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The Procter & Gamble Company (PG)

F1Q08 Earnings Call

October 30, 2007 8:30 am ET

Executives

A.G. Lafley - Chairman & CEO

Clayt Daley - CFO

Jon Moeller - VP & Treasurer

Analysts

Nik Modi - UBS

Bill Pecoriello - Morgan Stanley

John Faucher – JP Morgan

Amy Chasen - Goldman Sachs

Bill Schmitz - Deutsche Bank

Wendy Nicholson - Citigroup

Justin Hott - Bear Stearns

Lauren Lieberman - Lehman Brothers

April Scee - Bank of America

Chris Ferrara - Merrill Lynch

Ali Dibadj - Sanford Bernstein

Jason Gere - Wachovia Capital Markets

Bill Chappell - SunTrust

Joe Altobello - CIBC World Markets

Alice Longley - Buckingham Research

Linda Bolton Weiser - Oppenheimer

Bill Leach - Neuberger Berman

Operator

Good morning, everyone and welcome to Procter & Gamble's first quarter 2008 conference call. Today's conference is being recorded.

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 reports, 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 impacts of acquisitions and divestitures and foreign exchange where 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.

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 Jon Moeller, our Treasurer, join me this morning. I will begin with a summary of our first quarter results, and Jon will cover business highlights by operating segment. I will wrap up with our expectations for the December quarter and updated outlook for the fiscal year. Following the call Jon Moeller, Chris Peterson, John Chevalier and I will be available to provide additional perspective as needed.

Now onto our results. We began fiscal year 2008 with a first quarter in line with our guidance and our long-term growth targets. We delivered balanced top and bottom line growth in each geographic region and every reportable segment delivering year-on-year organic growth.

Earnings per share for the September quarter increased 16% to $0.92 per share. This included a one-time tax benefit of $0.02 per share. Excluding this benefit, the company's EPS growth was 14%. EPS growth was driven by strong sales growth and a modest operating margin improvement.

Total sales increased 8% to $20.2 billion, driven by 5% volume growth and 3 points of foreign exchange. Organic volume of sales for the quarter were each up 5%. Developing markets set the pace with double-digit organic and volume sales growth. Fabric and Home Care and Baby and Family Care led the segments, each delivering 7% organic sales growth.

Health Care and Beauty Care were at the low end of the segments. This was largely due to a tough base period comparison in which Crest Pro-Health and Olay Definity began shipping. Also, SK-II in Asia was a 1 point drag on Beauty Care growth. Importantly, market share in both Health and Beauty Care are up versus prior year. As such, we expect results to improve for these segments in the balance of the fiscal year.

Global market share trends over the past three months continue to be strong with about two-thirds of our businesses growing share. Price mix was neutral as pricing actions to recover higher commodity costs were offset by negative mix from strong developing market growth.

Next, earnings and margin performance. Operating income increased 9% to $4.4 billion, driven by sales growth and operating margin expansion. Operating margin was up 30 basis points, in line with previous guidance.

Gross margin was up 10 basis points to 52.9%. Pricing, volume leverage and cost-savings projects more than offset the impact of higher commodity costs and laundry compaction conversion costs. Higher commodity and energy costs hurt gross margins by about 80 basis points.

Selling, general and administrative expenses were down 20 basis points versus year ago. Lower overhead costs as a percent of sales more than offset higher marketing spending. The tax rate for the quarter came in at 27.6% due to the one-time tax benefit of $0.02 per share. This one-time tax benefit was due to a reduction in German statutory tax rates. As a result, we have revalued our deferred tax assets which generates a one-time gain. We expect this one-time tax benefit to be net incremental for the fiscal year as well.

Now let's turn to cash performance. Operating cash flow in the quarter was $3.2 billion, up nearly $300 million from the same period last year. The improvement was largely due to earnings growth. Working capital was a net use of cash in the quarter versus a year ago, primarily due to strong business growth. Receivable and inventory days were up one and four days respectively versus the year ago period. This was primarily due to stronger foreign exchange at the end of the quarter. Payable days were up four days versus year ago as we are converting a number of suppliers to new, longer payment terms.

Capital spending was $540 million in the quarter or 2.7% of sales, well below the company's 4% annual target. Free cash flow for the quarter was $2.7 billion. Free cash flow productivity came in at 87%, roughly in line with year ago. This puts us on track to beat our free cash flow target for the fiscal year.

We repurchased $2.6 billion of P&G stock at an average price of $64 during the September quarter, as part of our recently announced three-year $24 billion to $30 billion share repurchase program. Combined with $1.1 billion in dividends, P&G distributed $3.7 billion to shareholders in the September quarter, or 120% of net earnings.

To summarize, this is a good start to the new fiscal year. P&G continues to deliver broad-based, balanced top and bottom line growth.

I will now turn it over to Jon for a discussion of the business unit results by segment.

Jon Moeller

Thanks, Clayt. Starting with the Beauty segment, sales grew 6%, led by double-digit growth in Prestige Fragrances. The impact of the SK-II business disruption in Asia that began late September last year reduced total Beauty sales by approximately 1 point this quarter. In Fragrances very strong double-digit results were driven by recent initiatives on the Dolce & Gabbana, Hugo Boss and Lacoste franchises.

