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The Procter & Gamble Company (NYSE:PG)

F3Q07 Earnings Call

May 1, 2007 8:30 am ET

Executives

A.G. Lafley - CEO

Clayt Daley - CFO

John Goodwin - Treasurer

Analysts

Amy Chasen - Goldman Sachs

Bill Schmitz - Deutsche Bank

John Faucher – JP Morgan

Bill Pecoriello - Morgan Stanley

Lauren Lieberman - Lehman Brothers

Wendy Nicholson - Citigroup

Nik Modi - UBS

Jason Gere - A.G. Edwards

Chris Ferrara - Merrill Lynch

Connie Maneaty - Prudential

Justin Hott - Bear Stearns

April Scee - Banc of America Securities

Joe Altobello - CIBC World Markets

Bill Chappell - SunTrust Robinson-Humphrey

Alice Longley - Buckingham Research

Linda Bolton Weiser - Oppenheimer

Presentation

Operator

Good morning and welcome to Procter & Gamble's March quarter conference call. Today's discussion will include a number of forward-looking statements. If you will refer to P&G's most recent 10-K and 8-K report, you will see a discussion of factors that could cause the company's actual results to differ materially from these projections.

As required by Regulation G, P&G needs to make you aware that during the call the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results, excluding the impact of acquisitions, divestitures and foreign exchange were applicable. Free cash flow represents operating cash flow less capital expenditures. P&G has posted on its website, www.PG.com, a full reconciliation of non-GAAP and other financial measures. One final note: today's conference is being recorded.

Now I would like to turn the call over to P&G's Chief Financial Officer, Clayt Daley. Please go ahead, sir.

Clayt Daley

Thanks and good morning, everyone. A.G. Lafley, our CEO, and John Goodwin, our Treasurer join me this morning. I will begin the call with a summary of our third quarter results. John will provide additional perspective by operating segment, and I will wrap up with an update on the Gillette integration, our expectations for the June quarter and a brief outlook on next fiscal year. A.G. will join the call for the Q&A's, and as always, following the call I will be available with the rest of the IR team to provide additional perspective as needed.

Now onto the March quarter results. The business delivered balanced top and bottom line growth in the March quarter. Diluted net earnings per share were $0.74, up 17% versus year ago. Accelerating EPS growth was driven by a combination of strong sales growth and Gillette acquisition benefits. Total sales increased 8% to $18.7 billion, driven by volume growth of 6% and 2 points of foreign exchange. Organic volume and sales were each up 6% at the top end of our long-term target range.

Developing markets set the pace with double-digit organic sales growth. Fabric and Home Care led the segments with 9% organic sales growth. The Snacks, Coffee and Pet segment was at the low end with organic sales about in line with year ago, due to trade inventory reductions on coffee and the pet care recall. We expect results to improve for this segment over the next few quarters.

Next, earnings and margin performance. Operating income increased 9% to $3.6 billion, driven primarily by sales growth. The operating margin was up 10 basis points versus year ago. This was lower than we expected going into the quarter, due primarily to several onetime charges that negatively affected gross margins. Gross margin declined 10 basis points to 51.6%. Cost savings projects, pricing, volume leverage and mix added 90 basis points to gross margin. Higher commodity and energy costs reduced gross margin by 50 basis points. The other charges including onetime items related to the Gillette integration, restructuring charges and costs associated with the pet food recall hurt gross margins by 50 basis points.

Selling, general and administrative expenses decreased by 20 basis points behind overhead cost control, Gillette synergies and volume leverage. Non-operating income improved versus year ago due to minor divestiture gains and lower interest expense due to higher than expected cash flow. The tax rate for the quarter came in at 29%, down slightly versus year ago due to strong growth in developing markets.

Now let's turn to cash performance. Operating cash flow for the quarter was up $1 billion versus a year ago to $4.5 billion. Operating cash flow was driven primarily by earnings growth and a significant decrease in accounts receivable. Accounts receivable decreased by 3.5 days during the quarter, due to catch-up collections following the Gillette billing systems conversions and the holiday sales in the last quarter.

Free cash flow for the quarter was $3.7 billion, up $900 million versus year ago. Free cash flow productivity was 47% for the quarter. This brings free cash flow productivity to 97% fiscal year-to-date, ahead of our 90% target.

Capital spending was 4% of sales. This brings our fiscal year-to-date capital spending to 3.5% below our 4% annual target.

We repurchased over 1.3 billion of P&G stock during the March quarter as part of our ongoing discretionary share repurchase program. This brings our fiscal year-to-date repurchases to $4.1 billion. We now expect to repurchase about $5.5 billion this fiscal year. This is up versus our $4 billion to $5 billion historical range as a function of our strong cash flow. Our strategy is to maximize share repurchases within our commitments to the credit rating agencies. In addition, we recently raised our dividend by 13%, making this our 51st consecutive fiscal year of dividend increases.

To summarize, P&G continues to drive balanced top and bottom line growth. Accelerating EPS growth is being driven by strong sales growth, operating margin improvement and the Gillette acquisition benefits.

Now I will turn it over to John for a discussion of the results by business segment.

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John Goodwin

Thanks, Clayt. Starting with our Beauty business, sales grew 8% led by double-digit growth in Prestige Fragrances, Skincare, Feminine Care and retail Hair Care. Cosmetics grew mid-singles, and Personal Care and Cleansing Products were roughly in line with the year ago. Retail Hair Color was down versus prior year, due mainly to the discontinuation of minor brands.

The Fragrance business continues to be driven by innovations across the brand lineup, including Boss Femme, Lacoste Inspiration, BALDESSARINI, Hombre, Valentino Rock 'n Rose and Dolce & Gabbana ‘The One’.

In Skincare, Olay delivered double-digit global volume growth. The strong Olay results were led by North America and China. Both regions were up due to the successful launch of Olay Definity and continued leverage of the Regenerist franchise. Demand for Regenerist has accelerated since the publication of the January issue of Consumer Reports Magazine which named Regenerist as the best wrinkle cream in the market. In addition, the new Regenerist Eye Derma-Pod product became the top-selling eye treatment SKU in the market, essentially overnight. Olay's share of the US facial moisturizers is up nearly 4 points versus last year.

