Stock Analysis: Procter & Gamble (PG)

Company Description:

The Procter & Gamble Company (P&G), incorporated in 1905, is focused on providing branded consumer goods products. The Company markets its products in more than 180 countries. During the fiscal year ended June 30, 2007 (fiscal 2007), the Company was organized into three global business units: Beauty and Health, Household Care and Gillette GBU. P&G had seven segments under United States Generally Accepted Accounting Principles: Beauty; Health Care; Fabric Care and Home Care; Snacks, Coffee and Pet Care; Baby Care and Family Care; Blades and Razors, and Duracell and Braun. In September 2006, the Company's Sure brand (an antiperspirant and deodorant brand) was acquired by Innovative Brands, LLC. In January 2007, P&G acquired HDS Cosmetics Lab Inc., which manufactures and markets Doctor's Dermatologic Formula (DDF) skin care.

Click here for a full description of the company’s operations (provided by Reuters).

Annual Report Highlights (latest report is for the period ending 6/29/07):

Description of Business

Business Model. Our business model relies on the continued growth and success of existing brands and products, as well as the creation of new products. The markets and industry segments in which we offer our products are highly competitive. Our products are sold in over 180 countries around the world primarily through mass merchandisers, grocery stores, membership club stores and drug stores. We have also expanded our presence in “high-frequency stores,” the neighborhood stores which serve many consumers in developing markets. We work collaboratively with our customers to improve the in-store presence of our products and win the “first moment of truth” — when a consumer is shopping in the store. We must also win the “second moment of truth” — when a consumer uses the product, evaluates how well it met his or her expectations and whether it was a good value. We believe we must continue to provide new, innovative products and branding to the consumer in order to grow our business. Research and product development activities, designed to enable sustained organic growth, continued to carry a high priority during the past fiscal year. While many of the benefits from these efforts will not be realized until future years, we believe these activities demonstrate our commitment to future growth.

Key Product Categories. In 2007, one product category accounted for 10% or more of consolidated net sales. The laundry category constituted approximately 16% of net sales for fiscal years 2007 and 2006 and 17% of net sales in fiscal year 2005. In fiscal year 2005, we had three product categories, including the laundry category described above, that accounted for 10% or more of consolidated net sales. The diaper category represented approximately 11% of net sales in fiscal year 2005. The retail hair care category accounted for approximately 10% of net sales in fiscal year 2005. Fiscal year 2006 net sales percentages for the above categories decreased due to the addition of The Gillette Company on October 1, 2005.

Key Customers. Our customers include mass merchandisers, grocery stores, membership club stores, drug stores and high-frequency stores. Sales to Wal-Mart Stores, Inc. and its affiliates represent approximately 15% of our total revenue in both 2007 and 2006 and 16% of total revenue in 2005. No other customer represents more than 10% of our net sales. Our top ten customers account for approximately 30% of total unit volume in 2007, compared to 31% in 2006 and 32% in 2005. The nature of our business results in no material backlog orders or contracts with the government. We believe our practices related to working capital items for customers and suppliers are consistent with the industry segments in which we compete.

Sources and Availability of Materials. Almost all of the raw and packaging materials used by the Company are purchased from others, some of whom are single-source suppliers. We produce raw materials, primarily chemicals, for further use in the manufacturing process. In addition, fuel and natural gas are important commodities used in our plants and in the trucks used to deliver our products to customers. The prices we pay for materials and other commodities are subject to fluctuation. When prices for these items change, we may or may not pass on the change to our customers, depending on the magnitude and expected duration of the change. The Company purchases a substantial variety of raw and packaging materials, no one of which is material to our business taken as a whole.

Trademarks and Patents. We own or have licenses under patents and registered trademarks which are used in connection with our activity in all businesses. Some of these patents or licenses cover significant product formulation and processes used to manufacture our products. The trademarks of all major products in each business are registered. In part, our success can be attributed to the existence and continued protection of these trademarks, patents and licenses.