Hair Care delivered another solid quarter with mid single-digit sales growth led by double-digit growth in developing markets behind Head & Shoulders and Pantene. In the U.S., all-outlet value share improved for each of P&G's top three retail Hair Care brands: Pantene, Head & Shoulders and Herbal Essences. Combined, P&G's value share of U.S. Hair Care increased by nearly 2 points to 34%. Retail hair color sales were in line with prior year as the business prepares for the launch of the revolutionary Nice 'n Easy initiative, Perfect 10, in January.

In Skin Care, Olay sales grew double-digit in developing markets behind continued expansion of the key Olay franchises. This includes the launch of Olay Regenerist in Poland, new Olay Total Effects Skin Cleansing SKUs in Russia and a restage of the White Radiance line in China. Olay's excellent developing market results more than offset lower shipments in developed markets where the base period included the Olay Definity launch. Importantly, Olay Facial Moisturizer U.S. all-outlet value share continues to grow with past three months share up more than 1 point versus prior year to 43%.

Sales for the Grooming segment increased 9% for the quarter, driven by double-digit global sales growth for Blades and Razors. Global Blades and Razors value share has increased 0.5 point and now stands at nearly 71%. These strong top line results were led by over 20% sales growth in developing markets. Mach3 delivered high-teens shipment growth of blades in developing markets, due mainly to distribution synergies. Also, the Prestobarba brand in Latin America has benefited from increased distribution and strong results of the Prestobarba 3 initiative.

In male shaving, Fusion continues to drive strong share growth. In fact, Fusion has driven share growth in premium male systems in all markets where it has been launched. In the U.S., Fusion's share of male systems blades is up nearly 12 percentage points versus prior year to over 32%. Fusion and Mach3 combined share of U.S. male systems blades is up 5 points to 77%. In female razors Venus Breeze continues to drive strong share growth with U.S. all-outlet value share of razors up almost 5 percentage points to nearly 48% for the quarter. Braun shipments were lower versus prior year, due to supply constraints on the Home Appliance business in Western Europe and a de-emphasis of the business in the U.S.

Health Care sales increased 7%, led by high single-digit growth in Oral Care and Feminine Care. Sales were up mid single-digits for Pharmaceuticals and Personal Health Care. In Oral Care, Crest and Oral-B both delivered solid global growth on top of the base period that included the launch of Crest Pro-Health toothpaste in the U.S.. In the U.S. toothpaste business, Crest all-outlet value share was up more than 1 point to 37% behind new initiatives such as Crest Pro-Health Night Toothpaste and Crest Plus Scope Whitening Paste and Rinse. Oral-B manual brush share in the U.S. was up versus prior year as the business improved supply capability.

In Feminine Care, developing markets led the growth with a mid-teens shipment volume increase. The Naturella brand was up more than 20%, and Always grew double-digits in developing markets. In the U.S., Always and Tampax each grew all-outlet value share more than a point this quarter and are now at 56% and 51% of the markets respectively.

In Personal Health Care and Pharmaceuticals, the addition of the Swiss Precision Diagnostics joint venture and pricing and mix benefits in pharma were the main sales growth drivers. Prilosec OTC U.S. all-outlet value share was up more than 2 points to 43%.

Sales for the Snacks, Coffee and Pet segment were up 6% for the quarter as Snacks and Coffee each delivered double-digit sales growth. Pet Care was down versus the prior year due to the continued negative impacts of the wet pet food recall last fiscal year. The strong Snacks results were driven by the Pringles Rice Infusion launch in Western Europe. Coffees sales were up due to the launch of the Dunkin' Donuts brand into mass retail channels, Folgers new Black Silk and House Blend innovations, and price increases to recover higher commodity costs. Folgers all-outlet value share in the U.S. is up nearly 1 point to over 31%.

Next, Fabric Care and Home Care delivered another very strong quarter with 10% total sales growth. Home Care shipments grew double-digits, Fabric Care volume was up high single-digits and Batteries grew mid single-digits. Home Care grew behind the restage of the Dawn brand in North America, the launch of Febreze Candles and the continued expansion of Fairy auto-dishwashing in Western Europe. In the U.S., Home Care continues to build value share in key segments. All-outlet share for Dawn, Cascade, Febreze and Swiffer all increased from prior year levels.

Fabric Care volume was up in all geographic regions for the quarter, including high single-digit growth in North America. P&G launched the first wave of the North American liquid laundry compaction initiative in September, and conversion continues to go as planned. The first wave covered the southern portion of the United States. The second wave will begin in late January and will cover the middle and northwestern U.S.. Finally, the third wave will ship in April of 2008 covering the northeastern U.S. and Canada. Tide all-outlet value share in the U.S. increased more than a point to over 41% for the quarter. Market share for Gain, the second-largest detergent brand in the U.S., also increased.

Batteries volume was up 12% or more in each developing market behind distribution increases and solid market growth fundamentals. Sales in developed markets were up mid single-digits behind volume growth and pricing taken last fiscal year to recover higher input costs. Duracell all-outlet value share in the U.S. is down slightly versus prior year to just under 47%.

Baby Care and Family Care grew 10% on high single-digit volume growth for both businesses. Family Care top line growth was driven by pipeline shipments of the new Charmin Ultra Strong innovation, continued growth of Charmin basic and strong retailer support for Bounty. Bounty all-outlet value share is up more than a point to 44%. Charmin's share is in line with year ago levels at 27%.

