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Morningstar | P&G Shakes Up Organizational Structure to Maintain Competitive Edge; Shares a Bit Undervalued

We walked away from Procter & Gamble's investor event, held in Cincinnati on Nov. 8, with renewed conviction that the firm’s efforts to reignite its sales and profit trajectory are gaining traction. However, we don’t believe management is content with the status quo. The firm announced intentions to shake up its organizational structure by focusing on six sector business units that will have direct control over strategy, product and package innovation, and supply chain in its largest markets, including North America, China, Japan, as well as developed European markets, which in aggregate make up about 80% of sales and 90% of aftertax profit. The remaining regions will fall under the purview of CFO Jon Moeller, who will add the title of COO.

This shift aligns with CEO David Taylor’s goal over the past three years to enhance accountability across the organization and better align the firm’s resources and decision-making closer to the consumer, which we view as wise. While we think this structure will help P&G to be more responsive and agile, we don’t expect it to jeopardize the company's ability to harness the benefits of its scale and negotiating leverage.

Even though P&G is not immune to intense competitive and inflationary pressures, we think its productivity initiatives, vast scale, leading brand portfolio, and entrenched relationships with retailers support its solid competitive edge and ultimately stand to bolster its performance. As such, we don’t foresee any change to our $97 fair value estimate or our long-term outlook for 3%-4% annual sales growth and around 300 basis points of operating margin expansion to more than 24% at the end of our 10-year explicit forecast. Despite the recent uptick in price, we still view the stock as a bit undervalued, trading about 5% below our fair value estimate, and we would suggest investors keep this wide-moat name on their radar.

Throughout the consumer product sector, much angst has surrounded the competitive landscape and the ability of firms to offset higher commodity and transportation costs (which were more than a 5-point headwind in P&G’s fiscal first quarter) with higher prices. While management acknowledged the stepped-up competition from smaller, niche brands as well as private-label fare (which have gained around 300 basis points of share since 2013 in its categories), it said this has come at the expense of second- and third-tier offerings, with little impact on leading brands. We attribute this to P&G’s efforts to rightsize its mix--shedding 100 brands to focus on its core 65 over the past few years--and win at the shelf by enabling it to focus its resources on the highest-return opportunities, which we view as prudent.

One area where the success of this focus has been evident is in its feminine care (and more specifically, adult incontinence) business, where it maintains around 30% value share and has chalked up 12 consecutive quarters of growth (averaging around 3%). As a part of this attention, P&G has sought to break down the stigma associated with adult incontinence products (a market it re-entered in July 2014) by bringing to market new offerings that appeal to female consumers under its Always brand, most recently with the launch of Always Discreet Boutique, which more closely resembles real underwear compared with other products on the shelf. According to the firm, this particular product drove a 50% acceleration in category growth after its launch and increased the firm’s household penetration by 15 points. Despite selling at a 60% premium to base underwear offerings in this category, Always Discreet now boasts a dollar share north of 13%, up from around 10% before the launch of Boutique.

We think this supports our contention that management understands the need to consistently bring superiority to market (as it pertains to how a product performs, the packaging, its brand messaging, execution in store and online, as well as the value a product offers for both its retail partners and the end consumer). However, we don’t believe the firm is content to stop with some of its recent gains. Much discussion centered on the necessity of being more agile, starting small with product launches and tailoring offerings based on consumer response before rolling out on a larger scale, which we view as a favorable shift. Further, we were encouraged that P&G seems to appreciate the need to be present and innovate across all price tiers (affording the opportunity to trade consumers up and down within its brand set) to withstand intense competitive pressures, as the inability to do so has plagued its business in the past.

As an example, one laggard over the last few years has been the company's grooming operations (about 10% of sales), where it suffered from a lack of on-trend innovation as well as the fact that it wasn’t playing across all price tiers, which opened the door to competition. Despite this, we see similarities to the challenges that had previously plagued its beauty business. In the latter case, beauty (around one fifth of sales) had succumbed to intense competitive pressures from established branded operators and niche local players at a time when its innovation failed to align with consumer trends. However, management took prompt actions to course correct, opting to part ways with unprofitable products and launching fare centered on its core anti-aging messaging. And we’re encouraged that the firm isn’t resting on its laurels. Alex Keith, president of the global hair care and beauty sector, said the beauty business (which has strung together high-single-digit to low-double-digit top-line gains over the past few years) is constantly working to better assess evolving consumer trends. Building on its own organic research and development efforts, P&G now is also looking outward to aid its pipeline of innovation as it works to glean insights from consumers’ Google search patterns to determine up-and-coming trends, particularly as it pertains to new fragrances and product forms.

We think the firm is also taking a sound strategic path to rebut the pressures in its grooming business resulting from lower-price upstarts, by recalibrating its pricing, investing in on-trend new products, and launching its own subscription-based sales model. As a part of these efforts, P&G is launching a razor specifically geared to men with sensitive skin, a condition the firm claims affects 70% of males, and suggested further launches will follow. However, Gary Coombe (president of global grooming) stressed that the company is still not satisfied with the packaging in this segment and believes that further investments in this realm could also help stabilize its competitive position. As a result, we don’t anticipate these pressures will constrain performance indefinitely, but foresee grooming segment sales growth approximating 2% annually over the next 10 years.

While we don’t deny the need to boost its top-line trajectory and enhance its brand set, we view P&G’s intent to remove excess costs from its operations favorably as a means to fund additional spending behind its brands. During the past several years, P&G has reduced the number of plants it operates globally by 20% and manufacturing platforms by 50%. And in light of the ultracompetitive landscape in which it plays, P&G targets extracting another $10 billion of costs (a high teens percentage of its cost of goods sold and operating expenses, excluding depreciation and amortization) over the next few years by reducing overhead, lowering material costs from product design and formulation efficiencies, and increasing manufacturing and marketing productivity. The benefits of this focus on realizing efficiencies from added automation and standardized manufacturing platforms not only stand to boost P&G’s profitability and free up funds to reinvest behind its brands, in our view, but also further entrench its business with retailers. In this vein, we think the combination of six new mixing centers and dedicated shipping lanes has contributed to P&G’s ability to service 80% of its customers in less than one day, ultimately improving out-of-stock levels for retailers, and propping up one aspect of its intangible asset moat source.

Rather than merely bolster profitability, though, we believe the firm will prudently direct these savings to fuel further investment behind its brands (with a bent toward bringing value-added innovation to market and touting this fare in front of consumers), in line with management rhetoric. We forecast the firm will allocate 3% of sales to research and development and 11% of sales to marketing annually. We continue to view the firm’s stewardship of shareholder capital as standard. And while we expect that P&G’s path to sustainable sales gains could prove lumpy, we still believe the benefits from this enhanced focus will lead to increasing sales and volume growth and aid the brand intangible asset source underlying its wide moat in the longer term.