Competitive Condition. The markets in which our products are sold are highly competitive. Our products compete against similar products of many large and small companies, including well-known global competitors. We market our products with advertising, promotions and other vehicles to build awareness of our brands in conjunction with an extensive sales force. We believe this combination provides the most efficient method of marketing for these types of products. Product quality, performance, value and packaging are also important competitive factors.

Research and Development Expenditures. Research and development expenditures enable P&G to develop technologies and obtain patents across all categories in order to meet the needs and improve the lives of its consumers. Total research and development expenses were $2,112 million in 2007, $2,075 million in 2006 and $1,940 million in 2005.

Expenditures for Environmental Compliance. Expenditures for compliance with federal, state and local environmental laws and regulations are fairly consistent from year to year and are not material to the Company. No material change is expected in fiscal year 2008.

Employees. The Company has approximately 138,000 employees. During the fiscal year, approximately 2,200 employee positions were eliminated from the Company as a result of the Gillette integration. This brings the total positions eliminated as a result of the Gillette integration to approximately 5,000.

Risk Factors

• A material change in consumer demand for our products could have a significant impact on our business.
  
• The ability to achieve our business objectives is dependent on how well we can respond to our local and global competitors.

• Our ability to successfully integrate key acquisitions, primarily Gillette, could impact our business results.

• Our businesses face cost pressures which could affect our business results.

• We face risks associated with significant international operations.
  

• Our business is subject to regulation in the U.S. and abroad.
  
• If the reputation of one or more of our leading brands erodes significantly, it could have a material impact on our financial results.
  
• A material change in customer relationships or in customer demand for our products could have a significant impact on our business.

Properties

In the United States, we own and operate 39 manufacturing facilities located in 23 different states. In addition, we own and operate 105 manufacturing facilities in 41 other countries. Many of the domestic and international facilities produce products for multiple businesses. Beauty products are manufactured at 52 of these locations; Health Care products are manufactured at 21 of these locations; Fabric Care and Home Care products at 42; Baby Care and Family Care products at 33; Pet Care, Snacks and Coffee products at 15; Blades and Razors at 8; and Duracell and Braun products at 12.

Letter to Shareholders

We’ve grown P&G sales from $39 billion to $76 billion in the past seven years. We’ve more than doubled the number of brands that generate $1 billion or more in sales each year, and now have 23 of these leading billion-dollar brands in our portfolio. We’ve more than quadrupled the number of brands that generate at least $500 million in sales, and now have 18 of these brands poised to be our next billion-dollar brands. We’ve nearly doubled the number of countries in which P&G generates a billion dollars or more in sales each year, and now have 12 billion-dollar countries. We do more than a billion dollars in sales each year with seven retail customers, up from two in 2001. We’ve generated more than $43 billion in net earnings and $50 billion in free cash flow. P&G’s market capitalization has increased more than $100 billion since 2001, and today the Company is among the ten most valuable companies in the U.S.

Fiscal 2007 Results

2007 was a good example of how P&G’s design for growth works. It was the most demanding year we’ve faced since the beginning of the decade. Energy and commodity costs continued to rise. Competitive pressure intensified. We had to complete the vast majority of work to integrate Gillette. And yet, we continued to grow well within the Company’s target growth range.

• Net sales increased 12%, to $76 billion. Organic sales increased 5%.
  


• Diluted net earnings per share increased 15%, to $3.04.
  


• Free cash flow from operating activities was $10.5 billion, or 101% of net earnings.
  


• The growth was broad-based.
  


• Fabric and Home Care grew organic sales 8%, with double-digit growth in developing markets and mid-single-digit growth in developed regions. Key growth drivers included Tide Simple Pleasures, Gain Joyful Expressions, and Febreze Noticeables.
  


• Blades and Razors organic sales increased 8%, behind the continued expansion of the Fusion razor system and growth on Mach3 in countries where Fusion has not launched.
  


• Beauty organic sales increased 5%, led by strong growth in feminine care, prestige fragrances and hair care. Billion-dollar brands Always, Olay, and Head & Shoulders each grew sales double-digits for the year.
  


• Health Care organic sales increased 6%, driven by very strong growth in oral care. In the U.S., Crest extended its category market leadership to 38% behind the success of the Pro-Health line.
  


