A Deeper Look at P&G’s Q1 Results: Focus On The Bottom-Line Is Fine, But At What Cost?

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Procter & Gamble

Consumer processed goods behemoth Procter & Gamble (NYSE:PG) reported its fiscal 2016 first quarter results on October 23rd. [1] (P&G’s fiscal years end with June.) The company’s tunnel vision on protecting its bottom-line may be doing more harm than good in the short term. None of P&G’s five business divisions achieved positive organic revenue growth in the third quarter. This led to total organic revenue growth falling to negative territory for the first time in recent years. The company achieved strong improvement in the non-GAAP operating margin, but in the absence of top-line expansion, non-GAAP EPS contracted by 1% year on year. We believe that although P&G is on the right track for long-term growth, it may be pushing the envelope too much in the short term. By completely ignoring volume and market share growth in the short term, the company may be destroying shareholder value that could be difficult to recover even in the long term.

Snapshot of Procter & Gamble’s first quarter performance:

  • Net sales as reported declined by 12% year on year to $16.5 billion. On a constant currency basis, they decreased 1%.
  • Non-GAAP operating margin improved by 270 basis points to 23%
  • Non-GAAP EPS contracted by 1% year on year to $0.98
  • Fiscal 2016 organic sales growth guided to grow by up to low single-digits, reported sales to contract by high single-digits

Our price estimate of $76 for Procter & Gamble is nearly the same as its current market price.

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See our complete analysis for Procter & Gamble here

Price Hikes Continue Even as Volumes Slump Across the Board

Procter & Gamble has firmly emphasized in the past that it will give emphasis to value creation through margin protection, rather than pursue “meaningless” volume and market share growth. [2] In other words, P&G’s strategy to counter currency headwinds is to raise prices even if it means losing volumes and market share. This is exactly the current situation:   in the third quarter, price hikes had a positive impact of 2 percentage points, while organic volumes exerted a drag of 4 percentage points. Over the rest of the current fiscal year, P&G expects to utilize more of cost savings and product-mix to counter currency headwinds. [3]

The situation is further exacerbated by the ongoing restructuring at P&G, including the exits from unprofitable business lines and the early stage in revamp of core product categories. As we have previously mentioned, this is a transitional phase for P&G and some revenue disruption is inevitable. Nevertheless, the almost-exclusive focus on the bottom-line may end up doing more harm than good for the company and its shareholders. Organic revenue growth is expected to return to positive territory in the second quarter, [3] but P&G is unlikely to achieve meaningful volume growth in the near term.

Robust Margin Expansion Despite Reinvestments

Restructuring the product portfolio is just one of the aspects of P&G’s ongoing transitional phase. The company is simultaneously transforming its supply chain and has revamped its R&D investments. In supply chain, P&G intends to lower cost, reduce inventory, improve customer service levels, and increase product quality and process reliability. It is also localizing manufacturing and sourcing to reduce the exposure to foreign currency movements. The company is also targeting improved management of inventory and payables and has already made notable strides in these efforts. (Read: Can Procter & Gamble Return to Growth?)

These investments are being funded by the cost savings resulting from P&G’s robust productivity improvement measures. The company expects to achieve a mammoth $7 billion in cost savings in fiscal 2016, 15% above its original target of $6 billion. [3] The impact of these cost savings is clear in P&G’s margins – non-GAAP gross margin expanded by 250 basis points year on year in the third quarter, while non-GAAP operating margin improved by 270 basis points. Since most of the measures that led to these cost savings and the resulting improvement in margin are long term and sustainable steps, P&G may be able to hold on to the current margin level in the following quarters.

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Notes:
  1. Procter & Gamble Investor Relations []
  2. Procter & Gamble Fiscal 2015 Fourth Quarter Earnings Call Transcript, Seeking Alpha, July 30, 2015 []
  3. Procter & Gamble Fiscal 2016 First Quarter Earnings Call Transcript, Seeking Alpha, July 30, 2015 [] [] []