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Procter & Gamble
Equity Valuation & Analysis
As of November 1, 2007
Raider Investments Group
Brian Hooper
Tyler Yenzer
Nathan Yosten
Dustin Bradford
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Table of Contents
Executive Summary
Business & Industry Analysis
Company Overview
Industry Overview
Five Forces Model
Rivalry Among Existing Firms
Threat of New Entrants
Threat of Substitute Products
Bargaining Power of Buyers
Bargaining Power of Suppliers
Key Success Factors
Firm Competitive Advantage Analysis
Future Competitive Analysis
Accounting Analysis
Key Accounting Policies
Potential Accounting Flexibility
Actual Accounting Strategy
Quality of Disclosure
Qualitative Analysis of Disclosure
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Quantitative Analysis of Disclosure
Sales Manipulation Diagnostics
Expense Manipulation Diagnostics
Potential Red Flags
Undo Accounting Distortions
Financial Analysis
Liquidity Analysis
Profitability Analysis
Capital Structure Analysis
IGR/SGR Analysis
Financial Statement Forecasting
Cost of Equity Estimation
Valuation Analysis
Multiples Valuation
Discounted Free Cash Flow Model
Discounted Dividends Model
Residual Income Model
Long-Run Return on Equity Residual Income Model
Abnormal Earnings Growth Model
Credit Analysis
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Analyst Recommendation
Appendix
Regression Analysis
Income Statement
Balance Sheet
Statement of Cash Flows
Cost of Equity/WACC
Multiples Valuation
Discounted Dividends Model
Discounted Free Cash Flows Model
Residual Income Model
Long-Run Return on Equity Residual Income Model
Abnormal Earnings Growth Model
Altman Z-Score
References
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Executive Summary
Share data Observed NYSE:PG share price as of 11/1/2007 52-week range Shares Outstanding Market Capitalization Percent owned by insiders Percent owned by
institutions Book value per share Key 2007 financial data: Revenue Net Earnings Return on Equity Return on Assets
$68.59$61.03-$71.83
3,159 m$216.7 b
3.83%
58.7%$21.13
$76,476 m$10,340 m
15%7%
Valuation estimates Multiples valuation Trailing P/E Forward P/E P/B D/P PEG P/EBITDA P/FCF EV/EBITDA Intrinsic Valuations Discounted Dividend Discounted FCF Residual Income LR ROE AEG
$69.01$56.47
$307.10$37.55$89.49
$469.93$69.39$65.79
$126.83N/A
$41.87$33.11
$118.34
Published beta 0.92 Kd 6.26 WACCbt 8.61%
Altmans Z-Score
2003 2004 2005 2006 2007
4.6 3.76 3.44 2.67 2.89
Cost of Capital Estimation r2 Beta Ke 3-month 0.2862 0.9358 11.15% 1-year 0.2854 0.9337 11.20% 2-year 0.2847 0.9313 11.08% 5-year 0.2839 0.9305 11.03% 7-year 0.2838 0.9306 11.10% 10-year 0.2839 0.931 11.24
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Industry Analysis
Procter & Gamble (NYSE: PG) started from humble beginnings as a small soap
and candle company in 1837, and has since grown into a multinational corporation with
hundreds of product lines. The company is the largest firm in the personal products
industry of the consumer goods sector. Top competitors for Procter & Gamble include
Johnson & Johnson (NYSE: JNJ), Kimberly-Clark Corp. (NYSE: KMB), Colgate-Palmolive
Co. (NYSE: CL), Avon Products, Inc. (NYSE: AVP), and Unilever (LSE: ULVER.L).
The personal products industry is highly competitive. Top companies must rely
on brand recognition and product innovation to gain market share. The industry is
analyzed thoroughly using the five factor model. The first factor in the model evaluates
rivalry of existing firms. The collective result is that rivalry is high. The next factor
looks at the threat of new entrants, and reveals that substantial barriers exist which
keep the threat of new entrants low. Next is threat of substitute products, which shows
that brand recognition will keep customers loyal, but readily available comparable
products make the threat moderate. Analysis of the bargaining power of buyers reveals
that buyers have moderate power because retailers need to carry certain products at
certain prices to draw customers, in other words, the buyers (retailers) and suppliers
(personal products firms) are equally reliant on each other. Bargaining power of
suppliers reveals that suppliers have less power the bigger the buying firm is.
Certain key success factors must be present to be successful in creating value in
the personal products industry. While these factors vary from firm to firm, none of the
top companies rely on a pure cost leadership or pure differentiation strategy.
Prevalent cost leadership strategies include economies of scale and lowering the costs
of inputs. Differentiation strategies include superior product variety, brand building,
innovation, and superior customer service. Analysis of Procter & Gambles ability to
achieve a competitive advantage reveals that they have been very successful and can
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remain successful if they stay on top of research and development and maintains good
relationships with buyers.
Accounting Analysis
Procter & Gamble has six parts that sums up their companies accounting
analysis. These six parts are: key accounting policies, accounting flexibility, accounting
strategy, disclosure, potential red flags, and accounting distortions. Its main job is to
help an investor see if its company is doing well or if there is a potential problem in the
near future. Most of the accounting information came from Procter & Gamble as well
as other competitors in the industrys 10Ks.
Procter & Gamble is considered a flexible company because of the amount of
judgment decisions they allow their management to make. One of the main reasons
they are flexible is because they allow their companies management to make their
decisions on goodwill. This is a potential red flag area because goodwill is a huge part
of P&Gs company every since the Gillette acquisition. They are keeping it constant
instead of over or understating it so there was no manipulation. They are also a
company who is very transparent. This means they disclose more information than
most public companies. In their 10ks they have a detailed analysis of each section of
their company. This means they have a break up of different categories (cash & credit
sales), and segmented reporting (Baby care, Beauty, Household, etc.) for investors or
auditors to see. Due to their high disclosure, their flexibility through GAAP would be
obvious if there was a red flag. There were three ratios in the analysis that were a
concern when analyzing for potential red flags. However each of the three were
examined carefully, and it was determined there was no manipulation in the companies
accounting analysis.
Valuations
After all of the analysis of the industry, the firm, its accounting policies, and
financials, we can now do a valuation of Procter & Gamble. Several different valuations
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will be used to compute the per share price of the company. This per share price
compared to the actual per share price will advocate if the company is fairly valued,
overvalued, or undervalued.
The earnings multiples valuation is the quickest and easiest way to value a
company. Eight different ratios were used to determine the value. There was no
dominant valuation in this model to tell if it was fairly valued, overvalued, or
undervalued. There was a big variance in the per share prices, which made this method
of valuation very inaccurate and shows that it should not be the only form of valuation
for a firm.
Several different valuations were used to value Procter & Gamble. The
discounted free cash flow model uses expected future free cash flow models to arrive at
a per share price of -$274.17. Since this number is negative it is invalid and cannot be
used to value the company.
The discount dividend model calculates the price per share as the sum of each
of the next ten years expected dividends discounted back to the present value, added
to the terminal value of the perpetuity. This method gives us an undervalued per share
price of $126.83.
The residual income valuation model discounts residual earnings, which are
earnings in excess of normal earnings. The estimated share price of this model was
$41.87, overvalued.
The abnormal earnings growth model values a firm using forecasted earnings,
dividends, dividend reinvestment plan (DRIP), core earnings and normal earnings. Tying
these numbers together gives us a per share price of $118.34, which suggests that
Procter & Gamble is undervalued.
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Financial Analysis, Forecast Financials, and Cost of Capital Estimation
Liquidity, profitability, and capital structure ratios are all tools used by analysts
when looking at a firm. A firms performance can be assessed when the ratios are
compared against ratios from previous years and ratios of other firms in the industry.
Then, analysts will utilize the ratios in forecasted the firms future financial performance.
Regressions are used to estimate a Beta for the firm which is then used to find a cost of
equity using the capital asset pricing (CAPM) model. The weighted average cost of
capital (WACC) is then used to determine an appropriate cost of capital for the firm.