Baby Care top line growth was due mainly to the ongoing success of Pampers Baby Stages, Swaddlers and Cruisers products and Pampers Baby-Dry with Caterpillar-Flex. In the U.S., Pampers value share is up 2 points to over 30%; and in Western Europe value share is up a point to 54%. Pampers continues to expand its presence in developing markets with China, Russia, Poland, Saudi Arabia, India and the Philippines all posting shipments up 10% or more for the quarter.

That concludes the business segment review, and now I will hand the call back to Clayt.

Clayt Daley

Thanks, Jon. For fiscal year 2008, the priority for the company continues to be to sustain organic sales growth at or above target levels. We plan to invest in our leading brand equities, we plan to launch a strong innovation pipeline, and we plan to make significant progress on go-to-market reinvention. We again expect to deliver our annual double-digit EPS growth commitment without separately reported restructuring charges and excluding the positive year-on-year impact of Gillette dilution. Consistent with our plan, since we announced the deal, we expected Gillette to be non-dilutive to EPS in fiscal 2008.

That are a few factors that have changed since we provided our initial outlook on the fiscal year that should be discussed. Raw material and energy costs have increased significantly over the past few months. At current levels, we now expect these costs to impact gross margins by 75 to 100 basis points in fiscal year 2008. Given the increase in input costs, we have announced a number of price increases within the last 45 days.

Specifically, we have announced the following pricing actions in the U.S.:

Effective this month, a 4% to 8% increase on coffee and a 9% increase on fabric softeners. Effective in January 2008, a 5% to 12% increase on Olay and Ivory Personal Cleansing products. Effective in February 2008, a 5.5% increase on Bounty and Charmin, a 5% to 8% increase on Pampers and a 3% to 5% increase on Blades and Razors. We continue to evaluate pricing in other parts of the business.

In total, we still expect modest gross margin improvement in the fiscal year despite higher input costs. Pricing, volume leverage and excellent work in the business to implement cost savings projects should more than offset the increase in commodities and energy.

Relative to the consumer, our markets continue to grow in both the U.S. and around the world. While we have seen a modest slowdown in market growth rates in the U.S., international market growth rates continue to remain strong. In the U.S. we are not seeing any trade down to private label. Over the past three months, P&G is growing share in about 75% of the U.S. business, while private label share is declining in the vast majority of categories in which we compete.

We continue to see trade-up behind compelling consumer innovations; innovation is still creating value for consumers for which they are willing to pay a premium. Successful products such as Gillette Fusion, Olay Definity, Tide Cold Water, Downy Simple Pleasures and, of course, Crest Pro-Health are prime examples of what great innovation and affordable price can do despite an economy that is putting pressure on consumer spending.

Now we also know there's a lot of focus on our Beauty Care business. Beauty delivered 4% organic growth in the quarter, including a negative impact from SK-II of about 1%. While this is within the company's overall target range, we are looking forward to accelerated Beauty Care going forward. Competitors have increased spending, and we plan to respond with strong support behind our upcoming innovation program. This includes the Perfect 10 hair color launch, the Head & Shoulders restage, new premium items on Olay Regenerist and Definity, and several new Prestige Fragrance launches.

Now onto the numbers. For fiscal year 2008, we expect organic sales growth of 4% to 6%, in line with previous guidance. Within this, we expect the combination of pricing and mix to be flat to up 1%, foreign exchange should have a positive impact of about 3%, acquisitions/divestitures are expected to have a 1% negative impact on top line results, and therefore in total, we expect all-in sales growth of 6% to 8% for the fiscal year. This is an increase of 1% versus our previous guidance due to increase in foreign exchange outlook.

Turning to the bottom line, we are increasing our fiscal year earnings per share outlook by $0.02 per share due to the one-time tax benefit. Specifically we now expect earnings per share to be in the range of $3.46 to $3.49, up 14% to 15% versus the prior year.

We now expect operating margins to improve by 50 to 100 basis points driven by lower overhead costs as a percentage of sales and modest gross margin improvement. We have widened our operating margin guidance to reflect the increase in input costs and higher foreign exchange impacts. Foreign exchange affects operating margins as the U.S. business has significantly higher operating margins than the international business.

On the tax rate, we now expect the fiscal year to be at or slightly below 29%, excluding the 50 basis point benefit from the one-time tax item. This change in the base business tax rate is a result of updating outlooks for foreign exchange impacts, geographic sales mix and the impact of the company's ongoing tax planning.

Now I want to take a moment to provide some more perspective on tax. As we have said, quarterly tax rates will be more variable than in the past. Accounting rules require companies to recognize the full impact of discrete tax items in the quarter in which they occur. These include events such as resolution of outstanding tax audit settlements. These types of items are estimated in our guidance, but we have a varying degree of visibility on the timing and amounts. As we gain more visibility, we will update our guidance for them as we are doing this quarter.

In addition, there will occasionally be true one-time changes that aren’t foreseen and are not included in our guidance. The German tax rate item this quarter is a prime example. Absent these one-time impacts, we expect our tax rate to be at or slightly below 29%.

We continue to expect our share repurchases to be in the range of $8 billion to $10 billion for the fiscal year. As such, we expect interest expense to be up due to increased debt levels.