• Baby and Family Care organic sales increased 4%. This growth was driven by continuing expansion into developing markets and strong results on Pampers Baby Stages of Development and Baby Dry Caterpillar Flex products in North America.

Growth was also broad-based across geographic regions, led by mid-single-digit organic volume growth in North America and double-digit organic growth in developing markets.

In addition to solid business growth, we made excellent progress on the integration of Gillette.

This was the largest acquisition and the most complex integration in the consumer products industry and in P&G history—and we’re about a year ahead of schedule.

We measure integration success by tracking progress in four areas: business momentum, integration financials, project management, and fielding the best team from both Gillette and P&G.

Business Momentum. Our fiscal 2007 results demonstrate that we were not distracted by the integration. We delivered sales growth in line with our growth targets behind continuing product innovation and expansion into new markets.

Integration Financials. The dilution impact on earnings per share was $0.10 to $0.12 per share. This is better than the low end of our guidance range, which was $0.12 to $0.18 per share. The acquisition remains on track and is expected to be neutral to earnings per share in fiscal 2008. We expect cost synergies to be at the top end of the $1 billion to $1.2 billion target range and revenue synergies to be on target at about $750 million next fiscal year.

Project Management. We completed the integration of our sales force, distribution networks, and billing systems. Since integration work began, we’ve added more than 50,000 new product codes and 100,000 new shipping points to P&G systems. This enables us to go to market as one company and to fully leverage P&G’s scale.

Fielding the Best Team. Our management and employee team is comprised of the best of both companies. Several of our key management positions have been filled by Gillette employees, and retention is ahead of the target we established at close. Importantly, our employee survey results indicate that Gillette employees are positive about their integration with P&G.

Strategic Focus

P&G is focused on strategies that we believe are right for the long-term health of the Company and will increase returns for our shareholders. The Company’s annual financial targets through 2010 are:

• Organic sales growth of 4% to 6%. This is comprised of:
  


• 3% to 5% pre-Gillette organic sales target, plus
  


• 1% of growth acceleration through 2010 behind revenue synergies associated with the Gillette acquisition.
  


• Diluted net earnings per share (EPS) growth of 10% or better, excluding the net impact of Gillette dilution.
  


• Free cash flow productivity of 90% or greater (defined as the ratio of operating cash flow less capital expenditures to net earnings).

In order to achieve these targets, we focus on our core strengths of consumer understanding, branding, innovation, go-to-market capability and global scale and scope against the following growth areas:

• Grow our leading brands in our biggest markets and with our winning customers.
  


• Shift our portfolio mix to faster-growing businesses with higher gross margins that are less asset-intensive.
  


• Grow disproportionately in developing markets and with lower-income consumers.
  

Financial Highlights:

Revenue Growth (1-yr): 12.1%
Revenue Growth (9-yr average): 8.6%

Net Income Growth (1-yr): 19.1%
Net Income Growth (9-yr average): 13.3%

Earnings-Per-Share Growth (1-yr): 15.2%
Earnings-Per-Share (9-yr average): 11.5%

Free Cash Flow Growth (1-yr): 20.5%
Free Cash Flow Growth (9-yr average): 24.9%

Net Profit Margin (current): 13.5%
Net Profit Margin (10-yr average): 11.1%

Return On Equity (current): 15.9%
Return On Equity (10-yr average): 33.3%

Debt Ratio (current): 0.52
Current Ratio (current): 0.78

Financial analysis:

• P&G had decreased its overall reliance on debt, which is seen from the reduced debt ratio: it currently stands at 0.52 while during the past decade it has ranged between 0.60 and 0.70.


• ROA has been fairly consistent throughout the past ten years. Currently it stands at 7.9% and 10-yr average is 12.8%


• Although ROE has been relatively consistent at mostly ranging between 30% and 40%, its absolute range for the past ten years is between 15.9% (2007) and 61.8% (1998). 10-year average is 33.3%.


