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Both raw material and manufacturing costs are on the rise for consumer goods; the U.S. consumer price index rose to 233.32 index points in July 2013 from 228.72 index points in July 2012. This situation is raising concerns from consumer goods companies and is forcing them to implement effective cost-management programs. Companies in this sector are adopting various cost-cutting measures, in order to increase the earnings from highly inflated consumer goods.

Procter & Gamble (PG) is one such company improving margins by adopting similar strategies. In this article, we have analyzed the various cost-cutting measures the company has taken in 2013 to find out their impact on future earnings. Will these measures benefit shareholders?

Cost saving initiatives

Procter & Gamble's cost saving plan announced last year to cut costs of $10 billion by the end of 2016 is on track. To break the plan down, the company plans to save $6 billion in cost of goods sold, as well as $1 billion and $3 billion from marketing and non-manufacturing expenses respectively. As of June 2013, the company has saved $1.2 billion in the cost of goods sold.

This year, it is focusing on reducing its working capital requirement. It will do this by increasing the number of days of the account payable to its raw material suppliers. Currently, it takes 60 days to pay to its suppliers, and now it is trying to increase it to 75 days. The expansion of the credit limit will allow Procter & Gamble to use the funds for an extra 15 days, and once implemented it will save approximately $2 billion annually. We believe that this will reduce the company's working capital funding on an annual basis in the near future, and it will contribute towards higher earnings.

Furthermore, Procter & Gamble has been reducing headcounts since two years. By June 2013, it reduced 7,000 employees globally and currently employs 121,000 employees. The company will continue to reduce its non-manufacturing jobs over the coming years and plans to reduce the headcounts by 2%-4% annually till 2016.

These strategies are expected to favorably impact its EPS. With 2.7 billion shares currently outstanding and its savings of $1.2 billion last year, Procter & Gamble's strategies contributed EPS of $0.44 out of EPS of $3.86 last year. This year the company is expected to save $1.4 billion, which will bring additional EPS growth of $0.51. We believe this plan will increase EPS by $3.70 in the long run, assuming that the total outstanding shares remain constant. This incremental EPS is beneficial for income investors seeking earnings in their investments.

What are the peers doing?

Colgate-Palmolive (CL) and The Clorox Company (CLX) are in the same industry and are also adopting similar strategies to offset the high manufacturing and raw material cost. Colgate-Palmolive is running its Global Growth and Efficacy program in order to reduce the company's operating cost. This four-year program started in the fourth quarter of 2012, and the company will spend total of $1.1 billion to implement it.

The program is on track, and Colgate-Palmolive plans to invest $300 million by the end of this year for restructuring its costs. This year, the company is expected to save $30 million to $50 million with its cost restructuring. From the plan's fourth year and onwards, it expects to save approximately $400 million annually.

With 945 million shares outstanding currently, we estimate incremental EPS of merely $0.03-$0.05 this year, but once the plan is complete at the end of fiscal year 2015, these strategies will increase the EPS by $0.42 annually. This estimate assumes that the shares outstanding remain the same.

On the other hand, Clorox's gross margin increased from 42.7% in the fourth quarter of 2012 to 44.0% in the fourth quarter of 2013 ended in June. This increase is due to the various cost-cutting strategies undertaken by the company. The main driver of this margin expansion was the previously announced roll out of concentrated liquid bleach in 2012. Its bottle size reduced 33%, leading to a decline in packaging and shipping costs.

Clorox is aiming for an operating margin upsurge of 1.5% every year. It is adopting a strategy of reducing its selling, general, and administration, or SG&A, expenses as a percentage of sales. Last year its SG&A expenses were 14.4% of total sales. This year it has a target of reducing this to less than 14%. We believe that this strategy will contribute towards its yearly goal to increase operating margins.

Other initiatives

Procter & Gamble's oral care products hold 20% market share. It contributes approximately 7% towards the company's total revenue. The company is focusing on global expansion of its oral care segment. It observed that the toothpaste market in India is worth $1 billion and is expected to grow 14% over the next two years. To capitalize on this, Procter & Gamble recently entered the Indian market with Oral-B Pro-Health toothpaste. Its oral-B is a well-known brand in the toothbrush market, so this is a good strategy to take advantage of the untapped market.

However, Colgate-Palmolive already has 50% market share in India. Colgate's dominance is a risk for Procter & Gamble, but Oral-B is a well-known toothbrush brand in the Indian market. We believe this brand knowledge will help the company to enter the market smoothly and minimize the risk.

Company to buy for future earnings

The cost cutting strategies undertaken by these companies will act as a driver for earnings growth potential. Below, we have compared the trailing P/E and forward P/E of the above companies to show the impact cost cutting measures is having on earnings.

Company

Earnings growth (2014)

Trailing P/E

Forward P/E

Procter & Gamble

6.25%

18.51

17.01

Colgate-Palmolive

5.69%

20.65

18.73

Clorox

7.33%

19.56

17.94

Source: NASDAQ

Forward P/E is calculated on a company's next 12 months earning potential and trailing P/E is calculated from its past 12 months earnings. A lower forward P/E than trailing P/E depicts a company's high earnings growth potential, and by observing above table, all three companies are showing earnings growth potential over the coming 12 months.

Moreover, by comparing the trailing P/E of the above companies with the industry P/E of 18.60, we observe that, only Procter & Gamble has generated earnings in line with the industry's average earnings. The other two companies have generated lesser earnings than the industry average. This fundamental makes Procter & Gamble a more attractive option for investors.

Source: Procter & Gamble: Bulls Won't Regret It, And Neither Will You