Turning to the December quarter, organic sales are expected to grow in the 4% to 6% range. Within this, we expect a combination of pricing and mix to be about neutral, foreign exchange should add 3% to 4% to sales, acquisitions and divestitures are expected to have a negative 1% to 2% impact on P&G's top line growth and therefore, in total, we expect all-in sales growth of 6% to 8%.

Within the segments, Beauty Care results should improve. While organic sales growth and grooming is expected to be up modestly due to a strong base period comparison, Blades and Razors delivered 8% organic growth behind the Fusion launch in several markets.

Turning to the bottom line, we expect margins to improve modestly as SG&A improvement will be largely offset by lower gross margins. Gross margins are expected to be temporarily lower due to higher commodity and energy costs and the investments needed behind the North America laundry compaction initiative. We expect gross margins to recover in the second half of the fiscal year due to pricing, the benefits of the North American laundry compaction initiative and increased cost savings from restructuring projects.

We expect non-operating income to be up versus year ago in the quarter due to the timing of divestitures, but for the fiscal year, we continue to expect non-operating income to be lower than last year.

Finally, we expect the tax rate for the quarter to be at or slightly above 28% due to the anticipated timing of tax settlements. Net we expect earnings per share to be in the range of $0.95 to $0.97 for the quarter, up 13% to 15%.

In closing, P&G continues to deliver balanced top and bottom line growth. We are converting earnings to free cash flow ahead of target and returning more than 100% of this cash flow to shareholders through share repurchase and dividends. We are confident in our sustainable growth model going forward.

Now I would be happy to open up the call. A.G., Jon and I will take your questions.

Question-and-Answer Session

Operator

Your first question comes from Nik Modi - UBS.

Nik Modi - UBS

If you could just walk us through the MDOs where expectations are in line or above and also where they are missing your internal expectations, if you wouldn't mind doing that first?

Clayt Daley

Well, developing markets are on track as we said in the call. I think once we get beyond developing markets, we did note a slight slowdown in the U.S. market -- certainly not market shares, but the market growth -- and that has had some impact on the business. I think Europe is pretty much as we expected. It is not exciting growth, but it is about the same as it has been.

Operator

Your next question comes from Bill Pecoriello - Morgan Stanley.

Bill Pecoriello - Morgan Stanley

I wanted to just get a little more detail on the Beauty segment. You had talked about you gained share overall in Beauty, but I wanted to get a feel for how the timing of your innovation pipeline was impacting the growth this quarter versus the acceleration you expect? Have the categories slowed in the current quarter? You had mentioned competitive spend.

A.G. Lafley

The first thing we're watching, of course, is the market share. As we reported, the market shares actually look pretty good. Our Hair Care share had one of the biggest pickups we have had in a while in North America. The good news about Hair Care in North America is there has been a lot of competitive activity, and our share pick up was across all of our major brands. So we feel good about that, obviously.

If you go around the world -- without getting into all of the details -- we're in good shape from a share standpoint everywhere but [AFIAN] and Latin America, and we have got to pick up the pace there. So we're doing pretty well. We're doing very well in SEMEA. We still earned a very strong position in China. We're on an upswing in Japan. I just told you about the U.S., and we're in a very solid steady growth position in Western Europe.

There is a timing of initiatives issue. We had a strong base period. We introduced Herbal Essences Hot Spots initiative in I think June last year, and it carried through the first quarter. That is when the big launch was. We had Definity on Olay. So we had a pretty strong year ago period. If you look at our schedule of initiatives this year, they get stronger as we go through the fiscal year. You've got a base period effect and you've got a post period effect.

I will say two things. Obviously Susan and I would like to have a couple more points of growth out of the Beauty Care business. SK-II has not come back as fast as we would like, and we think it can come back faster. We have got that business refocused. I just came back from a couple of weeks in Asia. We will be investing behind our initiative program in the future, and we will be investing longer behind it because I think as I have talked before it takes longer to build the trial, and we can build more trial over time.

Finally, we are looking at ways that we can combine our Beauty Care initiatives across markets so we get a stronger MDO execution. I think there are a lot of opportunities for us there. So overall the Beauty strategy I think is where we want it to be. It is all about initiatives, timing and initiative execution.

Operator

Your next question comes from John Faucher – JP Morgan.

John Faucher - JP Morgan

There has been a lot of speculation coming from the sell side in particular in terms of how you are going to change your portfolio in terms of divestitures. Can you talk about some of the stuff we don't see in terms of the culture there and how easy do you think it will be or how difficult will it be to make changes in terms of selling off brands, businesses, what have you? Do you think there's a big cultural component that maybe we're not factoring in?

Clayt Daley

I would not say the cultural factor is an issue. I think we have been clear in the past on our criteria. We evaluate all of our businesses in terms of their ability to deliver sustainable earnings, sales growth, earnings growth and CFROI. If they can deliver over long periods of time, we like to have them, and businesses that are either underperformers or inconsistent performers become divestiture candidates. We have divested a number of businesses over the years and there have not really been cultural issues that have impacted those decisions.

The final comment I will make though is there has been a whole lot of speculation out there in the press, and that is exactly what it is; speculation. There is no news on this subject, and the speculation is just that.

A.G. Lafley

John, if you look at the track record from 2000 to the present, on a fairly regular basis we sort through our portfolio, weed it out and sold off or spun out from the businesses that either do not make strategic sense, aren't performing up to our expectations or just don't fit. We're going to continue to do that.

