The Procter & Gamble Company: New Revenue, Old Problems

With an eye toward rejuvenating its grooming division, Procter & Gamble Company  (NYSE: PG  )  introduced the "Gillette Fusion ProGlide with Flexball Technology" earlier this year. The razor features a swiveling ball hinge, which, according to the company, allows the Fusion's standard cartridge to conform more closely to the contours of the male face.

In press releases and during the product's unveiling, P&G touted the innovation behind the razor, which took five years to design, was tested on 24,000 men, misses 20% fewer hairs, and moreover, cuts hair shorter by 23 microns.

P&G's "Fusion ProGlide With FlexBall Technology" razor. Source: P&G.

Of course, a length of 23 microns, which can be roughly compared to one-half the width of a human hair, is highly unlikely to make a visible difference when lopped off a man's beard hair length.

That 23 micron improvement in shave efficiency is not a bad metaphor for the performance of Procter & Gamble over the last several years, in which the conglomerate has brought innovation to the forefront while seeing only marginal improvements in corporate results.

Much of P&G's malaise can ironcially be traced back to its acquisition of Gillette, which was initiated in 2005 and completed in 2006. P&G acquired Gillette for $53.4 billion, and in connection with the transaction, debt on the books nearly doubled over the two years, ballooning from $21 billion to $38 billion. Add in Gillette liabilities assumed, and total liabilities swelled over the two-year period, from $40 billion to $73 billion.

P&G also swallowed $35 billion in goodwill in the deal, which turned tangible book value negative -- a $27.5 billion abyss. But in exchange for the debt and goodwill, the company acquired many positives: It pulled Gillette's $10.5 billion in yearly sales under the P&G banner, it added power brands such as Braun, Oral B, and Duracell, and most important perhaps for the future, the company promised shareholders that the combined entity would post a fast organic revenue growth rate -- for a consumer goods company -- of between 5% and 7%, forecast through at least 2010. As you can see from the chart below, despite an initial bump, the higher growth rate never really materialized.

Source: P&G SEC 10-K filings, fiscal years 2006-2013.

Is there a single culprit behind P&G's lagging performance since acquiring the world's dominant grooming business?

An unlikely root cause
Of all things, P&G's powerful annual cash flow provides a clue. The company is quite focused on free cash flow, that is, operating cash flow after capital expenditures. It's one of the metrics that senior management is compensated for. Management is also compensated for keeping a high "free cash flow productivity ratio," which P&G defines as the ratio of free cash flow to earnings. 

Despite a talent for generating cash, P&G appears to have been overly focused on returning it to shareholders in the years since the Gillette acquisition. For example, since the beginning of fiscal year 2006, P&G has generated a colossal $121.7 billion in operating cash flow. Yet it's returned $107.4 billion to shareholders over the same period in the form of dividends and share repurchases. That's more than the total net income of $100.2 billion.

As a result, the balance sheet hasn't improved much at all since the acquisition. The company isn't exactly awash in liquidity, having now spent 30 consecutive quarters with an upside-down current ratio, that is, current liabilities in excess of current assets. The total liabilities of $73 billion with which P&G exited the Gillette acquisition have essentially remained on the books -- total liabilities today stand at $74 billion. And keeping this capital structure hasn't come cheap: Since the beginning of fiscal year 2006, P&G has incurred nearly $9 billion in interest expenses.

It's ironic that Procter & Gamble works so earnestly and effectively to optimize its business. Reviewing current-year goals, management is on track to deliver $1.6 billion in costs savings. It's also reduced employee count by 8,750 (from a total workforce of 121,000 at the end of the prior year) and is redesigning its supply chain. Yet while these efforts have helped produce $9.5 billion of operating cash flow so far in the first three quarters of its fiscal year, with one quarter to go, the company is promising approximately $13 billion of total return to shareholders between dividends and share repurchases. This ensures fiscal 2014 will mark another year of this curious paradigm. 

A financial formula with limited long-term opportunity
How comfortable are investors holding a company that, despite owning 25 "billion-dollar brands" -- eight more than Coca-Cola -- is focused on keeping a questionable capital structure and returning untoward amounts to shareholders, even when growth in share price indicates the formula isn't working?

PG Chart

PG data by YCharts.

To be fair to Procter & Gamble, we should probably look at total return price, which would factor in reinvested dividends. The result may surprise you:

PG Total Return Price Chart

PG Total Return Price data by YCharts.

Even P&G's hallowed dividend, which has been increased for an incredible 58 consecutive years and currently yields 3.25%, doesn't make up enough ground, when reinvested, to pull P&G within close range of its peers in terms of stock price appreciation. 

Procter & Gamble rightly celebrates its reputation for innovation. We're likely to hear soon how initial sales of the new Fusion ProGlide With FlexBall razor look. Perhaps the razor will get a boost from Argentinean soccer star and Fusion ProGlide pitchman Lionel Messi, especially if he continues to score in the World Cup tournament in Brazil. With fiscal 2015 approaching, investors may welcome a little innovation on the company's financial engineering side as well.

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