Procter & Gamble - Texas Tech University

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 world’s 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 10K). 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 world’s 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 10

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 & Gamble’s 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 Sales Growth 6% 6% 6% 68,222 76,476 6% 5% Procter & Gamble is categorized in the household and personal products industry of the consumer goods sector. Procter & Gamble’s 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 & Gamble’s major 11

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 & Gamble’s 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 & Gamble’s 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 12

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 & Gamble’s purchase of Gillette. Because of Procter & 13

Gamble’s 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 company’s historical growth rate can be used when trying to forecast future sales. The industry’s 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 Source: PG, JNJ, KMB, CL, and AVP 10k's; Unilever financials 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 14

also need to focus less on quality and more on price reduction when looking at nonbrand 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 competitor’s 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 15

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. 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 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 & Johnson’s ratio over the same period averages 1.18, while Kimberly-Clark’s is only 0.25. Colgate-Palmolive averaged 0.75. The industry average 16

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 ColgatePalmolive would probably be considered to be at an acceptable capacity. KimberlyClark may be considered to be at a very efficient capacity. Exit Barriers When a firm’s 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. 17

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 1830’s, 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 firm’s 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. 18

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 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) 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, 19

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 customer’s (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 lesserknown brand, allowing them to pay a premium on these items. Often, the brand names 20

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 develo

industry average, Procter & Gamble is gaining on their competition year by year. However, capital structure analysis shows that Procter & Gamble's 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