Operator

Your next question comes from Amy Chasen - Goldman Sachs.

Amy Chasen - Goldman Sachs

Would you mind just running through these price increases again? I think you went a little fast. As a follow-up to that, I just wanted to get your sense on how easy it will be to get this pricing relative to the pricing you took over the last two years, given that the consumer is probably in a less good place than she was two years ago?

Clayt Daley

Well, I will run through the list again, and then we will comment on the editorial side. 4% to 8% in coffee; 9% in fabric softeners. 5% to 12% on Olay and Ivory Personal Cleansing products; 5.5% on Bounty and Charmin; 5% to 8% on Pampers; and 3% to 5% on Blades and Razors. There was also a Eukanuba price increase implemented as well.

Pricing is always something that can create some uncertainty in the marketplace, but these are commodity driven. In most cases, competitors have announced similar price increases already, including some private label competitors which is virtually unprecedented. I think the chances of these price increases going through relatively efficiently is very high.

I think what we have seen over the last two or three years as we have been raising prices is that these are not huge increases. They are not sticker shock increases. Consumers have seen much larger increases in other things they buy than what they are buying from us. As we said before, we are not seeing private label shares growing, and therefore, I think this round of pricing we hope will be similar to what we have been doing over the last couple of years.

A.G. Lafley

Amy, if you just think about it real quickly, there is not going to be much customer resistance because they are seeing the same energy and commodity cost increases, and as Clayt said, they are pricing their private labels and they have been pricing the food side of their business.

Regarding the competition as Clayt said, many of the branded competitors have already announced and even private label manufacturers have announced.

Regarding the consumer, we have a pretty good idea of what represents the right value equation. We have proprietary test methods and we know what kind of increases we have been able to take. Here is the key: we're taking increases on brands and product lines that in most cases deliver superior performance and quality.

So we will see, but they are in line with the kind of increases we have taken in similar circumstances before. We're not talking about high out-of-pocket prices for consumers here, and we're talking about staple items.

Operator

Your next question comes from Bill Schmitz - Deutsche Bank.

Bill Schmitz - Deutsche Bank

For the December quarter, the new tax rate, is that going to be another $0.01 or $0.02 benefit to numbers?

Clayt Daley

The answer is the tax rate at around 28% by itself would create about a $0.01, but that has always been baked into our plans.

Bill Schmitz - Deutsche Bank

Okay. So that is nothing new?

Clayt Daley

Right.

Bill Schmitz - Deutsche Bank

In terms of the retail environment, is it consumer softness or is it the trade getting scared ahead of the holiday season in terms of the U.S. market softness?

A.G. Lafley

I think it is consumer, Bill. If you look at our numbers this time, when we do low single-digits, we do 2 to 4 in Western Europe to Japan and the U.S. That is all driven by macro economic and consumer. I don't think it is driven by any trade reaction. In fact, if anything if you look to what the trade is merchandising and what the trade is featuring and what the trade is focusing on, they are focusing on keeping the traffic flowing. In many cases, that benefits our leading brands and benefits our categories because they are weekly purchase and daily consumption.

Operator

Your next question comes from Wendy Nicholson - Citigroup.

Wendy Nicholson - Citigroup

If I've interpreted your message over the last couple of quarters the right way, it was that the emphasis of the company was going to shift more towards top line growth in '08 or '09 and that you were willing to forsake your operating margin target in order to accelerate that top line growth.

But if I look at the numbers today, it clearly looks like you're going to miss the operating margin target for 2010 by a couple of hundred basis points, maybe. But you are struggling to just come in line with the middle of your long-term guidance on the top line. So it does not look like all that higher spending is really translating to faster top line growth.

Do you think that is just a function of the difficult environment in the U.S.?

Second, can you talk about the restructuring charges -- that $400 million to $500 million that you were supposed to see in 2008 -- how much of that showed up in the first quarter? I know you don't want to call it out too specifically, but just to give us a sense of how much that hit your margins?

A.G. Lafley

Wendy, I think it's all a matter of balance. First of all, we think we are on track for our operating margin targets. So we need to talk with you in detail about that if there is a difference of opinion. We think we're making our gross margin progress and our operating margin progress, and that is important.

But it is a matter of balance. As Clayt said in the prepared remarks, well, first of all, you have got to step back. We feel great about our Fabric Care results. We feel great about our Home Care results. We feel great about our Baby and Family Care results. In all cases they are good or better than anybody in the marketplace, anybody in the world. We feel good about our Beauty and Personal Care results because the market shares continue to grow.

What you're looking at basically is a difference in footprint and a difference in mix. We have more exposure in developed markets. Some of our competition has a lot more exposure in developing markets, and we're all growing double-digits in developing markets.

There is an issue of balance which I want to be crystal clear about, and that is there are two things going on in some of the Beauty Care categories in some of the countries around the world. That is that the amount of spending has increased. When it is spending behind initiatives that differentiate your brands and product line, bring new consumers or increase the loyalty of current consumers, we think it is good spending and we need to stay competitive there. There are a few places where we have not been as competitive as we want to be.

The second issue is it takes awhile to build the kind of trial rates in a market like we are in right now, which is hotter, which is more fragmented, which with a media plan that has far more pieces to it and we're going to stay with our investment behind our initiatives longer.