Procter & Gamble is a fairly liquid company. All of their liquidity ratios, except
the current ratio, quick ratio, and working capital turnover, are in line with or above the
industry average. They actually lead the industry in accounts receivable days. They
have good profitability as well despite being below the industry average. All profitability
analysis shows either steady or growing profitability. Although they are below the
industry average, Procter & Gamble is gaining on their competition year by year.
However, capital structure analysis shows that Procter & Gambles ability to pay debt is
has declined. Their debt service margin has experienced a downward trend in recent
years. As a matter of fact, there were not enough cash flows last year to support the
current portion of debt due.
Financial forecasts were then developed for the next ten years using a basic
assumption of a ten percent growth rate in sales per year. The assumption was also
made that past ratios would be a good indicator of future ratios. The ratios discussed
above were utilized in this process to develop a reasonable estimate of Procter &
Gambles future performance.
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Company Overview
In 1837, Procter & Gamble (NYSE: PG) was started as a soap and candle
company out of Cincinnati, OH. Procter & Gamble has since grown to become the
largest consumer goods product company in the world, with $68 billion in sales
worldwide for fiscal year 2006. Corporate headquarters are still in Cincinnati, and they
maintain 39 manufacturing facilities in 23 states, as well as 105 manufacturing facilities
in 41 other countries (P&G 2007 10-K). Procter & Gamble manufacturing facilities
produce personal health care products, house and home care products, health and
wellness products, baby and family care products, and pet care and nutrition products.
These products have made Procter & Gamble a recognized global leader in the
development, manufacture and marketing of some of the worlds most trusted, quality,
leadership brands including Pampers, Tide, Ariel, Always, Whisper,
Pantene, Mach3, Bounty, Dawn, Pringles, Folgers, Charmin, Downy,
Lenor, Iams, Crest, Oral-B, Actonel, Duracell, Olay, Head & Shoulders,
Wella, Gillette, and Braun (www.pg.com). Procter & Gamble boasts over 300
brands being sold in as many as 160 countries (P&G 2007 10-K). Procter & Gamble
acquired many of these brands because of a preexisting solid consumer base.
With global operations employing 138,000 worldwide, it has been necessary for
Procter & Gamble to develop two training schools for senior managers (P&G 2007 10-
K). One is an advanced leadership school for senior managers. It targets the 135
general managers from different branches of the Procter & Gamble global division.
The other is an executive leadership program aimed at the highest-level managers in
the company.
Procter & Gamble strives to provide branded products and services of superior
quality and value that improve the lives of the worlds consumers (www.pg.com). This
commitment would not be possible without progressive breakthroughs in research and
development. Each year, Procter & Gamble increases funding on research and
development, currently around $2 billion total expenditure for fiscal year 2007. The
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company employs more than 7,500 scientists and holds more than 24,000 active
patents worldwide (P&G 2007 10-K). This focus on innovation and technology has put
Procter & Gamble as an industry leader.
Procter & Gambles vast customer base spans drug stores, high-frequency
stores, membership stores, grocery stores, and mass merchandisers. Because of the
broad array of products through a wide customer base, Procter & Gamble benefits with
being industry leader in sales and market capitalization. Figure 1 shows total assets
grew significantly, helped especially by the Gillette merger in 2005. Net sales received
a bump also, but adjusted sales growth shows no significant gains from the acquisition.
Fig. 1: Total Assets, Net Sales, Sales Growth, and Stock Prices (*In Millions)
2003 2004 2005 2006 2007
Total Assets* $43,706 $57,048 $61,527 $135,695 $138,014
Net Sales* $43,377 $51,407 $56,741 $68,222 $76,476
Sales Growth 6% 6% 6% 6% 5%
Procter & Gamble is categorized in the household and personal products industry of the
consumer goods sector. Procter & Gambles major competitors, also in the personal
products industry, include Kimberly-Clark Corp., Colgate-Palmolive Co., Avon Products,
Inc, and Unilever. Another major competitor, although not primarily in the personal
products industry, is Johnson & Johnson .
Industry Overview
The household and personal products industry is a highly competitive industry.
Most companies in competition with Procter & Gamble are focused to only one or two
different sub-industries of the personal products industry. Procter & Gambles major
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competitors, such as Kimberly-Clark Corp, Colgate-Palmolive Co., Johnson & Johnson,
Avon Products Co., and Unilever, are also diversified into many sub-sectors. Most of
these sub-sectors of the personal products industry are largely made up of
manufacturing through chemical processing or paper processing. Suppliers of the
chemicals are numerous, although price fluctuation may occur if availability is limited.
According to Procter & Gambles 10K filing, we may or may not pass on the change,
depending on the magnitude and expected duration of the change.
The companies in the personal products industry rely on brand recognition and
product innovation to build their customer base. Product innovation is a key step to the
corporate strategy for long-term growth of Procter & Gamble. This core philosophy is
what has caused Procter & Gambles stock climbing 65 percent higher today than it was
five years ago (See Fig. 2). The top competitors stock prices have only gained
between 14 and 60 percent. Not shown in the chart is Unilever, with a 17 percent gain
over the same period.
Fig. 2: Stock prices for P&G and top competitors over the last 5 years
Moneycentral.msn.com
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The Five Forces Model
In every industry, there is a model that can be used to identify the strategy,
profitability, and power of particular companies. This model is called the five forces
model. This gives an analysis of companies for competing and personal uses. The five
forces model consists of two major parts. The first part of the model consists of rivalry
among existing firms, threat of new entrants, and threat of substitute products. This
part measures how much actual and potential competition there is. The second major
part is between the bargaining power of buyers and the bargaining power of suppliers.
These two measure the power a company has or does not have over the buyers and
suppliers. In using this model, we will be able to identify these valuable parts of
Procter & Gamble.
Personal Products Industry
Rivalry Among Existing Firms High
Threat of New Entrants Low
Threat of Substitute Products Moderate
Bargaining Power of Buyers Moderate
Bargaining Power of Suppliers Low
Rivalry Among Existing Firms
Industry Growth
The growth in this industry has been moving up on a yearly average. Every
year, the industry seems to steadily increase its annual sales revenue (see figure 3).
Given this information, price wars are expected to happen. To be able to survive, these
companies have to manage decisions by getting rid of every expense that is not
needed. In 2005, the industry grew 8.14 percent. In 2006, the industry grew 11.87
percent. That is a 3.73 percent change in industry growth from 2005 to 2006. A major
portion of that was from Procter & Gambles purchase of Gillette. Because of Procter &
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Gambles purchase of Gillette in 2006 sales grew by 20.23 percent. This is a 9.85
percent increase from the 2005 sales growth of 10.37 percent. A companys historical
growth rate can be used when trying to forecast future sales. The industrys growth is
due to the rise in demand over the last five years. There has been a demand and will
always be a demand for these types of products. The consumers have to use these
products because they are a part of everyday life, which leads to the reason for the
sales growth.
Figure 3: Sales Growth Over the Past Five Years
Concentration
There is a high amount of concentration in this industry. All of the companies in
the personal products industry have to compete on price. Since most of these goods
are not commodities, it allows them to compete less on the price. This industry has
some specific goods people are willing to pay for, and other goods that they are only
willing to pay for the cheaper product. It is in these companies best interest to focus
on the specialty products by putting as much quality in them as possible. Companies
Source: PG, JNJ, KMB, CL, and AVP 10k's; Unilever financials
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also need to focus less on quality and more on price reduction when looking at non-
brand specific products.
Differentiation and Switching Costs
Many of the products offered in the personal products industry are of the same
quality and price, meaning that switching costs are relatively low. A switching cost is
the cost that the consumer encounters while changing from one product to another.
Many consumers will buy similar products based on which one is the cheapest, giving
them a low switching cost. For a company to be successful, it must differentiate its
products from its competitors products. A company can do this by creating brand
names and slogans that consumers will become familiar with, much like Procter &
Gamble has done with Duracell, Crest, and many of its other brand name products
(www.pg.com).