Lower year-on-year SK-II shipments partially offset the strong Olay results in Skincare. SK-II volume was off by nearly 40%, which translates to about 1 percentage point on the overall Beauty sales growth for the quarter. Consumption continues to build month on month, but it will take several more quarters to fully recover from the disruption last fall.

The Always brand delivered double-digit volume growth. Developing market volume growth was up high-teens with China up more than 20%. Shipments grew high-teens in the essential Eastern Europe, Middle East and Africa region. Now the Fem Care business' largest volume market behind the Ultra and Discrete upgrades. Always in North America was up high single-digits behind the Always Clean initiative. P&G now holds 50% of the US Fem Care market value, up 3 points from last year.

Health Care sales were up 10%, driven by growth in personal health care and oral care. Net earnings increased 31% behind gross margin improvements, Gillette Oral Care synergies and lower R&D costs in pharmaceuticals due to the timing of technology licensing payments. In Personal Health Care, Prilosec OTC volumes was up more than 20%, driven by continued consumption growth and versus a soft base period. Prilosec OTC all-outlet value share is up more than 2 points to 40%. Vicks also delivered double-digit volume growth, driven in part to the timing of the cold and flu season versus year ago.

Global Oral Care sales were up high single digits, driven by market share growth in the US toothpaste business and double-digit growth in developing regions. In the US, P&G's all-outlet value share in toothpaste is now at 39%, up more than 3 points versus prior year. The share gains have been driven by the Pro-Health line that launched last summer and Crest Nature's Expressions that started shipping in March. Unit volume in essential Eastern Europe, Middle East and Africa region was up more than 20%. In China Oral Care shipments were up high-teens, and value share is now at 25%, a percentage point improvement versus prior year.

Next in the Household businesses, Fabric Care and Home Care continued to deliver exceptional results with all-in sales growth of 12%. The growth is broad based as both Fabric Care and Home Care delivered high single-digit organic volume and sales growth, and each geographic region delivered at least 7% volume growth for the quarter. Market shares in the US were also strong across the board due to leadership innovation and excellent brand equities in essentially every Fabric and Home Care category. Tide Simple Pleasures, Gain Joyful Expressions, Downy with Febreze freshness, Febreze Noticeables, Cascade ActionPacs and an upgrade to Swiffer are a few of the innovation examples contributing to the growth.

Turning to Baby Care and Family Care, businesses delivered a good quarter with all-in sales growth of 10% and organic sales growth of 8%. The growth was broad based, with organic volume in developing markets up mid-teens and developed markets up high single-digits. Pampers diaper growth was led by P&G's big developing markets. Volume was up mid-teens or greater in China, Russia, Turkey, Poland and Saudi Arabia. In the U.S., Pampers diaper volume was up mid single-digits behind the growth of Pampers Swaddlers and the Caterpillar stretch initiative of Baby Dry. Pampers all-outlet value share in the U.S. is in line with the prior year at 28%.

In Family Care, Bounty volume in North America was up double-digits behind an absorbency and softness upgrade that provides streak-free and lint-free cleaning. Bounty value share in the US is up about a point to more than 44%. Charmin volume grew high single-digits in North America behind the softness upgrade to Charmin Ultra, which launched last fall. Also, Charmin and Bounty Basic both contributed to the top line growth. Charmin all-outlet value share is equal to the prior year at 27%.

Snacks, Coffee and Pet Care sales were in line with prior year levels as double-digit sales growth on Snacks was offset by declines on Coffee, due mainly to trade inventory reductions and Pet Care that was impacted by the product recall. The trade inventory reductions on Folgers reduced sales for the segment by 4 percentage points. Coffee sales were down, due mainly to trade inventory reductions for price increases taken in October '06 and January '07. In addition, we've seen aggressive promotion spending by a leading branded competitor whose early share for the quarter is indexing below volume share despite the two recent price increases. Importantly, market share remains strong for Folgers as past three-month U.S. all-outlet value share is up a point to 32%.

Strong Pringles growth was driven by the Gourmet Select and Pringles Minis initiatives. Both initiatives launched in the U.S. in December and have received incremental distribution support from retailers. Pringles all-outlet value share is up nearly a point to more than 15%.

Blades and Razors delivered 8% all-in sales growth for the quarter. Organic volume and sales were up a solid 4% versus a base period that included the Fusion launch in North America. Developing markets in Northeast Asia delivered high-teens volume growth. Great examples of the top line synergies gained from the combination of P&G and Gillette. Western Europe was also up double-digits behind the Fusion expansion. We continue to see strong results for Fusion in all markets where it has been launched. Fusion all-outlet value share in the US is approaching 48% of male razors and 32% of male cartridges. In the January/February market share period for Western Europe, Fusion reached 54% of male razors and 12% of male cartridges. In Japan, Gillette's share of male blades and razors is up nearly 4 percentage points to 30%.

In the Duracell and Braun business, reported sales and organic volume each increased 3% for the quarter. Net earnings for the segment were down sharply due to higher zinc costs and higher overheads resulting from the full inclusion of Gillette into P&G's cost allocation systems. Of course, cost allocation changes have no net impact to the total company results as the offsetting benefits are spread across the other business segments.

Duracell global organic volume was up low single-digits as double-digit volume growth in developing markets more than offset declines in North America and Western Europe. Mexico, Brazil, Russia and Poland led the developing market growth as we continue to drive for distribution synergies in high frequency stores. Developed market results were soft due mainly to heavy competitive activity, including the carryover effect of some distribution losses last summer.

Braun delivered mid single-digit organic volume growth behind the success of the Pulse Sonic, 360 Complete and Contour male shavers. Braun's value share for male shavers in the US is up more than 2 points for the quarter to nearly 26%, and in Japan value share is up more than 3 points to nearly 34%.

That concludes the business segment review. Now I will hand the call back to Clayt.

