Global consumer products powerhouse Procter & Gamble (NYSE: PG) reported disappointing second quarter results on January 27th (fiscal year ends in June). The company’s scale played against it in the second quarter as its outsized presence in emerging markets exposed it to severe currency headwinds. Consequently, increased pricing was not sufficient to prevent revenue from falling 4% year on year due to a negative foreign exchange impact of 5 percentage points. Likewise, cost savings could not preclude a year on year decline of 40 basis points in gross margin, which faced the brunt of unfavorable geographic and product mix also. Additionally, heavy impairment and restructuring charges dragged down net income as well as diluted EPS by 31%. Second quarter revenue stood at $20.1 billion, while net income was $2.4 billion and diluted EPS was $0.82.
P&G’s performance was not much better in non-GAAP terms either, which excludes the impact of foreign currency movements. Organic sales expanded by 2% year on year during the quarter, which was at the lower end of the company’s guidance of low to mid-single digit organic sales growth. Core EPS, which excludes discontinued operations and restructuring charges, declined by 2% year on year to $1.06. This puts P&G in a difficult position to achieve its full year guidance of low to mid-single digit growth. However, on a constant currency basis, core EPS grew by 6% in the second quarter, which keeps the company in the run for achieving the full year guidance of double digit growth in constant currency core EPS.
We are currently updating our price estimate of $87 for Procter & Gamble to reflect the second quarter results.
Currency Headwinds Eat Into Revenue Growth
Adverse foreign currency movements dealt a severe blow to Procter & Gamble’s second quarter top line and depressed revenue growth by 5 percentage points. Foreign exchange impact on the company’s business units ranged from 4 to 7 percentage points. The total foreign exchange impact on the bottom line was to the tune of $450 million in the second quarter alone; and the cumulative effect in the current fiscal year is estimated to be at $1.4 billion. Over $1 billion of this headwind is expected to originate from just six countries, namely Russia, Ukraine, Venezuela, Argentina, Japan and Switzerland. This marks the most significant currency impact that P&G has ever faced in any fiscal year.
The strengthening of the US dollar has impacted Procter & Gamble worse than most of its competitors because of the sheer scale of its presence in emerging markets. The company derives over $8.8 billion sales from the aforementioned markets, which is 2 to 3 times its next biggest competitor. This has resulted in disproportionate effect of foreign exchange fluctuation on P&G’s performance.
Higher Prices Impede Volume Growth
In the second quarter, P&G achieved positive volume growth in only one of its business units, Fabric Care and Home Care. Volumes in the Baby, Feminine and Family Care segment were flat compared to the same period previous year, while volumes of Beauty, Hair and Personal Care, Health Care, and Grooming segments fell by 2% each.
In contrast, P&G achieved pricing growth in each of its segments with the exception of Health Care, which remained flat. Pricing growth was the highest in the Grooming unit, in which higher prices contributed 4 percentage points to revenue growth. Interestingly, the Grooming business was also the worst hit by currency headwinds, which pulled down the unit’s revenues by 7 percentage points.
The company resorted to higher prices to counter currency headwinds and commodity cost inflation. Further, it has stated that price upticks in the near term will be centered in the developing markets, while no such increase in prices is planned for the developed markets.
However, declining volumes indicate that consumers may be shunning P&G’s products in favor of lower priced products of its competitors. This is especially true for developing markets, where the premium category products have not seen the same kind of adoption rates as in developed markets. When seen in conjunction with the sluggish economic growth in major markets like China, it is quite possible that P&G’s higher prices may result in loss of market share as consumers switch to cheaper alternatives.
Cost Savings Fail to Protect Margins
P&G’s gross margin fell by 40 basis points in the second quarter, while operating profit margin 80 basis points compared to the same period previous year. The decline in gross margin was led by an unfavorable geographic and product mix, followed by currency headwinds and commodity cost inflation. Selling, general and administrative (SG&A) costs as a percentage of sales also increased by 40 basis points year on year. This, along with the lower gross margin, contributed to the decline in operating profit margin.
On the flip side, the company achieved substantial manufacturing cost savings during the quarter, as part of the ongoing restructuring program. SG&A costs also declined on an absolute basis, thanks to savings from efficiency and productivity efforts in marketing spending and overhead.
However, P&G failed to convert these cost savings into improvement in bottom lines, due to the combination of high commodity cost inflation and currency headwinds. The company has the practice of importing its products into diverse geographic markets rather than manufacturing products locally, which inherently results in higher commodity costs. This practice includes imports into countries like Venezuela, Argentina, Russia and Japan, currencies of each of which have significantly weakened against the US dollar. This resulted in substantial currency headwinds on costs also, which puts additional pressure on the bottom line in the second quarter.
To address this issue, P&G has plans to localize its manufacturing supply chain over time so that its foreign exchange exposure can be curtailed. It is currently building about 20 new manufacturing facilities in those developing markets that have caused the most significant currency headwinds. The company is also attempting to source materials locally in order to further reduce the impact of foreign exchange fluctuations.
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