Scale/ Learning Economies
Fig. 4: Total Assets over the Last Five Years
In order for a company to be competitive and profitable, it must be a giant in the
personal products industry. The size of a firm can determine how successful it is going
to be. Having a large firm allows a company to attract more customers than a small
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firm would by name recognition and perceived value. In addition, large companies
have the ability to reduce costs and bring down prices, making it difficult for new
entrants to compete. To facilitate, figure 4 shows Procter & Gamble (PG) and Johnson
& Johnson (JNJ) have the largest number of assets, making them the biggest
companies in the consumer goods market. Therefore, these companies are also the
leaders in this market.
Ratio of Fixed to Variable Costs
Analysis of the ratio of fixed to variable costs gives insight into how well a
company is utilizing its facilities. A firm with a high ratio of fixed to variable costs is
either not making efficient use of its existing capacities, or is having trouble selling
product. A firm with a low ratio of fixed to variable costs is making more efficient use
of its existing capacities. Different industries have different normal fixed-variable
costs ratios, so a ratio close to 1:1 may not be desirable or even achievable. In order
to calculate the ratio, fixed costs, which are general, selling, and administrative
expenses, are divided by variable costs, which are the costs of products sold.
Fig. 5: Ratios of Fixed to Variable Costs over the Past Five Years.
Figure 5 shows the average ratio of fixed to variable costs for Procter & Gamble over 5
years is 0.64. Johnson & Johnsons ratio over the same period averages 1.18, while
Kimberly-Clarks is only 0.25. Colgate-Palmolive averaged 0.75. The industry average
2002 2003 2004 2005 2006 Avg.
Procter & Gamble 0.60 0.60 0.66 0.66 0.66 0.64
Johnson & Johnson 1.17 1.16 1.20 1.23 1.16 1.18
Kimberly-Clark 0.26 0.25 0.25 0.25 0.25 0.25
Colgate-Palmolive 0.72 0.74 0.76 0.76 0.79 0.75
Avon Products 1.17 1.20 1.22 1.23 1.33 1.23
Unilever 0.75 0.70 0.60 0.63 0.64 0.67
Industry Average 0.79
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is 0.79, but since historical figures do not vary much suggests that firms either find it
difficult to change or it is not financially detrimental to keep the current state.
Objective interpretation of the averages would suggest Kimberly-Clark is making the
most efficient use of its resources, while Avon is making the least efficient use.
Excess Capacity
Excess capacity occurs when a firm is not producing as much as it could be
producing. This results in wasted money due to fixed costs. In this situation, a firm
would decrease price to spark demand. This effectively solves the problem of excess
capacity by increasing production. Figure 5 also allows for the interpretation of excess
capacity. Without investigating into alternate causes for the high ratio, Avon would be
a candidate for decreasing price to increase demand. Procter & Gamble and Colgate-
Palmolive would probably be considered to be at an acceptable capacity. Kimberly-
Clark may be considered to be at a very efficient capacity.
Exit Barriers
When a firms operating costs exceed revenue for a long enough period, the firm
may go out of business. In certain industries, barriers may make exiting the market
difficult and often they are forced to stay in business. Contract cancellation costs with
suppliers, asset write-off expenses, or regulations that must be followed are all costly
exit barriers. One large potential barrier to exit for the personal products industry is the
expense of writing-off assets. Much of the equipment is highly specialized chemical
processing equipment which may be difficult to sell or remove. The costs associated
may be more than the company wants to put on its balance sheet.
Conclusion
With a high industry concentration, relatively low switching costs, large
economies of scale benefits, and possible high exit costs, rivalry among existing firms in
the personal products industry tends to be high.
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Threat of New Entrants
The personal products market is a relatively difficult market to penetrate due to
the high degree of concentration. A highly concentrated market makes it difficult for
new entrants to succeed because there are only a few major companies in the industry
that are very competitive. Large companies in the personal products industry have a
huge competitive advantage over new entrants because of their size and experience.
The first companies entered the personal products industry as early as the 1830s,
giving them many years of experience and knowledge to be able to create barriers that
a new entrant would have to overcome to be successful. These barriers include
economies of scale, distribution access, and legal issues.
Economies of Scale and First Mover Advantage
A firms economy of scale can also give them a competitive advantage over new
entrants. The ability to increase production can drive down input costs, giving you
economies of scale. Increasing production is something that can only be done if your
firm is large enough to do so. A firm must have large amounts of assets to be able to
produce goods on a larger scale, making it hard for new entrants to compete with
production costs and price. For example, Procter & Gamble (PG) and Johnson &
Johnson (JNJ) have to highest amount of total assets in the industry with amounts of
$138 Billion and $75 Billion (PG and JNJ 10-K). This allows these two companies to
dominate the consumer goods market, giving new entrants a disadvantage at
competing on cost, quantity produced, and price. Large firms in the consumer goods
market also have the first mover advantage. The first mover advantage lets the first
companies in the industry create different standards and agreements. The first ones in
the industry can regulate it; make it extremely difficult for a firm to enter their market.
For example, a first mover in the personal products industry would have an advantage
because they would be able to register patents, develop market share, get over the
learning curve, and gain reputation over companies that would enter the industry later.
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Distribution Access and Relationships
Access to existing distribution channels can be a substantial barrier that new
entrants would have to face in order to enter the industry. Supermarkets and other
retail stores have a limited amount of shelf space available for consumer goods. This
shelf space is usually used up by the big firms that have existing relationships with the
customer, making it difficult for new entrants to obtain the required room for their
products. A preexisting relationship is important in the personal products industry
because it allows the producer to negotiate pricing and discounts with the buyer. Brand
recognition is also a factor. If a company does not have brand recognition, they will not
be able to get their product distributed as well as a large company would. Without
distributor relationships and brand recognition, a new company will not have much
success upon entering the consumer goods market.
Legal Barriers
Legal barriers can also make it hard to enter the personal products industry. A
new entrant has many regulations, laws, patents, and copyrights that they have to
abide by when they are entering into an industry. The personal products industry is
Fig. 6: Intangible Assets for 2006 Source: PG, JNJ, KMB, CL, ULVR, & AVP Balance Sheets
very research-intensive. This produces many patented products that cannot be copied
by newcomers. For example, as figure 6 shows, market leaders Procter & Gamble (PG)
and Johnson & Johnson (JNJ) have $33.6 billion and $15.4 billion in intangible assets,
Firm Intangible Assets (in millions) (2006)
Procter & Gamble $33,626
Johnson & Johnson $15,412
Kimberly-Clark $821
Colgate-Palmolive $0
Avon $80.4
Unilever $6,312.21(Converted from Euros)
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which includes copyrights, patents, trademarks, and goodwill (PG and JNJ balance
sheets). This much money invested in intangible assets shows that these two industry
leaders have many innovative ideas that they are protecting from being used by any
other company that wants to enter their market.
Conclusion
There are many different barriers in the personal products industry that a new
entrant would have to overcome to enter. The large companies have a huge
competitive advantage over new entrants that leave new entrants with little success in
gaining any market share. With established economies of scale, access to distribution,
relationships, and legal barriers in the favor of existing firms in the industry, a new
entrant would little success in competing. This almost eliminates the threat of a new
entrant in the personal products industry.
Threat of Substitute Products
The threat of substitute products is the customers (retail stores) willingness to
switch to a different product that is similar to yours. In the personal products market,
the threat of substitute products is always present. There are always substitutes
available for every different kind of product in the personal products industry, creating a
mild threat of substitute products. However, there are some factors in considering a
product to be a substitute. The relative price and performance of the substitute product
must be close to the original product to be considered as a substitute. In addition,
customers willingness to switch is a factor in considering a substitute for a product.
Relative Price and Performance
In the personal products industry, price is usually perceived as value. Many of
the name brand items, like Tide laundry detergent, Crest toothpaste, and Bounty paper
towels are often at a higher price than a generic brand of the same items would be.