Clayt Daley

Thanks, John. I will start with a brief update on the progress of the Gillette integration. We're now 19 months into the integration. The integration continues to progress very well, thanks to the excellent work by all the Gillette integration sub-teams around the world. We remain on track with both revenue and cost synergy targets.

Let me highlight a few areas. During the March quarter, we completed the fourth and final major integration wave. We integrated billing systems, sales forces and distribution networks in an additional 22 countries, representing about 15% of the business. These conversions have each gone very well without any significant business interruptions. About 95% of the business is now running through common billing systems, sales forces and distribution networks. The few remaining countries will be transitioned over the next six to 12 months.

With these integrations largely behind us, our focus is now on distribution center consolidation, plant systems integration and go-to-market reinvention. This work is well underway, but it will take a couple of years to complete each piece. We expect to reduce the number of distribution centers by about 50% by the end of fiscal 2009. Likewise, we expect to integrate the Gillette plant systems at about the same time.

Go-to-market reinvention is a multiyear project, focused on driving incremental top line growth and cost efficiencies. We expect this to add about 2 percentage points to top line growth over the next four years or about half a percentage point per year. This gives us more confidence in our ability to deliver our long-term growth targets. In summary, we remain on track with both integration and acquisition economics.

Now let's move onto guidance. For the current fiscal year, we expect P&G to deliver its sixth consecutive year of growth at or above our long-term sales target. Organic sales, which exclude the impact of foreign exchange and acquisitions and divestitures, are expected to grow 5% to 6%, in line with previous guidance. Within this, we expect a combination of price and mix to have a neutral positive 1% impact. Foreign exchange is expected to increase sales by about 2%. Acquisitions and divestitures are expected to add about 4% growth. As such, we expect all-in sales growth of 11% to 12% for the year at the top end of our previous guidance range.

Turning to the bottom line, we are improving our outlook for the fiscal year based on the EPS results in the March quarter. We now expect EPS to be in the range of $3.01 to $3.03. We expect operating margins to improve by about 100 basis points, driven primarily by gross margin. This includes Gillette dilution, which we expect to be at the low end of the previous $0.12 to $0.18 guidance range. We expect one-time items associated with the Gillette acquisition to be $0.06 to $0.08 per share, in line with the previous guidance.

Turning to the June quarter, organic sales are expected to grow 5% to 6% against the strong base period in which organic sales were up 8%. Within this, price mix is expected to have a neutral to positive 1% impact. Foreign exchange is expected to add about 1%, resulting in estimated all-in sales growth of 6% to 7%.

Turning to the bottom line, we expect operating margins to be up about 100 basis points in the June quarter, driven by both gross margin improvement and SG&A efficiency. As a result, we expect strong earnings per share growth due to both base business results and the ramp-up of Gillette cost synergies. Specifically, we expect earnings per share to be up 16% to 20% in the range of $0.64 to $0.66 per share.

Now moving to next fiscal year: our financial planning process is underway, but it is not yet complete; however, I do want to provide some preliminary perspective. For fiscal year 2008, the priority for the company is to sustain strong sales growth. As such, we plan to invest in our leading brand equities. We plan to launch a strong initiative program, and we plan to make significant progress on go-to-market reinvention.

We expect a number of factors to affect earnings per share next fiscal year. First, we expect to complete a number of restructuring, effectiveness and efficiency improvement projects which we plan to fund internally. However, the amount of restructuring spending is likely to increase versus the current year and may be above our ongoing$ 150 million to $200 million after-tax target range.

Second, we expect a tough competitive environment as many of our competitors are continuing to spend savings from restructuring programs on increased price discounting, trade promotions and marketing spending.

Third, we plan to convert our North American Liquid Laundry Detergent business into a 2X concentrated formula over the course of next fiscal year. We're planning a phased rollout with three geographic waves. The waves are planned for September, January and April. We expect this to be a win for consumers, retailers, the environment and P&G. However, there are a number of one-time implementation costs that we expect to incur next fiscal year during the transition. These include the costs of new molds, manufacturing changeover costs, retail conversion costs and higher marketing support. As such, we expect next year to be a net investment year for this project.

Finally, at current levels we expect raw materials and energy costs to be up versus fiscal 2007. The amount of the increase should be significantly smaller than what we have seen over the past three years. As such, we expect cost savings projects and volume leverage to provide greater benefit to gross margin next fiscal year.

Based on our initial estimates, we expect to deliver on our double-digit EPS growth commitment next fiscal year, which also eliminates the impact of Gillette dilution. We continue to expect Gillette to be neutral to EPS in fiscal 2008. As such, we are comfortable with the current consensus estimate of $3.47 a year or $3.47 per share. But, as I said earlier, the priority for next fiscal year will be to sustain strong top line growth.

Additionally, we plan to increase discretionary share repurchase next fiscal year while maintaining our AA credit rating. This reflects both the cash flow we expect from the business and the proceeds from the sale of the European Tissue business.

Again, this is just a quick overview. We are still completing our planning for next fiscal year, and we will provide more full guidance on fiscal 2008 during the June quarter earnings call.

Finally, I would like to announce a change in our guidance policy. We have decided to stop providing regular mid-quarter guidance updates. We are making this change based on feedback from many of our long-term shareholders. They have told us that the mid-quarter guidance update is creating greater short-term share price volatility and is not of strategic value to them. This policy change will be effective in the October/December quarter, which is the second anniversary of the Gillette acquisition, the time this deal becomes non-dilutive. As such, we will continue to issue mid-quarter updates for the next two quarters as we do not want anyone to construe this policy change as a lack of confidence in the business or a potential problem of any kind.

In closing, P&G continues to deliver strong results. We're making good progress on the Gillette integration and executing with consistency and excellence on the established business. Our outlook for next fiscal year is balanced, with strong investments planned in the business while meeting our EPS commitments.

A.G., John and I would like to open the call up for questions. As a reminder, we are limiting questions to one per person.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Amy Chasen – Goldman Sachs.

Amy Chasen – Goldman Sachs

Good morning. You were talking about the Gillette go-to-market and what you expect that to contribute to sales and some efficiencies and so on. I think you said that you expect Gillette integration to contribute .a half point to sales growth over each of the next four years. But I thought your target was 1% annual contribution?