Finally, I don't want to get into specific examples, but we have got a couple of competitors that are spending on a single brand launch more than we spend across the whole category. We can’t sit in situations like that and let them try to buy the market share. That just isn’t going to happen.

So that is really what we're looking at. It is a dial turn to get the balance right on the Beauty and Personal Care side of the business, where it is a hot market right now. There is a lot of activity. But I think if you step back and look at the whole portfolio, it is pretty understandable and the share growth is what we're really focused on. Because in the end, that is about consumers voting for your brands and your products everyday in the store and liking what they use at home because they come back and purchase them again.

Clayt Daley

Obviously we're still guiding the 1,500 basis point margin improvement in this year. The restructuring that we have announced, the $300 million to $400 million program, is baked into those margin plans. I think what we have said on numerous occasions before is that we have a target to get to a certain EBIT level by the end of the decade. We're not fixated on a margin number, and that is obviously a combination of sales growth and margin expansion and we are on track to achieve our objectives by the end of the decade.

Operator

Your next question comes from Justin Hott - Bear Stearns.

Justin Hott - Bear Stearns

Can you tell us a little bit more about how this consumer slowdown might hurt you in the U.S. compared to some of the others you have seen? How might your strategy be similar or different from what you have done in the past? Secondly, maybe a little more color on the innovation pipeline, how you feel on Olay?

A.G. Lafley

I think the pressure on consumers in the U.S. is well reported and extremely well covered. I mean it is on housing, energy costs, debt and there is more pressure on lower income consumers than there is on middle and upper income consumers, and I think that shows in the profile of retailer results and channel results. I think that is fairly well understood.

The second thing I would say is this industry and our company is a relatively good performer in these kinds of economic conditions. I think that has been the history at least in the 30 plus years I have been with the company. We do relatively better in recession, and some are predicting a recession right now but it is not clear there is going to be one. The reason I think is fairly straightforward. We sell almost exclusively certainly predominately every week purchase, everyday usage Household Care and Personal Care products. What we're seeing is a little bit of softness in some of the markets, but they are still growing. That is the key and that is important.

The second thing we're seeing is that the question that we got from Amy about pricing is a good one, but we are not seeing pressure on the consumer value side. We would not be building share on 77% of our business in the U.S. if our consumer value was out of line. So the consumer value looks about right. As you know, we have been driving trade ups in a lot of Household Care and Personal Care businesses. So that is fairly encouraging.

In fact, the private label shares are as weak as they have been this decade in the U.S. So that suggests that the price premiums that we're taking still represent excellent consumer value. Now we are obviously all over that testing for pre-market and watching it in market.

The last thing I would say is about the innovation program. That is when we are ready to go and for a lot of good reasons, this program gets little bit stronger each quarter as we go through this fiscal year. We have new lines on the Skin Care side and specifically on the Olay side. We have new lines of Regenerist products. We have new SK-II bundles. We have Definity, a new line of Definity products.

I think you have seen our clinical strength products from Secret and Gillette, and we have got some new cosmetic products coming on Cover Girl and Max Factor, and we have a very full bundle of fragrance products that I think as you know go in for the Christmas season for the most part every year. So we've got a pretty good lineup on Skin Care.

Operator

Your next question comes from Lauren Lieberman - Lehman Brothers.

Lauren Lieberman - Lehman Brothers

A question about the overall model. Going back a couple of years, one thing that I think I always missed was the power of the leverage you were getting on growing the top line and controlling overhead. It does seem like that is going a long way to offset some of the raw materials cost inflation you're going to be facing. But it does feel like that leverage is maybe decelerating a little bit.

Also it feels like the higher margins, structurally attractive mantra of a couple of years ago that some of those businesses may be requiring greater investment to get the growth than you had initially thought. Are those fair statements or what am I maybe missing?

Clayt Daley

I think obviously there has been a surge on the Gillette synergies over two years and continuing this year that has positively impacted the overhead costs in SG&A. But our view is that we're committed to ongoing productivity improvements in SG&A, and we have specific targets by business unit. We believe that those targets that we have established by business unit, they are relative to their growth plans and so they are not going to inhibit their growth plans. So we believe we can adequately fund innovation for growth at the same time we can improve overhead cost efficiency going forward.

A.G. Lafley

Lauren, we have run 5% to 6% a year productivity improvement this decade. We're going to continue it. We are structured to do it. We are focused on it, and as Clayt said, we have specific goals by businesses.

Your question about support is a good one, and it is actually a tale of two cities. Clearly in some of the Beauty categories the price of poker has gone up. That is crystal clear. Part of that is driven by the amount of new brand and new product activity. That pace has quickened. Part of it has been driven by the intensity of the competition. But one critical point that you have to keep in mind, the Beauty industry is huge worldwide; hundreds of billions of dollars. If you take the top five competitors and add them up, you're still only at about 40% of any market.

So there is plenty of room for everybody to grow share. When you get into developing markets, there is even more room for everybody to grow share and to grow their business at a fairly good pace because you've got a lot of category development going on in addition to the markets that are there, especially in the larger urban centers.

What is going on in our Household businesses is actually the cost of doing business is stable or going down a bit because there's less competition. So if you look at our Fabric Care business, and you know the story there, there have been withdrawals by a couple of major competitors from major markets that reduces the cost of playing poker. If you look at some of the other big businesses we're in, Home Care or Baby Care or Family Care, I think the MSA and MDA spending has been fairly, what I would call measured and prudent, because of the structural nature of those kinds of businesses. So yes, it is costing a little bit more in some businesses to compete, but in other businesses it is not.

