While investors might take issue with Procter & Gamble's (NYSE:PG) recent revenue growth rate, in which the top line has expanded by only 2.4% since fiscal 2011, the consumer goods giant has excelled in cash flow generation. P&G recorded cash flow from operations of $13.9 billion in fiscal 2014, on sales of $83 billion. Free cash flow productivity, an internal measure defined as the ratio of free cash flow to net earnings, was 86% in 2014: for every $1 of earnings, the company converted an impressive $0.86 to cash, after accounting for capital expenditures.
Those capital expenditures amounted to $3.8 billion in fiscal 2014. Over the last few years, P&G has spent somewhere in the neighborhood of $4 billion annually on capital expenditure, or capex. With revenue stagnant, should P&G allocate more of its nearly $14 billion in annual operating cash flow to capex in order to provide an earnings boost?
On the surface, it appears difficult to trace the relationship between capex (spending on manufacturing plants, fixed assets such as equipment and real estate, technology, etc.) and the company's ultimate results.
In trying to interpret the chart above, let's sprinkle in a grain of salt: investments can sometimes take years to manifest results on the profit and loss statement. Another interpretation of this image might be that without P&G's significant capital investment in the five-year period, earnings results could have been worse!
Still, increasing wisely allocated capital expenditures should eventually lift earnings. Thus, investors can reasonably expect that the orange line that represents net income should over time climb in the direction of the blue capex line.
What major investments define P&G's capital expenditures? Over the last few years, the company has plowed dollars into global manufacturing. As I explained last year in an article on P&G's investment in Africa, by increasing its local manufacturing presence in emerging economies, P&G taps new consumer growth and benefits from the use of local material inputs in production, thereby reducing the currency impact that a strong dollar has wreaked upon multinationals recently.
In addition to new plants in emerging markets, P&G has invested capital in two other major areas: streamlining its supply chain and restructuring its distribution approach. Procter & Gamble is reducing the number of single-category plants it operates -- facilities that are devoted to a single brand category -- and replacing these with more efficient multicategory plants. The conglomerate is also simplifying its distribution, moving to fewer centers that are closer to major population centers, with the goal of having 80% of production within one day's shipment to store shelves.
In the company's most recent earnings conference call, CFO Jon Moeller remarked that the supply chain simplification effort savings, which had previously been pegged at $200 million-$300 million annually, had been revised upward 100%, with new anticipated annual savings of $400 million-$600 million annually within three to five years.
Capital spending taken in context
The current expenditures winding through the massive P&G system are targeted toward a different company than the one we see today. As you've no doubt heard if you follow P&G, the company is trimming the brands and businesses under its various product categories to become a simpler, more agile business. Management wants to sell, spin off, partner, or otherwise divest 90 to 100 brands, leaving a company of between 70 and 80 value-driving brands.
The brands slated for reduction account for roughly 10% of company revenue and 5% of total profit. Management believes trimming these brands will increase total revenue by 1%. How can you simultaneously get rid of 10% of revenue and grow the top line by 1%? Simply put, the revenue from this group has been declining by 3% annually for the past three years, effectively dragging on the other 90% of revenue that is expanding.
One benefit of reducing the conglomerate's brand proliferation is the streamlining of stock-keeping units, or SKUs, that have to be managed. Every variation on a product that we see on a store shelf represents a unique SKU in that line, thus increasing manufacturing complexity.
With the reduction in SKUs that will result from a leaner collection of brands, can we infer that capital spending will have a greater impact on remaining SKUs?
I asked this question via email of John Chevalier, director of investor relations at P&G. Chevalier cautioned that it might be a stretch to assume that a reduction in SKUs increases the per-dollar impact of capex on remaining SKUs. For example, some lines to be disposed of might be currently contracted out to third-party manufacturers; thus, they would not be affected by a change in capital spending. Moreover, the slow-moving SKUs slated for disassociation are not vastly material to P&G's overall capital spending.
Yet Chevalier pointed out something that I believe is crucial to understanding the overall initiative. To quote him directly: "We think reducing the internal complexity caused by maintaining slow-moving SKUs will be an important enabler of improved cost, cash and customer service performance."
This specific example points to a larger theme that investors should consider. Creating a company that is simpler to operate and more nimble in its approach to manufacturing and distribution could trump any efforts to simply throw more good money at the current, rather unwieldy, portfolio of products. Management forecasts that it will spend 4%-5% of sales on capital expenditures in the current fiscal year, which would place investment in the approximate spending range of the last three fiscal years. P&G will need roughly two years to fully execute its simplification effort; in the meantime, the current capital expenditure targets, rather than insufficient, seem well advised.