This is because customers believe these name brands have more value than a lesser-
known brand, allowing them to pay a premium on these items. Often, the brand names
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also have a higher performance than a generic or lesser-known brand would, due to
research and design on brand name products. Many hours are spent on research and
design in big companies so that they can make their products even better for the
customer. This usually results in an increase in performance so that the customer will
benefit more from buying their product. Therefore, the threat of substitute products
depends on the customers wants and needs. If they want better performance at a little
higher price, they can buy the brand names; or, if a customer is willing to give up a
little performance for a lesser price, generic and lesser known brands are what they
choose.
Buyers Willingness to Switch
Buyers willingness to switch is a critical part of the threat of substitute products.
In the personal products market, the buyers willingness to switch is usually low. A
buyer (retail store) of personal products usually has good relationships with their
suppliers, making them partial to their products. For example, Wal-Mart sells all of the
products from companies in the personal products industry, which means that they
have a good buyer/seller relationship. This relationship developed by the popular and
well-known brand names that come out of the companies in the industry. If a company
in this industry did not have familiar names, they would not have much shelf space, if
any, in retail stores like Wal-Mart. Since the buyers (retail stores) have good
relationships with the well-known companies in the personal products industry, they are
unlikely to switch to a different product offered by someone else trying to compete in
this industry.
Conclusion
Substitute products in the personal products industry are readily available by
much smaller and different firms, but due to brand name recognition and developed
relationships, it is not likely that a buyer will switch products. The added benefit, due to
the higher price, is usually enough to keep customers happy with the brand name
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products. Therefore, the threat of substitute products in the personal products market
is low, due to the high concentration of the industry.
Bargaining power of Buyers
Bargaining power is the ability to influence the setting of prices
(http://www.photopla.net/wwp0503/buyer.php). It is based on the relationship
between the firm and the buyer. The main question in this part of the five factor model
is who has the power over whom? In this case, the retailers are the buyers and
Procter & Gamble is the firm. Obviously, the source with the most power will be able to
control the other. If the company has the most power then they will be able to raise
prices and most likely be the only source around. If the buyer has the most power then
the company will have to lower its costs and add a lot more expenses to its list.
Switching costs
The cost of these customers switching from Procter & Gamble to Johnson &
Johnson would be low in certain products. This is because most of these products on
the shelf are close to the same price. However, the quality they would receive would
be less in most cases. Johnson & Johnson would have similar quality to Procter &
Gamble, but the other smaller competitors could not compete with the price and
quality. This is not an industry to get started in if you are small because these huge
companies already have a major head start on you. A large company in this industry
could switch to another large company if it was the last resort.
Differentiation
There is a lot of differentiation when comparing Procter & Gamble products and
the products of other competitors in the industry. According to their 10k, Procter &
Gamble has narrowed their range to three different subjects; these subjects are beauty,
household care, and health and well-being. All of these areas have been differentiated
accordingly. Procter & Gamble has some of the best product names and quality in
retailer stores and pharmacies around the world. With new ideas coming up every
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23
year, it gives them an advantage when dealing with retailers. Recently, they had a
breakthrough with Crest toothpaste. The new product was called Crest Pro Health and
was a huge success. It had more than $100 million in sales in the first year. Most of
Procter & Gambles brands have different product lines to offer, much like this one.
This product differentiation gives them more power when dealing with retailers.
Johnson & Johnson is very similar in the way that they have a lot of brand power and
quality in their products.
Price Sensitivity
Procter & Gamble is very differentiated, and because of this, it has to be less
price sensitive. In this industry, like most, the best option is to sell at the price desired.
If companies can do this then they have power when dealing with buyers (retailers).
Some of these retailers are Wal-Mart, HEB, Walgreen, etc. Buyers want the best
products on their shelves. These large retailers are forced to keep their own costs
down. Compromising with them more will help to put more products on the shelf. The
companys brand image can also help your business in a competitive industry. With the
advertising and high quality expected in Procter & Gambles brands, retailers will be
convinced that these products will create profits for them. If the product is a small part
of the buyers costs, they are less likely to look elsewhere for a better price.
Importance of Product for Costs and Quality
In the personal products industry, it is very important to have brand power and
quality. If one is lacking it will be very difficult to start a new company and compete
with others. All of the top companies in the personal products industry are greatly
helped by already having the best brand names. These companies have more
bargaining power with customers because their superior products demand a premium
price.
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Bargaining Power of Suppliers
Our suppliers are valued partners in the success of our business. Our
relationships with them must be characterized by honesty and fairness. Suppliers are
selected on a competitive basis based on total value, which includes quality, service,
technology, and price (Sustainability guidelines for Supplier Relations, 2007 P&G 10-K).
Bargaining power of suppliers involves the relationship between the firm and the
suppliers. When there are fewer companies, the supplier is able to have more control
over a firm in this industry. Procter & Gamble has many sustainability guidelines that
must be followed in order to be involved with their suppliers. Some of these guidelines
are legal compliance, human rights, employment practices, forced labor, and child
labor. Most of the companies in this industry have guidelines like these because they
are ethical companies who want to do the right thing. Supplier diversity is a
fundamental business strategy at P&G (www.pg.com). Since Procter & Gamble has
this option, this allows them to be more diversified. This also allows them to have
some power over their suppliers. If one of the suppliers is trying to raise prices, they
can just go to another. A great portion of a companys success in this industry depends
on brand name. These suppliers know this, which leaves them with some power.
Suppliers have to provide good materials for people to see the quality. There are a few
companies in this industry that can manage and compromise with suppliers like Procter
& Gamble. Because of their large size and name, these companies are not only able to
get whom they want, but they can also control prices. This is a big plus for these
companies in this industry.
Key Success Factors for Value Creation
In order to be successful in the personal products industry, a company must
employ a mix between differentiation and cost leadership strategies. Customers in the
industry have come to expect high quality products at relatively low prices; therefore, a
company will not survive in the industry with a straight cost leadership or a strait
differentiation approach. According to Procter & Gamble, there are five areas that are
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critical to winning in consumer products (www.pg.com). These five areas are
consumer understanding, brand building, innovation, go-to-market capability, and scale.
Colgate-Palmolive Co., one of Procter & Gambles major competitors, also cites strength
of brand, innovation, and cost control as factors for success in the personal products
industry (www.colgate.com). Neither strategy outlined here is true differentiation or
cost-leadership; however, more emphasis is placed on the differentiation strategies.
Cost Leadership Elements
The personal products industry has high rivalry among existing firms and a low
threat of new entrants. Therefore, companies in the personal products industry must
be able to utilize economies of scale in order to be successful. The manufacturing
process incurs high fixed costs that need to spread out over as many units as possible.
By driving down per unit costs, the final products can be sold at lower prices in the
market enabling firms to compete on price. Beating competitors on price is a common
tool in gaining market share against the existing firms. In addition, having such a
large-scale production process makes it difficult for new entrants to succeed. In order
to compete effectively in the industry on price, a new firm would have to jump straight
in with a huge capital investment that would allow them to mass-produce. This is
difficult for new firms to do; therefore, a new firms costs tend to be higher than an old
firms costs. This will result in higher selling prices making it less attractive to
consumers. If a firm is not large enough to increase production to a level that will
facilitate low per unit costs, it simply will not survive.
Firms must also be able to lower their input costs. Colgate-Palmolive Co.
expressed concern over rising input costs in their 2006 10-K. Increases in the prices of
their raw material commodities can have an adverse affect on their profit margins
especially when they are unable to pass these expenses on to consumers by increasing
prices (www.colgate.com). If a company were to try to pass these expenses on to
consumers through price increases, customers would simply switch to a competitors
product. There is a good degree of brand loyalty in the personal products industry;
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however, even consumers who prefer one brand to another can only tolerate small
price increases. Therefore, effective management of input costs will allow a company
to maintain low prices and a good competitive advantage in the personal products
industry.