Clayt Daley

Of course, part of our ongoing plans is not to reduce marketing investment as a percent of sales; that which is embedded in the SG&A.

Operator

Your next question comes from April Scee - Bank of America.

April Scee - Bank of America

Could you just give us a quick update on the litigation between Procter and Teva for Actonel? Specifically, how do you think about the chances of an at-launch risk by Teva given Teva's propensity to be somewhat aggressive and the unusually long time for the court to make a decision? Are you doing anything to prepare for that possibility?

A.G. Lafley

Obviously the decision is pending. We think our case and our position is a strong one, and we will carry the day. Yes, Teva or any other generic manufacturer could take the risk that you described, but it is triple damages if they lose. So it is a big bet and that is their choice. But that is the game in pharmaceuticals right now, and we think we will prevail. We have got patent protection through 2013, and we're just going to have to see.

Operator

Your next question comes from Chris Ferrara - Merrill Lynch.

Chris Ferrara - Merrill Lynch

Can you talk about the combined impact of higher commodity costs, which you said were about 15 to 25 basis points more than you had said in the previous guidance and then all of the pricing you just cited? So, in other words, how much of that pricing you cited today is incremental relative to your guidance? Is that overall pricing or commodity/pricing drag greater than it was before, and is that why the full year EPS guidance when you exclude the tax change is a little bit lower than it was before?

Clayt Daley

Well, it has nothing to do with the tax change, so let me say that right upfront. I would say that the pricing we have done -- and I'm not going to be specific, by the way, by business -- but the pricing we have done is a little bit greater than we had anticipated going into the fiscal year.

Some of that could be timing and some of that could be amount, but clearly I think if you recall what we said three months ago, six months ago, we actually were hoping commodity and energy costs would begin to plateau going into this year, and you saw the commodity impact decline in each quarter last fiscal year and now you have seen the commodity impact step back up in July, September. We have obviously had to react to that.

A.G. Lafley

Chris, the way to think about this is the combination of firm price contracts, hedges, inventories on hand dampen the effect a bit on the current fiscal year. But obviously we have all got our crystal balls out to try to figure out where things are going to go in 2008. We believe the prudent approach is to take the pricing. That gives us more flexibility. If commodities come off, we can always adjust pricing and if they stay high or continue up, we're in a better position.

Clayt Daley

Just to try to close the loop on the tax area, as the foreign exchange has increased the percentage of our business outside the U.S. that has an impact of lowering the tax rate. It also has an impact of modestly lowering the margin because the margins outside the U.S. are lower than the U.S. So really what you're seeing here is a big mix effect as opposed to changing anything fundamentally.

Operator

Your next question comes from Ali Dibadj - Sanford Bernstein.

Ali Dibadj - Sanford Bernstein

As I look at this, it looks like you are banking more and more on this growing non-operating income line to make some of your numbers. I want to understand two things. One is, just to understand why that needs to be? How should we expect that growing or changing going forward?

Two, really unraveling on the pure operations of the company, as far as we're concerned the gross margin was a little bit higher than we had expected and I think than your guidance was, and operating margin was a little bit less. I'm just trying to get underneath the real operations of it and understand a little bit of the puts and takes on marketing, on savings, and in particular how should we expect that going forward? Those two parts would be real helpful.

Clayt Daley

Well, in non-op I think we have said the non-op is going to be down for the year, although it varies very much for quarter to quarter. Of course, a lot of that relates to an ongoing minor divestiture program that we do that hits certain quarters. But I don't think it is a make-up factor on the year.

A.G. Lafley

I think as we have said, we plan to continue to improve the gross margin line and the operating margin line. You asked for some additional detail on the components. Our marketing spending was actually up a bit this quarter. So the issue which I tried to be clear on is if we had it to do over again, it would have been up a bit more in Beauty, and we would have made it happen. With a stronger initiative program going forward, you can anticipate where the marketing spending is going to be going forward. We're going to support the initiatives.

Regarding the overhead, I think we have been pretty clear on the overhead. We done a good job of managing our productivity, and we're getting good scale leverage there. The one other piece we have not talked about is cost of goods, which we call total delivered costs. I would say the organization has done a pretty doggone good job there. We have not been able to obviously offset all of the energy and commodity cost pressure, but we have ongoing programs that put a dent in it so we don't have to rely on pricing for all of it.

The last piece that I think is relevant and important is how we are managing our mix. I think we're doing a reasonably good job of managing our mix. In the Household categories, we are demonstrating that the consumer will trade up and pay a bit more for better performing, better quality products, and that has been the case for several years in the Beauty and Personal Care categories.

Clayt Daley

Relative to the operating income, operating income was up 9%. The operating margin was up right in line with guidance. So maybe we ought to chat on the phone later to understand what your concerns are.

Operator

Your next question comes from Jason Gere - Wachovia Capital Markets.

Jason Gere - Wachovia Capital Markets

I'm not sure if you have talked about products that are on allocation. Can you talk about how much that impacted organic sales this quarter, and how that compares to last quarter, and can you talk about the progress on building capacity?

Clayt Daley

Actually very little now, except Braun. There's still some Braun household items where we have a supply problem.