• All margins (gross margin, operating margin, and net profit margin) have improved during the past ten years despite the mature business model of this consumer products giant. Profit margin has improved from 10.2% in 1998 to 13.5% in 2007 and posted an 11.1% 10-yr average. Although the 3.2% difference in the profit margins might seem as a paltry change, one has to keep in mind that it’s still a 23% improvement of the profit margin in a very large and established global company.


• Revenue growth has really picked up in the last five years as can be seen from the following: 9-yr growth is 8.6% while 5-yr growth is 13.8%. Revenue growth in the most recent fiscal year (2007) was 12.1%.


• Similarly to revenue growth, net income growth has also down very well in the 21st century. P&G posted net income growth of 19.1% in 2007 and averaged 13.3% for the past nine years. These numbers are truly amazing when you consider that this company is over hundred years old.


• Free Cash Flow margin improved from 6.3% in 1998 to 13.7% in 2007. FCF growth has seen impressive growth in this company: 20.5% in 2007 and 24.9% average for the past nine years.


• I can’t say that I like how low P&G’s current ratio is at 0.78. Its current ratio has been below 1 in four of the past ten years and when it was above, it wasn’t by much. I’m not sure how much of a concern this should for such a large company with a robust free cash flow, but if it stays below 1 for a considerable amount of time it may present a problem.


• On the efficiency side, company’s accounts receivable have been growing at a much faster pace than the overall revenue meaning that it is not getting payments from customers nearly as fast as it used to. If this trend persists, it may put a significant pressure on the operating cash flow (which it already does). A/R Turnover Ratio has decreased from 27 in 1998 to 12 in 2007; Avg. Collection Period has increased from 14 days in 1998 to 30 days in 2007. (On the other hand, P&G also takes a longer time to pay its bills: instead of taking 16 days to pay the bills in 1998, it now takes 42 days for P&G to do that.)


• Inventory Turnover has also been consistently decreasing: from 6.4 in 1999 to 5.6 in 2007. This means that every year inventory sits in the warehouse extra 8 days (65 days instead of 57 in 1999).

Discounted Cash Flow (DCF) Analysis:

I used discounted cash flow analysis to arrive at the intrinsic value of the company. I estimated that free cash flow would grow at an average rate of 9% per year for the next 10 years and at 3% (trailing GDP growth) perpetually after that.

I used a discount rate of 9.5% because this company represents a relatively low risk due to its established portfolio of products and significant market share in many market segments.

Using the assumptions listed above, my intrinsic value of the stock came out to $83.68. My intrinsic value of P&G is about 10% higher than what Morningstar has as a “fair value” for this company. Disparity most likely stems from my belief that this company will grow at least 9% annually for the next 10 years because of its great competitive standing and a very capable and competent management team while Morningstar estimates a more tepid growth.

Pros:

• Company has 23 products that bring in at least $1 billion in revenue each.

• Majority of P&G’s products are in the top 3 within their market segment.

• P&G is very profitable for a company its size and is not afraid to grow through acquisitions.

• Acquisition of Gillette has boosted company’s top and bottom lines already and will continue benefiting the company in the future through improved distribution and marketing channels.

• Company is likely to divest one or more of its underperforming businesses within the next few years.

• P&G repurchased $5.6 billion worth of common stock in 2007 and plans on buying back $24-30 billion worth of common stock within the next three years.

Cons:

• It maybe difficult to expand market share for a company of this size.

• Increased overall competition in consumer products markets is putting downward pressure on P&Gs revenue and earnings growth.

• Share price has already gone up as investors accounted for the benefits of the Gillette acquisition.

Final Decision:

I think this is one of a handful of companies that can be held for a lifetime as a solid investment. But, as with any other company, it needs to be bought at the right price to maximize the benefits of owning this company’s shares. Currently, P&G’s stock trades at $72 vs. $.84 that I have for intrinsic value of the company. Given my safety margin of 30-50%, my typical buying price range for P&G would be is $42-$59. But even now, at a discount to my intrinsic value of about 14%, I’m still considering adding this stock to my portfolio as I expect it to keep going up. I will report on my final decision when I’ll make it.