doubt that today’s results will put the concerns of activist investor Bill Ackman (who has become more vocal regarding his disfavor with management, particularly CEO Bob McDonald) to rest. From our view, management cannot afford to fall short of its promises again, as the clock is ticking on its turnaround.

 

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