Differentiation Elements
Despite using a mix of cost-leadership and differentiation methods, the personal
products industry does lean more heavily towards differentiation. Firms spend a lot of
time and money trying to make their products stand out from the rest. Consumer
understanding is key in order to differentiate a product. The first thing a firm must do
is figure out exactly what it is that the consumer wants. Firms do this through the
utilization of market research and tests. The results of these tests will let firms know
where demand lies. They will then gear their research and development to satisfy
these consumer demands.
Personal products companies must also provide a superior product variety. Firms
in this industry have numerous products and product lines. The main reason for this is
that different consumers want different results out of the same product. For example,
some toothpastes are aimed at cavity protection while others are targeted for
whitening. Most personal products have different varieties in order to satisfy different
needs. If a firm cannot match a product with a customers need, the customer will turn
to a competing firms product that does address their need.
Brand building in the personal products industry plays a big role in a companys
success. Brand building seeks to increase the product's perceived value to the
customer and thereby increase brand franchise and brand equity
(www.wikipedia.com). When a company is able to deliver a consistent product for an
extended period, they begin to develop a trust with consumers. At this point, a
companys brand itself will increase in value allowing a premium to be charged for its
brand. This increases margins that eventually lead to higher profits.
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Innovation is the single most important strategy in the personal products
industry. Personal products companies are constantly announcing new products and
improvements, and consumers have come to expect them. When these new products
are released, older products may be rendered obsolete. If a company cannot innovate
and keep up with competitors, their own products will quickly become outdated.
Demand for such products will drop until they eventually become extinct. An example
of product evolution can be seen with razors. Razors were originally single blade
instruments. Now they have evolved into instruments with upwards of four blades.
There are also electric razors. Razors are just one example of a personal product that
has changed through innovation. Successful personal products companies must have
the innovative capabilities to improve upon all their existing products. Figure 7 shows
an overall increase in research and development spending over the last two years by
the four major players in the personal products industry.
Figure 7: Research and development expenses
02000400060008000
1000012000
Millions of Dollars
2004 2005 2006Year
Research and Development Expenses
Johnson & JohnsonProctor and GambleColgate-PalmoliveKimberly ClarkAvonUnileverIndustry
Competitors in the personal products industry must also be successful at getting
their product to market. They must effectively manage their products supply chains
and distribution channels. In order to accomplish this, they need to have some power
over buyers. This gives them the ability to distribute their products to wherever they
see fit at the price they see fit. If a retail store has the power to dictate which of a
Figures, in millions of dollars, obtained from
2006 financial statements for each company.
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firms products will ultimately get shelf space and at what price, the firm is not able to
manage the exposure of its own products. In such a case, the retail store is not acting
in the best interests of the firm. Therefore, companies in the personal products
industry need to have some bargaining power over buyers in order to move their
products through the supply chain at a profitable price.
The final element of the differentiation strategy that companies in the personal
products industry must utilize is superior customer service. Products provided in this
industry are indeed personal. Therefore, companies must make every effort to
maximize the satisfaction of their customers. People use these products everyday, and
in doing so, develop an attachment to them. A trust is then formed between the
manufacturer and the consumer. It is the responsibility of the manufacturer to
maintain that trust. If firms do not effectively manage relationships with consumers,
consumers will then turn to another firm. At this point, it is very difficult to regain the
trust of a consumer.
Conclusion
Creating the right mix between cost-leadership and differentiation strategies is
essential to last in the personal products industry and to create value for the firm. Most
firms will favor differentiation; however, cost-leadership must be addressed as well.
Consumers in this industry do desire a certain quality of products, but they will switch
to a lower cost provider if prices are too high. The personal products industry is very
research intensive; therefore, constant innovation is necessary in order to survive.
Finally, firms in the industry must offer a good variety of products while building a good
brand image and maintaining good customer service.
Competitive Advantage Analysis
The personal products industry, as stated above, contains many entrance, exit,
and legal barriers. This allows established firms to look forward into the future instead
of constantly worrying about new entrants into the industry. This has also allowed them
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to be more efficient in the research and development aspect of the firm. It has been
shown that in the personal products industry it is necessary to perform intense research
and development in order to stay ahead of the competitors. For example, Procter &
Gamble steadily increased their research and development investment from year to
year. In addition, they have also made many acquisitions, such as The Gillette
Company in 2005, in order to provide a global advantage in the personal grooming
sector of the personal products industry. Research and development is extremely
important in the personal grooming sector. This can be seen when thinking how just
ten years ago there was no such thing as the Gillette Mach 4, or such high
performance shaving gels and creams as the ones being produced today by Procter &
Gamble. The personal products industry is technologically advanced; therefore, major
players in the industry have had to become extremely efficient and competitive while
keeping the prices low and new entrants virtually non-existent. In addition, Procter &
Gamble has been able to rely heavily on feedback from their consumers, in order to
provide them with functional, yet aesthetically pleasing products. Providing better
customer service is just one way Procter & Gamble has implemented and succeeded
with their differentiation strategies in the industry.
Through maintaining strong relationships with their retailers, Procter & Gamble
has also been able to hold on to vital shelf space, and prime brand recognition. These
intangible assets are extremely important, and if lost, could be detrimental to the firm.
In the personal products industry, it is often noted that the brand sells itself. For
example, consumers often times will automatically buy a certain brand due to history
and satisfaction with that particular brand or product. This is the case only if the
product is reasonably priced. This is where solid relationships with buyers come in to
play. In the personal products industry, the connection between the consumer and
manufacturer is the retailer whom sells the product. Therefore, as long as Procter &
Gamble can maintain their firm relationships with its buyers, they can continue to
dominate the market share in the personal products industry by producing quality,
differentiated products at a reasonably low price.
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Future Competitive Advantage
Procter & Gamble has long been known for their expansion and global research.
In fact, P & G now sells its products in more than 13,000 cities and towns in China
alone, and that number is sure to grow even larger in the years to come
(CNN.Money.com). Procter & Gamble was even recently named the #10 most admired
company in the world by Fortune Magazine, as well as being placed in the top ten in
total sales from the time period of 1999 2007. Although corporate segment net sales
decreased $235 million in 2007, this can be attributed to high transaction costs from
the acquisition of The Gillette Company, and higher interest expenses (P&G.com). Yet,
Procter & Gamble recorded an increase of 18% in their operating cash flows in 2007
and this can be attributed to higher net earnings as well as the acquisition of The
Gillette Company (P&G.com). Since Procter & Gamble acquired Gillette, it has seen an
increase in their Razors and Blades net sales by 49%. This is shown in figure 8 below.
Figure 8: Sales growth of Procter & Gamble by segment
Beauty Health
Care
Fabric &
Homecare
Family
Care
Razors &
Blades Net Sales Growth 9% 14% 11% 6% 49%
Overall, in the future you can look for Procter & Gamble to make huge strides. Due to
their enormous size and ability to turn profits (12% increase in 2007), it is almost a
given that Procter & Gamble will do well in this industry for years to come
(Fortune.com). Also, the constant dedication to research and development continues to
be a high priority for Procter & Gamble. Though many of these activities and costs will
not be realized in the coming year, Procter & Gamble believe this to be a demonstration
of their commitment to the future and the satisfaction of its consumers. With their long
history of achievements and dedication to the factors presented above, success is sure
to come for Procter & Gamble.
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Identification of Key Accounting Policies
Analysis of a companys formal accounting practices starts with identifying key
accounting policies. These key accounting policies are those that help achieve a
companys key success factors discussed previously. The degree of success a company
enjoys directly relates to their ability to successfully implement certain key accounting
policies. Procter & Gamble cites its key success factors as being consumer
understanding, brand building, innovation, go-to-market capability, and scale (2007
P&G 10-K). Analysis of key accounting policies involves assessing the amount of
disclosure the company is willing to give about how they achieve their key success
factors.