Clayt Daley

No, we basically said we think that… There are a couple of things going on here. The go-to-market reinvention by itself we expect to deliver 2 points of growth over about four years. That is the half a percent per year. The Gillette deal in aggregate, including the other factors -- the synergies on Oral Care, on Personal Care, other things we have done in the markets that are not go-to-market reinvention -- are what make up the difference.

A.G. Lafley

So it is one plus one half.

John Goodwin

Don't forget, Amy, that we took our organic growth targets up from 3% to 5% to 4% to 6% to reflect that extra growth from Gillette. So the 4% to 6% actually includes the Gillette synergies as well, so that is all wrapped into the 4% to 6%.

Amy Chasen - Goldman Sachs

Okay. But A.G. you just said it is 1.5 all together.

A.G. Lafley

Let me explain. We said that we would increase our growth rate from 4% to 6% to 5% to 7% through the balance of the decade and then Clayt said, okay and that comes from Gillette revenue synergies which at or ahead; okay? All we're saying is in addition to that, we now have firm plans in every MDO operating region for go-to-market reinvention, which will deliver 2 points over four years.

We're not raising our goal. We're simply saying that the addition of the go-to-market reinvention gives us confidence that we can sustain strong performance within our goal range. But we have not changed the Gillette revenue synergies target through the balance of the decade, and we have firmed up the go-to-market reinvention potential.

Amy Chasen - Goldman Sachs

Because I believe originally when you started talking about go-to-market, I think you had said that that encompasses the Gillette stuff. It sounds now -- and correct me if I'm wrong -- that you are now more confident in go-to-market as a standalone project separate and away from Gillette.

A.G. Lafley

We are because it is much more clearly defined. So region by region we have firm goals for every region. We know what the key drivers or contributors are of the go-to-market reinvention program in each region, and we have a firm schedule to execute on.

Amy Chasen - Goldman Sachs

Just two follow-ups related specifically to this. (1) When do we start to see that half a point from go-to-market? (2) What about the cost side of go-to-market?

A.G. Lafley

On the cost side, we have identified costs and cash opportunities. Again, they are detailed by business unit and by region. On the one half, as Clayt said, starting next year.

Amy Chasen - Goldman Sachs

In FY08?

A.G. Lafley

Correct.

Amy Chasen - Goldman Sachs

On the cost side, you have identified opportunities. Can you quantify those?

Clayt Daley

Well, it is part of the overall synergy plan. What we have said before is, that $1 billion to $1.2 billion cost synergies we said we think we're going to be at the upper end of that range. That is really all baked into the same plan.

Operator

Your next question comes from Bill Schmitz - Deutsche Bank.

Bill Schmitz - Deutsche Bank

Good morning. Can you just comment on what you do to accelerate Beauty growth? I know some of the big focus businesses are doing all right like Olay, but it seems like Hair Care has been a little bit of a stumbling block recently. Obviously Color Cosmetics has been a problem for awhile. What is going on in the competitive environment, and what do you need to do to get that line moving again?

A.G. Lafley

Bill, I think the first thing we have to do is step back and look at whether our strategies are working and I think they are working reasonably well. Our focus in the Beauty Care business is on Skin Care and Hair Care. Our Skin Care business is strong by any stretch, even with the SK-II issue in China this year, which has clearly been a drag; a full point last quarter, a point on the Beauty Care line this quarter. We will come all the way back from that. It is just going to take time.

I think our Skin Care business is strong, and I think you see that clearly in the numbers and clearly in the health of the Olay brand.

On the Hair Care side, if you look at our worldwide progress, it is actually pretty doggone good. We're growing high mid singles on a total global basis; in developing, we're actually growing double-digits this fiscal year. One of the issues in the US this year is our major Pantene initiative was originally planned for three to six months earlier in the year. It is actually going right now. That is what we call the Pantene Parthenon initiative. It is getting a great retailer reception. We are cautiously optimistic about what that will do.

Head & Shoulders continues to be strong. It is on its way to becoming a $2 billion business. It just became a $1 billion business a couple of years ago. We have clear leadership in that segment of Hair Care. Herbal Essences is growing. We grew double-digit worldwide in the most recent period and fiscal year-to-date. The relaunch in the US is going quite well. I think we're going to exceed $700 million in sales this year. I believe this brand is on its way to $1 billion.

Stepping back, I do like our position in Skin Care and I do like our position in Hair Care. In Skin Care we're not the leader, but we're growing faster. In Hair Care we are the leader and we are still growing. We're heading for $1 billion in Hair Care sales in China. Growing high singles or double-digit every period with higher than a 50 share in the Shampoo segment, which is far and away the biggest and still growing our share there, despite all the spending by all of the competition.

We are like rack ‘em and stack ‘em freaks in benchmarking everything. If you step back and look at P&G versus our best Beauty Care competitor over the last one, three, five years, we are outperforming in Hair, Skin and Fine Fragrance. They are outperforming in Color, in department stores and specialties and clearly in Color Cosmetics. That is where we are right now. I don't think that is a bad place to be.

We will continue to work our way up the learning curve in retail coloring and styling. We are very focused in Color Cosmetics. We're playing where we can play effectively. I think our Cover Girl share was up a point in the most recent quarter.

Let's face it, we are learning Professional, and what we're doing there is we're focusing on four markets, which are 50% of our Professional sales. We're focusing on putting the Wella system, which is very education and service-oriented, in place around the world. We made a big change in the US, which clearly we gave some ground in the short-term to put ourselves in a stronger position in the mid and long-term. And we're being very choiceful, as I said, in Color Cosmetics.

If you stepped way back, our Beauty Care, the last thing we're doing is we have been slowly but surely weeding some of the weaker brands and lines out because we want to focus on the businesses that we can grow. But if you still way back, we have been very consistently growing up our top line. Our gross and operating margins are leading the pack in the industry and growing and our profitability has been quite good.

