Earlier this week, consumer staples giant Procter & Gamble (PG +2.67%) reported its second fiscal-quarter results. While global volumes declined 1%, revenue increased 4% as P&G has been impressively increasing prices, demonstrating the value of its higher-end household products. Perhaps more impressively, P&G's cost control and operating leverage allowed its currency-neutral core earnings per share (EPS) to rise by a much higher rate of 18%.
That is, of course, except for one item that affected generally accepted accounting principles (GAAP) earnings That came in the form of a non-cash write-down of P&G's prized Gillette business. Of note, Gillette was previously an independent company and a core holding of Warren Buffett's Berkshire Hathaway (BRK.A 0.20%) (BRK.B 0.11%) throughout the 1990s before P&G bought the company in 2005.
While it's nearly 20 years after the acquisition, since Warren Buffett likes to invest in premium brands with incredible staying power, it's a bit surprising to see the write-down. So, what's going on here?
NYSE: PG
Key Data Points
Why Buffett loved Gillette
Buffett first bought Gillette for the Berkshire Hathaway portfolio in 1989 but in the form of preferred stock. Those preferred shares paid out a nice 8.75% dividend, with the option to convert to common shares at a higher strike price. Those shares converted in 1991, and Gillette went on to be a big winner for Buffett. However, as Buffett later lamented in his 1995 letter, Berkshire would have made an extra $625 million by that year had Buffett just bought the common stock instead of the "less risky" preferred stock.
In his shareholder letters, Buffett shed some light on the logic behind purchasing Gillette, likening its premium brand to Coca-Cola. At the time, both stocks had dominant market share, top-of-mind brands, and hard-to-replicate distribution systems that combined into a "protective moat around their economic castles." Buffett went on to say that
Worldwide, Coke sells about 44% of all soft drinks, and Gillette has more than a 60% share (in value) of the blade market. Leaving aside chewing gum, in which Wrigley is dominant, I know of no other significant businesses in which the leading company has long enjoyed such global power.
Gillette also had the benefit of a literal "razor and blades" model in which one would have to buy Gillette blades on an ongoing basis, setting up nice, high-margin and recurring revenue. And in 1997, Buffett made the point that as a premium shaver, it's unlikely existing customers would "trade down" to less expensive shaves once they've had the comfort of Gillette for just a few more bucks per year.
Given Gillette's dominance of the razor market, it's no wonder that P&G looked to buy the business in 2005 for about $57 billion in stock. So Buffett acquired P&G shares in the deal.
Buffett would later trade those P&G shares back to P&G itself in return for Berkshire acquiring the Duracell battery business, which Berkshire now completely owns. And Buffett sold Berkshire's remaining 315,400 shares of P&G shares just last year in the third quarter.
But with Gillette being such a premium business hailed by the world's greatest investor, why is P&G writing down the value of the asset?
Work from home claims another victim
While Procter & Gamble management didn't cite work from home specifically, management did note in its filings that it had decided to impair the goodwill paid as part of the 2005 acquisition as a result of using a higher discount rate and lower "residual growth" rates. Management also noted in the quarterly report that the residual growth rates could be caused by "changes in the use and frequency of grooming products, shifts in demand away from one or more of our higher priced products to lower priced products or potential supply chain constraints."
Analysts seem to think the "changes in the use and frequency" of grooming products is negatively impacted by hybrid work and the work-from home trend, and that's probably right. After all, if you don't have to be face-to-face with your boss five days a week, odds are you aren't going to shave nearly as much!
So P&G took a $1.3 billion impairment charge on the Gillette "asset" it acquired. And there could be more to come. Back in December, P&G noted it could take up to $2.5 billion in impairment charges this year for Gillette.
Obviously, it was hard for anyone to predict a global pandemic would sweep the world 15 years after the acquisition. P&G is likely seeing a reduced growth rate for the razor business, which it apparently believes will continue indefinitely as hybrid work trends established during the pandemic continue into the future.
Image source: Getty Images.
Even a Buffett stock can get disrupted
The lesson here is that even the best businesses in the world can be curtailed, slowed, or even disrupted by societal and technological changes that are larger than the scope of the business.
Beyond Gillette, Buffett's Berkshire has seen several of his owned businesses lose their luster over the years. One example is Buffett's newspaper holdings, specifically in The Washington Post and Buffalo News. These once-dominant local franchises have been disrupted by the internet and social media. Another example is World Book, once a giant encyclopedia franchise, which was disrupted by digital tools and online encyclopedias.
The lesson is: Even if you own a seemingly foolproof, wide-moat franchise, always be on the lookout for disruption coming along likely from new technology advances. As we've seen in these franchises and now with Gillette, even the best businesses aren't immune.
But the write-down may not be that bad
It should be noted that if P&G had developed Gillette from the ground up, there wouldn't be any impairment at all. But when a company makes an acquisition, the amount it pays over the asset's book value is recorded as an intangible asset on the balance sheet in the form of goodwill. If that asset becomes "impaired" -- a somewhat subjective assertion -- a company can write off part of the asset, record a non-cash loss, and reap a tax benefit.
It appears as though work from home may have provided a valid "excuse" for P&G to do the write-off. Although Gillette was marked down, P&G still sees about $12.8 billion in the Gillette "intangible asset" even after last quarter's $1.3 billion charge.
Moreover, P&G still seems bullish on the power of Gillette's franchise even if growth is slowing. On the conference call with analysts, management noted:
Gillette's superior propositions like the Gillette Labs razor with an exfoliated bar that removes dirt and debris before the blades continue to drive growth in the global grooming category. Gillette Labs has reached shares greater than 20% in markets like Spain and France and is building momentum in the U.S. and China. The global grooming category is on track for $1 billion of retail sales growth this fiscal year with Gillette driving 2/3 of the increase, well ahead of our global share.
P&G's grooming category, of which Gillette is the main component along with the Braun and Venus brands, still managed to grow 5.5% year over year ahead of P&G's overall growth rate.
Therefore, it appears Gillette's market position may be just as strong as ever even if people are shaving a bit less these days. But at least P&G can reap some tax savings in the meantime.