Five years ago, Procter & Gamble reportedly owned 12 brands earnings over a
billion dollars in revenue each (2002 P&G 10-K). This number has grown to 23 billion-
dollar brands, with 18 expected to hit the billion-dollar mark in revenue within the next
few years (2007 P&G 10-K). Nearly doubling the amount of billion-dollar brands owned
was not accomplished just by building these brands from the ground-up, many were
acquired through the Gillette, Wella, and Hutchison acquisisions. Focus on brand
building through acquisitions may result in increases to the Goodwill line item on the
balance sheet. Purchased goodwill is the difference between the fair market value of
the net tangible and identifiable intangible assets and the purchase price of the
acquired business (Kieso, Weygandt, &Warfield, 2007). Procter & Gambles purchase
of Gillette resulted in $35.3 billion in goodwill recorded on the balance sheet. As stated
in their 2007 10-K filing, Procter & Gamble does not amortize goodwill, management
assesses it yearly and records impairment if they feel it is necessary.
Procter & Gamble invests an increasing amount of money every year in
innovation through research and development. Both the 10-K and the annual report to
shareholders liberally emphasize the amount of research and development required to
keep the firm growing. All research and development expenses are charged to
Research and Development Expense on the income statement as part of selling,
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general, and administrative expenses. Expensing research and development (instead of
debiting an asset account) is a requirement of GAAP because of the uncertainty of the
results of the research and development (Kieso, Weygandt, & Warfield, 2007). When
research and development results in a useful product and is patented, the legal fees
associated are debited to intangible assets and amortized for the useful life. This is the
procedure Procter & Gamble uses, and states so in their 2007 10-K filing.
With products sold in over 180 countries, 18 of which generated over a billion
dollars in sales last year, Procter & Gamble must be concerned with the risks involved
(2007 P&G 10-K). Procter & Gamble claims to use direct netting to get rid of settlement
risk, risk involving the exchange of currency (2007 P&G 10-K)
(http://www.riskglossary.com/link/netting.htm). Interest rate exposure is lessened
through hedging the interest rates of certain debts in foreign interest rates to reduce
volatility in currency exchange rates. Procter & Gamble uses forward contracts and
options with less than 18-month maturities to curb short-term changes in currency
exchange rates. Since Procter & Gamble also manufactures products in countries
around the world, commodity prices can fluctuate due to economic, political, or
environmental factors. Fixed-price contracts, as well as swaps, options and futures
contracts, are used to reduce exposure to these issues.
Another key accounting policies refers to the disclosure associated with pension
plans and other post-employment benefit plans. Procter & Gamble claims that
contractual commitments associated with pension funding is not currently
determinable (2007 P&G 10-K). They do, however, project near-future expense
variables based on many different assumptions: discount rate; expected salary
increases; certain employee-related factors, such as turnover, retirement age and
mortality; expected return on assets and health care cost trend rates (2007 P&G 10-K).
U.S. GAAP policies are followed in expensing the costs, including a recent addition to
policy, disclosure of under/over funded status.
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Accounting flexibility
A firms accounting flexibility is based on how a company allows their managers
to make decisions in accordance with GAAP. Procter & Gamble considers three items to
be important. These items are employee benefits, goodwill, and revenue recognition.
Both show how Procter & Gamble illustrates a large or small amount of their flexibility in
its accounting policies. The least flexible is revenue recognition because of the strict
GAAP standards and the required amount of accounting. The other two show a lot of
flexibility by using judgment calls and estimations in their accounting policies.
Goodwill
In 2005, Procter & Gamble purchased Gillette to take their company to the next
level. After they purchased Gillette the companys goodwill skyrocketed from 19.816
billion to 55.306 billion. In 2007, it remained steady at an amount of 56.552 billion. Of
the amount of goodwill in 2007, 35.3 billion were from the purchase of Gillette. The
overall amount of goodwill is expected to remain steady unless there is another huge
purchase or sell. Procter & Gamble does not amortize their goodwill, but they do test it
annually for impairment. They also treat other intangible assets in a similar manner as
they do their goodwill. The reason they are a flexible company is that they allow the
management of their company to make judgment decisions when they are evaluating
economic and operating changes. This is putting a lot of trust in your management by
letting them make decisions outside of what is required. When impairing their goodwill
they use forecasts in growth rates and cost of equity. This causes even more judgment
calls by managers. Other companies in this industry such as Johnson & Johnson and
Kimberly-Clark use similar techniques. Kimberly-Clark recorded goodwill in 2006 of
2860.5 million. That is around 16.7 percent of its total assets. In 2006, Johnson &
Johnson reported goodwill as 18.9 percent. In the previous year, they reported
goodwill at 10.2 percent. Overall Procter & Gamble and other companies in the industry
show that they are flexible through the amount of decisions they allow their
management to make.
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Employee Benefits
Procter & Gamble has a lot of benefits, most being post-employment. These
benefits are pensions, specific benefit plans, and other post employment benefit plans.
These Other benefit plans are mainly health care and life insurance based. As far as
their accounting decisions, they are very flexible because you have to be able to
estimate expected salary raises, discount rates, and employee related factors. These
factors are all different because not every employee has the same health. Some
employees are obviously going to cost more to insure than others are. There are many
factors that play into employee benefits. All these factors increase a companys
flexibility because it enables them to make independent decisions aside from what is
required. They also comply with GAAP through certain ways. They defer the difference
between the actual results and their own assumptions up to 10%. Anything over 10%
is expensed in the next year. It is evident that Procter & Gambles employee benefits
are flexible because of the assumptions the company allows management to make.
Revenue Recognition
Of these three, revenue recognition is the least flexible and uses more required
accounting than judgment calls. The reason they do this is that there is not much
judgment needed. Everyone follows a basic strategy. Procter & Gamble recognizes its
revenue when the title has been passed to new owner. This is standard procedure for
all companies in this industry. Another procedure that is involved with revenue
recognition is how they deal with product discounts and returns. They use another
standard industry norm of reducing sales in the time the product is purchased. As said
before there is little if any room for flexibility in revenue recognition. It is standard to
follow the industry norm and record at the time of acquisition.
Conclusion
Although Procter & Gamble is reasonably flexible, they also give a lot of
disclosure through their 10k and annual reports. The reason they are reasonably
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flexible is because of their high flexibility in goodwill and employee benefits and their
low flexibility in revenue recognition. Again, in this industry there is a lot of flexibility
given to the managers. The reason is that their KAPS allow them to make more
judgment calls rather than follow straight out of the book. So not only do they follow
GAAP requirements but also make adjustments when needed.
Accounting Strategy
Companies generally have to follow the GAAP Guidelines while disclosing
financial information in their annual reports. However, it is much better if some
information about results, trends, and insight used by the management could be
provided to the investors. This not only builds trust for the company but also enables
investors to make sound investment decisions. Procter & Gamble uses the Managers
Discussion and Analysis section in the annual report to discuss the financial results
which include several non GAAP financial measures used by them. Along with this, they
have also provided the comparable GAAP measures in their discussion. It is quite clear
that Procter & Gamble is an aggressive company because of excessive amount of
information they provide. By doing this, they are signaling to investors that they are a
high disclosure company that not only show what GAAP requires but they stretch the
limits. For example, Procter & Gamble segment reporting consists of three global
business units which are beauty and health, household care, and Gillette. In each of
these three global business units, Procter & Gamble categorizes their seven reportable
segments under U.S. GAAP. Those are beauty, healthcare, fabric and home care, pet
health, snacks and coffee, baby and family care, blades and razors, and finally Duracell
and Braun. An example of disaggregating is the companys choice to split credit sales
and cash sales. This also allows investors to see a more detailed part of their company.
When compared to a low disclosure firm the roles are completely reversed. A low
disclosure firm on the other hand only provides to investors what GAAP requires of
them. They do not provide any additional information. Procter & Gamble is considered
a very aggressive company not only because of their high disclosure, but also because
they always show an increase in reported earnings. Each year as shown in figure 9,
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36
their reported earnings have grown. They are also proud to show that they give a lot of
dividends and pensions. Their companys motto is Procter & Gamble is designed to
grow (P&G Annual Report). Their transparency is just another factor that shows their
aggressiveness. Either Procter & Gamble can manipulate reported earnings to show a
high income, or they can reduce it to pay a smaller amount of taxes. In 2006, they
overstated their assets to possibly make the company look better. However, they will
have to pay a lot more for taxes. As shown this accounting strategy is very aggressive.