The last thing I will say is, stand by. We have a hell of an innovation program, and it is across the board. Clayt mentioned that. We are going to invest in our leading brands, we're going to invest in our innovation program and our initiatives next year. So I'm not discouraged by the Beauty Care business. We have come a long way. We have built a lot of capability. We have a strategy that is working. We've got a great leadership team there, and we're going to be very competitive.

Last point on Beauty, it is so big. That the industry is so big. It is so demographically advantaged. No single competitor has even 10% of the market. There is plenty of room for everybody to grow and do well.

Operator

Your next question comes from John Faucher – JP Morgan.

John Faucher - JP Morgan

I was wondering if you could give us an idea as we look at the Braun Duracell numbers that came in a little lighter than expectations, I believe it is mostly Duracell driven. What is going on in the category there and what steps are you taking to get that moving again?

A.G. Lafley

We will double team this one. I think Braun is pretty simple, John. We have narrowed the focus of the strategy. We are trying to drive margin improvement, which is incredibly important for this business before we feel comfortable making major investments. So you see us doing better in the electric razor business, in the epilator business. We're growing share in key markets there, and we've got a nice innovation program there. You see us stepping up and shutting down a big, frankly, noncompetitive manufacturing site in Western Europe, in Spain.

If you look inside the results, we are improving our gross and operating margins. We are not where we need to be, but frankly Daryl and his team are working on all the right stuff. So I think that is a patience story. It was a business that, frankly, in Gillette was not performing like it should have, and we're going to get it performing. The last thing I would say is they are going to become a design and device leader for us in the network. So they are definitely contributing.

Duracell is a very different issue. As Clayt said, we're growing pretty well ex-US and ex a couple of markets in Europe. Frankly, in those markets, our key competitor basically set back the whole price increase in the US this quarter on a lot of promotions; a lot of coupons, a lot of BOGOs, a lot of stuff.

Clayt Daley

Buying store space.

A.G. Lafley

Basically bought space and bought display, and this is the game you can play in the short term. The obvious response will be we will stiffen our consumer promotion program, and we will stiffen our trade program retailer by retailer. The snake will swallow that frog and be about the same size. That will be sort of a tit for that tat game. There are no issues with the Duracell equity. We still have a strong or stronger equity in most markets. There is no real issue with the product lineup. We just lost around the promotion and pricing game in the most recent quarter.

Operator

Your next question comes from Bill Pecoriello - Morgan Stanley.

Bill Pecoriello - Morgan Stanley

Can you help us understand on the gross margin, operating margin versus your expectations in the quarter, because there is a number of things going on. You had the pet recall, coffee inventory, you had negative mix in a couple of divisions that you might not have expected when the savings came in. So, in terms of the negative mix, the blades/razors you had the strong growth in the D&E, but you knew you were lapping Fusion. So, if you could help us understand versus the expectation where did you see the negative mix and break out those other items?

Clayt Daley

You have mentioned a number of the points that are spot on. The couple that I would add to that are we have some charges that came in the quarter; some were related to the Gillette integration, and some were related to our ongoing restructuring program. Of course, we are telling people to implement those projects as quickly as we can, so the degree to which people can implement projects earlier is good.

Now we are not changing the guidance on the year on margin. Those were things that were baked into the plan for the year. They just happened earlier than we expected them to happen, and the process of trying to project margin while a major acquisition integration is going on is not an exact science. We were off a bit this quarter. Of course, the pet recall, which happened after we've provided the guidance, did not help either.

So when you take all those factors together, that really explains what happened in the March quarter. But importantly, we have said we think the margin for the year is going to be about the same, and therefore, the offsets will come in the April/June quarter and are consistent with the guidance for the April/June quarter.

Operator

Your next question comes from Lauren Lieberman - Lehman Brothers.

Lauren Lieberman - Lehman Brothers

Following up on that, it still feels to me even though you said that the Gillette cost synergies are running ahead and you are on track or ahead, it still just feels like there was something missing this quarter from a margin perspective. I understand that there were some greater than expected one-time expenses. Should we think about you took more upfront charges this quarter so there should be an acceleration in the savings in the next couple of quarters?

Clayt Daley

John mentioned this in his prepared comments, but I want to be clear. What we have done as of the Jan-March quarter is we now are allocating all of our corporate costs to the Gillette businesses, both Gillette Blades and Razors and Duracell Braun as if they have been part of the company all along. During the earlier parts, before we had actually implemented a lot of the integration, some cost synergies that were coming out of the former Gillette company were flowing into the Gillette businesses. They weren’t at that point getting the full cost allocation for P&G.

So you could argue that in a perfect world the margin improvement might have been a little higher than it would have been on a full cost allocation basis a year ago. So now we're seeing the impact of allocating the costs. I understand that the segment numbers are a little bit impacted by this, but the Gillette cost synergies are still completely on track, and that is consistent with the dilution. We thought dilution was going to be $0.12 to $0.18. We're now basically saying dilution is the bottom of the range, and therefore, we are still feeling very good about it.

The other final thing I would say is that in the year-ago period there was a legal settlement in the Gillette segments that was about 20 basis points or so roughly, and that is also creating a little comp issue when you are looking at it strictly quarter to quarter.

Operator

Your next question comes from Wendy Nicholson - Citigroup.

Wendy Nicholson - Citigroup

First on the Gillette business, I know part of the strategy when you bought the business was to expand the number of distribution points, if you will, in certain markets where your business was strong of the Gillette products and vice versa. Can you quantify, for example, in the Gillette business how much more distribution they have than they did, let's say, two years ago because they are benefiting from your sales force in markets like China?

My second question is, you talked about higher restructuring charges in fiscal '08. Is there any chance that you decide to drop those below the line and make them extraordinary like some of your competitors have done?

A.G. Lafley

On the distribution thing, it is a rolling initiative. For instance, the Duracell results in developing markets, a fair amount of that is driven by additional distribution in what we call higher frequency stores. One of two things happen. Either we're getting distribution where we had none or we're getting more distribution and a better display and physical presence, and I think that is building.