Sustaining Growth (FIGURE 9)
P&Gs performance in fiscal 2006 continues the consistent growth
we have delivered in the first half of the decade. Since 2001:
Net sales have increased 12% per year. Organic sales
have increased 6% per year. Total sales have grown from
$39 billion to $68 billion.
Earnings per share have grown an average of 12% per year.
Free cash flow has grown to nearly $9 billion per year,
totaling more than $35 billion over the past five years.
Procter & Gamble is a company which goes to great lengths to disclose its
companys information. Through their disclosure comes their aggressive strategy. After
researching their financial statements and annual reports it was determined their
industrys competitors disclose large amounts of information. It was also determined
that according to their key accounting policies they are considered an aggressive
company. Nevertheless, this leads a potential investor to think that they can be trusted
because of their high transparency.
Qualitative Analysis
Qualitative analysis is a useful tool in determining the overall transparency and
decision usefulness of the reported financial statements. In order to allow outsiders to
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37
get a good picture of a companys performance, the company must release adequate
information. However, disclosure must also be at a level that does not harm a firms
competitive advantage. Incentives are always present that tempt managers to bias
company reports; therefore, an in-depth look at those reports must be taken in order to
ensure the accuracy of reported information.
The first area that needs to be evaluated is the companys overall level of
disclosure. Procter & Gamble does a good job disclosing financial information. The
notes to their financial statements give a good explanation for everything put into the
financial statements. They dont leave analysts guessing where the numbers came
from. If anything seems out of the ordinary, it is addressed either in the notes to the
financial statements, or in the management discussion and analysis. For example, in
2006 Procter reported a 19 percent increase in selling, general, and administrative
expenses. In comparison to other years, this is a large jump. If no other disclosure
were given, this increase would signal a red flag to analysts. However, the
management discussion and analysis section of Procter & Gambles 2007 10-K goes on
to explain how this large increase resulted from the acquisition of Gillette
(www.pg.com). This good level of disclosure is also consistent throughout the industry.
Dis-aggregation of financial information is also important in order to obtain an
accurate picture of a companys performance. If a company lumps items on financial
statements together, analysts cannot be sure how to allocate the data to individual
business activities. The line items on Procter & Gambles financial statements are
somewhat aggregated; however, in the notes to their statements, line items are further
broken down. One example of this is Procter & Gambles reporting of long-term debt.
Long-term debt is shown as one line item on the 2007 balance sheet. However, note 5
of the 10-K filing dis-aggregates all the long-term debt into individual liabilities complete
with interest rates and due dates (www.pg.com). Figure 10 shows the dis-aggregation.
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Figure 10: Dis-aggregation of long-term debt notes
June 30 2007 2006
LONG-TERM DEBT 3.50% USD note due October 2007 $ 500 $ 5006.1 3% USD note due May 2008 500 500Bank credit facility expires July 2008 4,537 19,5554.30% USD note due August 2008 500 5003.50% USD note due December 2008 650 6506.88% USD note due September 2009 1,000 1,000Bank credit facility expires August 2010 1,830 1,8573.38% EUR note due December 2012 1,882 1,7794.50% EUR note due May 2014 2,016 4.95% USD note due August 2014 900 9004.85% USD note due December 2015 700 7004.1 3% EUR note due December 2020 806 7639.36% ESOP debentures due 2007-2021 (1) 968 1,0004.88% EUR note due May 2027 1,344 6.25% GBP note due January 2030 1,001 9175.50% USD note due February 2034 500 5005.80% USD note due August 2034 600 6005.55% USD note due March 2037 1,400 Capital lease obligations 628 632All other long-term debt 3,657 5,553Current portion of long-term debt (2,544) (1,930) 23,37 35,976
(www.pg.com)
This method of reporting is much more transparent than the single line item on the
balance sheet, and it better depicts Procter & Gambles long-term debt. The rest of the
personal products industry practices similar dis-aggregation methods in reporting.
When a company with multiple segments reports financial information, it needs
to be reported by individual segments. This allows analysts to assess the performance
of each segment of the company. Some segments will out perform others; however, if
there is no individual segment disclosure, there is no way to determine which segments
are the strongest and which are the weakest. Procter & Gamble does report their
financial results based on segments. This breakdown can be found in the notes to
financial statements. For instance, note 12 of Procter & Gambles 2007 10-K breaks
down performance by segment (www.pg.com). Figure 11 from note 12 shows global
segment results.
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Figure 11: Global segment results
Before-Tax Depreciation
&
Capital
Global Segment Results Net
Sales Earnings Net
EarningsAmortization Total
Assets Expenditure
s
BEAUTY AND HEALTH
BEAUTY 2007 $ 22,981 $ 4,794 $ 3,492 $ 577 $ 14,470 $ 641 2006 21,126 4,359 3,106 535 13,498 577 2005 19,721 3,977 2,752 535 11,494 535
HEALTH CARE 2007 8,964 2,148 1,453 279 7,321 189 2006 7,852 1,740 1,167 234 7,644 162 2005 6,078 1,210 811 161 2,536 112
HOUSEHOLD CARE
FABRIC CAREAND
HOMECARE 2007 18,971 4,156 2,793 453 7,649 654
2006 17,149 3,553 2,369 435 6,928 567 2005 15,796 3,186 2,129 391 6,845 647
BABY CARE AND
FAMILY CARE
2007 12,726 2,291 1,440 671 7,731 769
2006 11,972 2,071 1,299 612 7,339 739 2005 11,652 1,924 1,197 580 7,272 684
SNACKS, COFFEE AND
PET CARE 2007 4,537 759 477 164 2,176 141
2006 4,383 627 385 159 2,122 150 2005 4,314 714 444 162 2,197 142
GILLETTE GBU(1)
BLADES AND
RAZORS (1) 2007 5,229 1,664 1,222 657 24,160 210
2006 3,499 1,076 781 489 24,575 271 2005
DURACELL AND
BRAUN (1) 2007 4,031 588 394 194 6,998 135
2006 2,924 400 273 155 7,384 108 2005
CORPORATE 2007 (963) (1,690) (931) 135 67,509 206 2006 (683) (1,413) (696) 8 66,205 93 2005 (820) (1,030) (410) 55 31,183 61
TOTAL COMPANY 2007 76,476 14,710 10,340 3,130 138,014 2,945 2006 68,222 12,413 8,684 2,627 135,695 2,667 2005 56,741 9,981 6,923 1,884 61,527 2,181
(www.pg.com)
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This level of segmentation disclosure is consistent with that the rest of the personal
products industry.
Conclusion
On an absolute basis, Procter & Gamble exercises a high quality of disclosure.
Their 10-K information provides in-depth notes and management discussion and
analysis that discuss any foggy aspects of the reported financial information. This is
done by dis-aggregating single line items found on the financial statements as well as
breaking down results by segments. On a relative basis, Procter & Gamble reports with
about he same disclosure as its competitors. Overall, the personal products industry
practices high disclosure. The tables presented above are not exclusive to Procter &
Gamble. 10-K reports produced by Johnson & Johnson, Kimberly-Clark, and Colgate-
Palmolive all had dis-aggregated reports as well as segmented reports.
Quantitative Analysis
Quantitative Analysis is the financial analysis technique that seeks to understand
behavior by using complex mathematical and statistical modeling, measurement and
research (investopedia.com). This tool will be used to compare sales manipulation
diagnostics and expense manipulation diagnostics. Since there is flexibility in
accounting, a company could manipulate their revenue and expenses in a fiscal year,
which could alter their actual performance. Any inconsistence in a corporations
numbers could throw up a red flag to investors. A thorough analysis of these ratios
can show how accurate or inaccurate the quality of disclosure is from a company. In
the following paragraphs, we will compare sales manipulation diagnostics, which
includes net sales compared to cash from sales, net accounts receivable, unearned
revenues, warranty liabilities, and inventory. We will also compare expense
manipulation diagnostics, which compares sales to assets, changes in operating cash
flows to operating income and net operating assets, and pension and other employment
expenses to selling, general, and administrative expenses.