We increased our distribution in Mexico, for example, in higher frequency stores in batteries from 55% to 90% in the stores where we are present. Now obviously, we would like to get that to 95% and beyond. As a result of that, our value share is up over a point to 47 plus in Mexico. You asked about China. In Blades and Razors I think we've added about 70,000 new stores to direct coverage through our distributors. This is almost a 50% increase. Our Gillette System Razor share was up almost 6 points in the quarter. So we're plugging away at it.

I will be the first to say that we still have some opportunities we can’t close on. Our distribution opportunities in toothbrushes, for example, is outpacing our capacity. So we have made a number of investments in additional capacity so we can catch up with demand and with distribution opportunity. I fully expect by the end of 2007/2008 fiscal year we will have opportunities matched with capabilities, and we ought to be able to fulfill all of them.

Clayt Daley

I will just comment on the restructuring subject. As we have said before, we have been spending $150 million to $200 million after-tax in restructuring. We believe that restructuring is an ongoing activity, As we have said, we are probably going to spend more than $200 million next year because we are really getting focused on how do we continuously improve the cost structure of the company, improve our operating efficiency and effectiveness.

But we just don't believe that reporting separate charges is right. It tends to be fashionable right now, but we don't think it's the right thing to do long-term. We think that there's an operating discipline here for the company that says restructuring is an ongoing activity. Frankly, as we have talked through a lot of our major shareholders, they are happy about the fact that we are viewing it that way and that we are viewing restructuring as something we need to do continuously as opposed to an episodic kind of event.

A.G. Lafley

Wendy there is also, frankly, an organization capability and organizational culture advantage to doing it this way. I think Clayton, John and the team talked a little bit at CAGNY about our belief that we can continue to improve our productivity on all sorts of major productivity measures. Over the last year we have quietly identified productivity goals and opportunities for the company over the next five years. We really want to get our businesses, both the global business units and the market development operations and our supporting functions Global Business Shared Services, all focused on continuous improvement in productivity until we become clearly best in class and achieve all of the benefits of our global scale.

That is the basic idea. We already know from the work going on in some of the businesses and functions that there are going to be opportunities, and those opportunities are going to require some restructuring. As we plan for the next year or two, we're going to plan for the restructuring. There will be a benefit for our consumers because we will be able to offer better value everyday in our pricing. There will be advantages for our customers and suppliers because we will run a more efficient supply chain and there will be advantages for our shareholders because we will get better returns. We will get better returns on every person. We will get better returns on every asset.

We have been doing 5% or 6% or better per year in terms of productivity over the last five or six years, and we think we can at least continue that, maybe accelerate a bit in a good year.

Operator

Your next question comes from Nik Modi - UBS.

Nik Modi - UBS

If you can talk about the transition in the Health Care business as you go away from drug discovery and towards partnerships, when we will start seeing that new model start taking place on the P&L? Can you talk about some of the projects that you are working on?

A.G. Lafley

Let's step back because as I have said before, the one strategy that we need to fully clarify, focus and prioritize is our Health Care strategy. Broadly what we're doing is we're moving to more consumer poll-driven Health Care products and even testing services.

On the pharmaceutical side, we will continue to drive as long as we can our major Actonel and Asacol brands. But we have shutdown our discovery operations and we have in-licensed a number of new drugs. Enablex is in the market and doing quite well and already contributing to the sales and profit of the business unit. The other drugs are in Phase II, so we are a few years away. But we still have confidence in the strategy. Because we have picked some fairly narrowly focused therapy areas that we understand that relate to businesses that we want to be in.

On the over-the-counter side, Prilosec keeps going from strength to strength. We've got Metamucil and Pepto going. Frankly, Vics is on its way to becoming $1 billion brand, and I will be the first to tell you when we made that acquisition in the mid-80s, Pantene and Olay took off over the next 10 to 20 years, but we sort of let Vics just wander along. We've had a very focused effort the past year, year-and-a-half or two, and we're really seeing it coming in the results, not just in the US and Western Europe but even in developing markets. So I like that over-the-counter business.

Finally, I think you know we announced a couple of joint ventures in January. One gets us into home consumer, home testing devices. We have a pretty good company that is already in the business out of Boston and then we are going to test a services model with this MDVIP company out of Florida and you will see us do a couple of things. One, you will see us organically create some new product lines in the businesses and brands, and you will also see us take small positions either as full acquisitions or as joint ventures to continue to learn in areas that we are interested in, which are primarily consumer driven.

Last point is Oral Care is obviously a big part of our Health Care strategy. I have said before and I really believe that there is plenty of room for our principle competitor to grow and for us to grow in the Oral Care business. I was looking over the past decade because this quarter to quarter stuff, you can lose track of what is really going on in the business.

But ten years ago in 1998 the first full year after Total was introduced in the US, we had a 25 plus share, Colgate had 27 plus share in the US? Nine to ten years later all-outlet we have a 38 share, almost a 38. They have about a 32, almost a 32. Our share is ahead in food and drug; so it's not just on an all-outlet basis, which captures, by the way, half of the market that is not included in food and drug.

We also made a very concerted effort to focus on China because if you put the US and China together, you have got over a third of the volume of Oral Care in the world. So instead of chasing 100 markets, which we would not have the capability to do, we focus on a couple. We are actually focusing on ten. In China we have the leading brand. We're growing from strength to strength. We have very strong equity.

Beyond the competitive brand to brand stuff, we have built a regiment of products so we can do everything from denture adhesives to floss to a full line of brushes now with Oral-B, which will come when we get the capacity in place because we do make some very excellent products. In fact, our new under $20 rechargeable brush is taking off, absolutely taking off. So I think the combination of the Oral Care, the consumer driven Health Care and the shift in Pharma to more licensed in and very focused areas are going to serve us well.

Because if you step way back, the biggest market that we compete in by far, by far is health care. The biggest component of GDP for most developed countries is health care, and the rate of growth is staggering. So this Company has got to have a strong position in health care for the 21st century and we are going to get it.

Operator

Your next question comes from Jason Gere - A.G. Edwards.

Jason Gere - A.G. Edwards

Can you guys just talk a little bit more about Western Europe and the environment there? What is going on competitively? How are the categories growing and how you are performing?

A.G. Lafley

Western Europe is actually one of our positive stories for this fiscal year. It is not an easy economy. It is not growing very fast. It is not an easy retailer environment. It has got the highest discount penetration and the highest private-label penetration in the world. It is not an easy competitive environment. But despite all that, we're growing our volume and our sales mid single-digits. We have been growing our total share for nine plus months in a row, so every month this fiscal year. We're now growing volume share, in 14 categories accounting for more than 70% of our business, and we're growing value share in all but one of our major categories.

We have made real inroads with some of the major discounters in distribution and presence. We're widening the share gap versus our key branded competitors. We have got a really good innovation program and we are building real capability there.

Operator

Your next question comes from Chris Ferrara - Merrill Lynch.

Chris Ferrara - Merrill Lynch

I want to ask about the long-term targets you guys have out through the Deliver the Decade concept. The 24% operating margin we know you guys have clearly said is either something you would like to deliver, but if you can drive the higher end of sales growth, then you won't deliver that 24% margin. The midpoint of the top line range of 6% and 24% margin implies a certain level of EBIT dollars. If you guys were to not deliver that 24% margin, does that imply that those EBIT dollars, the sacrificing of margin savings for better top line growth, does that imply better EBIT dollars than you would have delivered if you did do the 24% margin and 6% top line, or is that off?

Clayt Daley

You are on all the right issues. The 24% goes back to when we announced the Gillette acquisition. We basically put that target out there because we wanted to reassure our shareholders that the synergies that were going to come from Gillette were going to be on top of regular margin improvement on the base business and that we were not taking a timeout on margin improvement on the base business because of Gillette. So it was somewhat of a mechanical projection at the time.

You're exactly right. We are actually ahead of the game plan on sales growth versus when we established that target. So in order to deliver the double-digit EPS growth -- and that is the key point, the key message I want to leave you -- maintaining double-digit earnings per share growth is the primary objective. What we have said is if we can do that with more sales growth and less margin expansion, that is okay. In fact, we're perfectly happy with that as an operating strategy, which means by the end of the decade if we can sustain top line growth, margin could be somewhere in the 22% to 24% range. I don't want to get too specific because I don't want to imply that we are going to do anything to try to hold back sales growth.

Now getting to the key point of your question in terms of how much EBIT dollars come out of all that, I think the EBIT dollars that come out are probably comparable to what we would have done if we had done less sales and hit the 24% versus doing more sales and something less than a 24%. Because, of course, it is the EBIT dollars that will eventually drive the earnings per share. So that is the way we're thinking about it.

Operator

Your next question comes from Connie Maneaty - Prudential.

Connie Maneaty - Prudential

Do you guys have the schedule for how laundry compaction is going to work in the second half of this year?

A.G. Lafley

Yes, we do. The first wave is this fall in September. It is a three wave rollout, and I want to say September, January, April. The issue is it is such a big business, that is about the maximum that we can crank out wave by wave.

Clayt Daley

That is being done because of literally what is feasible to do in the manufacturing plants.

A.G. Lafley

Connie, this is going to be a great initiative. It is a clear win for consumers as John said in his comments. It is better value, it is better performance and it is a better environmental and sustainability profile. It is a big win for our retailers and our supply chain. Once we get through the fairly major investment that Clayt referred to, which we will make this fiscal year, it is going to be a big return for the company. So this is a win all the way around. Everything we have done in the test market and in the learning market so far with a lot of major retailers give us confidence that we can execute this with excellence.

Operator

Your next question comes from Justin Hott - Bear Stearns.

Justin Hott - Bear Stearns

You have talked in the past about increasing advertising effectiveness. Can you give us some guidance on the balance between advertising sales growth this quarter and how advertising is improving?

A.G. Lafley

I think our advertising as a percent of net sales is about the same. I want to say it is around 10% in the US; a bit more right? Which is actually, Justin, the kind of result I would like to see because we are investing. We are investing in our innovation, and we are investing in our leading brands so that means that the market mix modeling work and the marketing ROI work that is being done in the businesses on the brand is contributing. It means we are getting a little bit more effectiveness and efficiency for every dollar spent.

Now in terms of trends, while we are still investing a lot in television especially in developing markets, because it is a hell of an efficient investment because there is just so much scale. If you step back and look at our mix across most of the major brands it is clearly shifting and it is shifting from measured media to in-store to the Internet and to trial activity.

Just a quick comment on trial activity. I think you know we went back and ran a second round of sampling on Gillette and Fusion, and you're going to see us do more trial activity and more sampling. Because we still have relatively low trial rates and a lot of consumer trial opportunities on some of our major brand initiatives. So we have identified a fairly long list of opportunities and the different businesses and brands are getting out and against them.

But more is going in the store. More is going on the Internet. More is going to non-measured media and we are getting a little bit more efficient every quarter, every year because of our focus and, frankly, our discipline with market mix modeling and marketing ROI.

Operator

Your next question comes from April Scee - Banc of America Securities.

April Scee - Banc of America Securities

I was just looking for a little bit more detail on the developing markets. Clearly double-digit growth, it is still strong, but your peer group also had a very strong quarter from what we have heard so far in the March quarter from the developing markets. I'm just wondering how much from a top line perspective are the developing market top line synergies contributing? Should we start to see that pick up as we get through the June quarter and into fiscal '08?

A.G. Lafley

Well April, developing markets are an engine of growth and are going to continue to be an engine of growth. Yes, we had a very good quarter, pretty strong double-digit growth across the developing market. We are building off a pretty big base now. If you think of our base, it is roughly 27% of company sales, give or take, on a $76 billion business, that is $20 billion. $20.5 billion roughly. So this is a big base.

I think what you see in some of the relative growth rate is just the difference in scale. We have got a $3 billion business in China, almost $1 billion business on hair alone. We're growing at a good rate, but some of our competitors are growing off much, much, much smaller business bases. The kind of bases we had five, six, seven years ago. So you're going to get a higher growth rate.