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Sales Manipulation Diagnostics
Analyzing the sales of a company over a period can show if there are any
distortions to the accounting during those years. Also, comparing these numbers to
their competitors can also show if there are any manipulations of their accounting.
Sales manipulation diagnostics will be used in the following paragraphs for the personal
products industry.
Net Sales/ Cash From Sales
Net sales divided to cash from sales is an important ratio because it shows the
amount inventory sold on credit. An ideal ratio is 1:1. This ideal ratio can be reached,
but it is very hard to maintain due to the high amount of sales on credit. Sales on credit
cause a delay in the amount of cash received, which causes this ratio to be higher than
1:1. It is normal to be slightly higher than a 1:1 ratio in the personal products industry.
Procter & Gambles ratio has fluctuated from around 1:1 to 1.02:1 in the past five
years. This alternating ratio shows that there were higher amounts of sales on credit
one year, but the next year the cash from the sales was received. Therefore, this ratio
shows that the net sales and cash from sales reported are believable.
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Net Sales/ Accounts Receivable
Comparing net sales to net accounts receivable shows us a companys accounts
receivable turnover. Accounts receivable turnover is the effectiveness of a company
collecting debts. As seen in the above graph, all companies have fairly steady net sales
to net accounts receivable ratios. Procter & Gamble has the most fluctuation from 14.28
percent to 11.54 percent, but this number has steadily decreased over the past five
years. The decrease in this ratio, however, is not significant enough to cause a red
flag because there are no sharp increases or decreases over time. A higher ratio
means that the company is more efficient in collecting its accounts receivable. Upon
analyzing this ratio, we believe that net sales are supported by accounts receivable and
that Procter & Gamble are not manipulating their sales.
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Net Sales/ Inventory
Net sales compared to inventory will show how a companys inventory turnover.
Inventory turnover is the measure of how well a company can turn inventory into sales. Each
company in this industry has maintained steady net sales to inventory ratios over the past five
years. From 2003 to 2006, Johnson & Johnsons ratio increased, meaning that more sales were
generated with the inventory that they had. Then in 2007 there was almost a 2 percent
decrease, meaning that fewer sales were generated. Procter & Gamble has had a ratio of
between 11 percent and 12 percent over the past five years. Since there is little fluctuation in
this ratio, there is no reason to believe that Procter & Gamble has manipulated net sales with
respect to inventory.
Conclusion
Using sales manipulation diagnostics for companies in the personal products
industry has shown that some companies have more distortion than others do.
Investors should still be extremely careful in examining a company and be very cautious
if any distortions are found. Procter & Gamble was, overall, consistent in its accounting.
However, this does not mean that Procter & Gamble has no distortion at all. The
financial statements and annual reports should still be examined thoroughly before any
important decisions are made.
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Expense Manipulation Diagnostics
Analyzing the expenses of a company over a period can also show if there are
any distortions to the accounting during those years. Comparing these numbers to their
competitors can show if there are any manipulations of their accounting as well.
Expense manipulation diagnostics will be used in the following paragraphs for the
personal products industry.
Asset Turnover
Asset turnover is generated by comparing sales to total assets. This ratio shows
the amount of sales produced for every dollar of assets produced. All the firms in the
industry, except Procter & Gamble, have maintained a steady asset turnover ratio over
the past five years. The industry leader is Avon, which means that they are efficient in
producing sales with the assets that they have. Procter & Gambles ratio had a
substantial decrease from 2005 to 2006. This would normally raise a red flag for the
company, meaning that assets were understated substantially. However, the sharp
decrease in asset turnover for Procter & Gamble was a result of the acquisition of The
Gillette Company on October 1, 2005. This acquisition increased Procter & Gambles
assets by $74 billion in this year. From 2006 to 2007, Procter & Gambles asset turnover
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ratio rose slightly due to the increase in sales from the Gillette acquisition, and will
continue to increase in years to come.
Cash Flows from Operating Activities/ Operating Income
The ratio of cash flows from operating activities compared to operating income
shows how operating income is supported by cash flows. In the personal products
industry, each company maintained a low and relatively steady ratio with an average of
around one over the past five years, with the exception of Unilevers spike in 2005.
Procter & Gambles ratio fell roughly 0.4 percent from 2003-2005. A drop in cash
caused this decrease in the ratio from operating activities in 2005 while operating
income was steadily increasing. This drop in cash from operations was due to the initial
operating expenses of the Gillette acquisition. Operating cash flows increased in 2006
by 31 percent due to the benefit of acquiring Gillette (PG 10K). This caused the ratio to
become steady for the next two years. Upon analyzing this ratio, it shows us that cash
from operating activities is supported by operating income for Procter & Gamble.
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Cash Flow from Operating Activities/ Net Operating Assets
The ratio of cash flows from operating activities to net operating assets shows how
operating revenue is generated for every dollar in net operating assets that the
company has. The higher the ratio, the more revenue a company has from its fixed
assets. As the graph shows, Johnson & Johnson is the industry leader in this area,
producing $1.05 in revenue, on average, with each dollar in net assets. Procter &
Gamble is on the middle of the industry and has an average ratio of around 0.65 that
has had little fluctuation over the past five years. Even though Procter & Gamble is
among the top in the industry based on cash flow from operations data, they have a
lower CFFO/NOA ratio due to the very large amount of fixed assets that they have
compared to others in the personal products industry.
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Pension Expense/ SG&A
The pension expense to selling, general, and administrative expense ratio shows
how much money is being spent on retirees compared to the rest of SG&A expenses.
Pension expense is a part of SG&A expenses. As a result, this ratio should be relatively
low so that pension expense is only a portion of SG&A expenses. All companies in the
personal products industry have maintained a low ratio over the past five years. Procter
& Gambles ratio has relatively small change, if any, during this time period. This is
because both pension expense and selling, general, and administrative expenses are
increasing at about the same rate.
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Other Employment Expenses/ SG&A
The ratio of other employment expenses to selling, general, and administrative
expenses shows how much is spend on other employee benefits, except for pension
funds, compared to all SG&A expenses. Other employee benefits in a company can
include life, dental and health insurance, retirement programs, and even family
benefits, and is included in SG&A. This ratio should remain relatively stable over time
because the expenses should typically increase or decrease collectively. An increase in
this ratio means that more is being spent on other employment expenses compared to
SG&A. Procter & Gamble has had little fluctuation over the past five years in this ratio.
Conclusion
Using the quantity of disclosure method has shown that some companies in the
personal products industry have more distortion than others. However, these distortions
could be caused by changing their accounting policies, managers, or methods. Even if
these changes explain the distortions in accounting, investors should still be very careful
in examining the company. Procter & Gamble was, overall, consistent in its accounting.
However, this does not mean that Procter & Gamble has no distortion at all. The
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financial statements and annual reports should still be examined thoroughly before any
important decisions are made.
Potential Red Flags
Whenever analysts come across questionable financial reporting, they will red
flag it for further analysis. This is where biased and tampered financial reports will be
exposed. One potential red flag discussed above was with the other employment
expenses to selling general and administrative expenses ratio. Procter & Gamble
reported a small decrease from 2003 to 2005 while the rest of the industry remained
fairly flat. Although the move differed from that of the rest of the industry, it was small
enough to be ignored and is considered to be insignificant. One ratio that displayed a
broad range over the last five years was total accruals to change in sales. However,
the rest of the industry reported very sporadic results here as well. Therefore, there is
no evidence of manipulation here. The last ratio that presented a possible red flag was
cash flows from operations to operating income. This ratio did have a fair decrease
from 2003-2005; however, it never jumped outside the range of the