The other point I would make and I think it's a really important one, is just like I feel like in Beauty Care, Health Care and Personal Care, the underlying dynamics of the market offer opportunities for growth for all the best players. I think that's true pretty much in developing markets too. We are still on fairly steep rising income curves. We are still just at the takeoff points for some of these categories. You have to have a certain amount of income to be able to afford to purchase and use a lot of these categories on a regular basis, even on an occasional basis. So I think there's a lot of growth there.

The last thing I would say is what we found really makes the difference are three fairly simple things. One is you've got to build a local organization, and I think one reason we have been fairly successful is we have built a strong local organization.

The second thing is you have got to build a very strong distribution network and system, and we have an approach which we have talked about on a number of analyst conferences which works quite well. We basically build a distributor system, and we have fairly strong distribution in virtually all of these markets.

The third is you have got to build leading brands position. You absolutely positively have to build leading brand positions. They get built by deep understanding of consumer needs and basic product lines that meet consumer needs.

So I feel pretty good about our developing market position. I think you saw an announcement where we're going to put Asia together so we can drive some real learning and synergy across the Asian markets and grow even faster there because Asia and Central and Eastern Europe, Middle East are going to be the real developing marketing engines of growth.

Operator

Your next question comes from Joe Altobello - CIBC World Markets.

Joe Altobello - CIBC World Markets

I just wanted to go into the operating leverage story for a little bit. It seemed like it slowed a little bit this quarter. What was odd was that on the segment level, it actually looked pretty good. But the above the line corporate spending year-to-date by my math is up about $300 million. I was curious, is that the Gillette integration spending? Is that restructuring? Is there an allocation issue in there?

Clayt Daley

I think there's some of both. I mean, as we have said, a lot of the Gillette integration spending does not qualify to be part of the intangibles, so there is baked into the dilution numbers transition spending that is occurring that has to get booked against P&L as it is incurred. The other part is, yes, the internal restructuring program, our $150 million to $200 million after-tax restructuring program, is also probably going to be spent towards the upper end of that range this year.

Operator

Your next question comes from Bill Chappell - SunTrust Robinson-Humphrey.

Bill Chappell - SunTrust Robinson-Humphrey

I just want to follow-up on Connie's question on compaction. With the first big wave coming in September, are you not seeing any of the costs, new molds, whatever in this June quarter, or is everything really weighted toward fiscal '08? When do you expect -- is it end of fiscal '08 or early '09 -- that you would actually start to see benefits from this program?

Clayt Daley

The costs really are incurred when you start manufacturing the product. Because obviously the initial production of the new compacted product, those cases are the ones that bear the higher mold costs. They are the ones that bear the higher conversion and operating costs. So because the first wave is September, most of those costs really start in next fiscal year. There's not much in the current fiscal year. They really do hit next fiscal year disproportionately.

As we have said, we think when we come out of next fiscal year into fiscal '08 and '09, that we should not only have a number of those conversion costs behind us, but we should begin to start seeing the benefit. Now of course, there will be some benefits that come in next year, but they are being more than offset by the conversion costs in the fiscal 2007/2008 year.

Operator

Your next question comes from Alice Longley - Buckingham Research.

Alice Longley - Buckingham Research

Could you elaborate a little bit on why the Beauty margins were down in the quarter and why Fabric Care were up? Those two categories are important. As a follow-up, should we be expecting the Fabric Care margins to be down over the next fiscal year, or will growth in developing markets more than offset the pressures here?

Clayt Daley

Well, the Beauty Care margins are being impacted by marketing spending behind the initiative programs. That is the primary factor that is influencing Beauty Care margins is investment behind the business.

For the Fabric and Home Care segment, it is pretty close to call. I'm not positive whether those margins will be up or down. I will say that the impact of the conversion of liquid detergents in the US, there probably won't be any margin growth next year but I'm not sure as we have gone through the numbers as to whether that would actually be down or not.

Operator

Your next question comes from Linda Bolton Weiser - Oppenheimer.

Linda Bolton Weiser - Oppenheimer

You have gotten the pricing now in Olay well past the $20 market retail and I noticed you introduced a $7 or $8 deodorant. I was just wondering if you feel the price value relationship for the consumer is getting out of whack in any of your businesses, and if you are seeing any need at all at this point to consider rightsizing in any of your businesses?

A.G. Lafley

Not really, Linda, not really. Certainly not in developed markets, meaning the US and Western Europe. This is such a complex subject, and I don't want to dive into the complexity, but what we really try to do is have what we call a point of entry product line that is accessible and affordable. On Olay that is the Complete line, basically. And then we build the lines out, offering basically more regiments and more value in terms of more performance. That is pretty much what we do whether it is Skin Care, whether it is Hair Care, whether it is one of our Fabric and Home Care businesses. In fact, interestingly some of the high-ends of the market have been growing faster than some of the middles of the market. That has certainly been the case in Hair Care, and that has been the case in Skin Care.

The one place where I think we still have a big opportunity to offer more consumer value, and that is going to mean affordability and accessibility, is still in developing markets because we can trigger faster growth in those categories if we can get in at a price point that will enable regular purchase and usage. So that is why we're doing things like this disposable diaper test market which we expanded in China. That is why we have done the India diaper program, the India Hair Care program. We have a very simple product called Downy Single Rinse that we introduced in Mexico that enables all of these women who are basically hand washing in developing markets to save water and, frankly, to get through the job a little bit faster. That has taken off, we're expanding that. We have some Feminine Care products, Naturella, that we have been able to introduce at a little bit better price point that have done very well. But we need more.

The key here, though, is we're trying to innovate to meet her needs and her habits and practices. So we don't want to dilute products. We still want to delight her, but we want to understand the task at hand for her and then give her just what she needs to get that done, no more. When we do that, we can price it right. We can size it right. We can get it in distribution in those higher frequency stores. That is where our big opportunity is, on affordability.

Operator

With that, we will conclude today's question and answer session. Gentlemen, I will turn the call back to you.

Clayt Daley

Thank you for joining us today. We certainly appreciate your interest in the company, and as I said at the outset, the IR team and I will be around for the rest of the day for any follow-up discussion if necessary. Thanks very much.

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