A.G. Lafley

We're pretty much out of the woods on brushes, toothbrushes and disposable razors which were big issues. Braun has been an ongoing issue because we are converting out of the big Spanish manufacturing facility and moving into Eastern Europe.

Broadly the capacity question is we're going to keep investing in capacity, and a lot of it is going into developing markets for obvious reasons. If you're growing double-digits in developing markets on a business that is well over $20 billion now, you are going to be investing in capacity. So in places like SEMEA and places like Asia, there is going to be a lot of capacity going in. But we will get it done at 4% or less CapEx which is our commitment.

Operator

Your next question comes from Bill Chappell - SunTrust.

Bill Chappell - SunTrust

If you could give us a little more update on compaction? We have heard from some vendors there is actually some volume growth as consumers are getting used to the new bottle sizes. Are you seeing that, and when will you have an idea to quantify the benefits on gross margin for that business in terms of seeing other competitors give back price or whether the prices will hold?

A.G. Lafley

Compaction and concentration is going really well. Now I have to hasten to say we are seven weeks into it or six weeks into it, so it is very early days. I think we started shipping on about the 10th of September. But the sell-in has gone really well. The distribution is in good shape. The resets in retail stores across America are well underway, and we estimate that 90% of them will be done by the end of October.

We're seeing most of the competition is basically following. There have been public reports by some of our major customers that they are going to drive for full conversion as soon as the third wave is launched, which I believe is April of next year. All of the early anecdotal -- and it is primarily anecdotal -- qualitative feedback from consumers has been relatively encouraging. They understand it. They are buying at the rates we expected and hoped they would buy at.

We're going to know a lot more after the next quarter. We're expecting this to be frankly a win for consumers, a win for retailers and a win for manufacturers. The value is holding, and the price per load is holding so far. There are indications that some consumers are trading up. So far, so good, and we will obviously be all over it.

On your question on gross margin, I don't think we have been specific, but obviously this is going to be a margin builder.

Clayt Daley

Well, it is a margin builder, and given what is going on in commodity prices right now, I think the chances that the savings get priced away are pretty low.

Operator

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

Joe Altobello - CIBC World Markets

A quick question on your margin target for 2010. You mentioned earlier obviously that U.S. businesses have much higher margins than international but it seems like the U.S. versus rest of world growth differential has widened given the slowdown in the U.S.. If we do see a protracted consumer slowdown here in the U.S., does that put your target at risk?

Clayt Daley

Joe, the target is really an EBIT target. Our target is to expand margin by 50 to 75 basis points per year. Really, the controlling objective is to get to an earnings per share number, which requires us to get to an EBIT number. Therefore, the exact split between sales growth and margin expansion is one where it will fall the way it falls.

I would not say that this situation in the U.S. relative to international growth at this point would cause us to change our 50% to 75% target. I still think we're likely to fall in that range despite the mix shift that may be occurring; some of it related to currency and some of it related to relative market growth. So I still think we feel pretty good about the goals toward the end of the decade.

A.G. Lafley

The last thing I would say, Joe, is while our margins are obviously strong in the U.S. given our share leadership positions, our margins are improving at a good rate in developing markets. We make good margins.

Clayt Daley

After-tax margins and developing are comparable to developed. But there is a different mix on the internals where we tend to be outside the U.S.: a lower tax rate, therefore a slightly lower operating margin and somewhat lower gross margins. So there can be some change in the internals, but we get to the same end point, and that is the objective.

Operator

Your next question comes from Alice Longley - Buckingham Research.

Alice Longley - Buckingham Research

A major theme of this call is that competition is spending more in some Beauty categories in some countries. Are you talking mainly about Skin Care in the U.S. and Europe, or are there more categories and more countries involved?

A.G. Lafley

Well, I think it is pretty clear if you just look at the activity, there is a fair amount of spending in Hair. You just need to look at where the competition has launched. I just got back from two weeks in Asia, and there is a lot of activity going on. Asia is a very hot market right now. So Hair has been a very competitive market. Skin has been a very competitive market. We're going into a very competitive season in Fragrance. I don't think it is isolated. I think the whole thing has picked up.

By the way, I don't think it is a bad thing. I have got to try to make this point again. It is good for consumers because there is a hell of a lot of new innovative products going to market, and they are getting a lot of choices and better performing and better quality products at good prices. It is good for retailers because Beauty and Personal Care categories are growing, and they desperately need growth. Frankly, it is good for manufacturers because if you look at the way the beauty markets are structured and you take the big manufacturers and you add us all up, we're still a minority of the total market.

I mean there are what, 900 Chinese hair care brands and we have half the market in shampoos. The shampooing frequency is all the way up to two times a week. One more shampoo a week and the shampoo market grows another 50%. That will happen.

The conditioner and treatment market is relatively modest in China but starting to catch on because so many women are working. Their hair is much thicker, and conditioning and treatment matters a lot more. The styling market is relatively immature in China, and it is starting to take off in the cities. Retail coloring, there is a small but clearly viable retail coloring business.

So I just think the market still remains very attractive in Beauty and Personal Care. There is a lot of growth to be had. Not surprisingly, the multi-category competitors like the Unilever's and P&G and the pure-plays are going after the growth. There is a little bit more spending going on. We watch it -- of course we watch it. But it is hard to know every minute exactly what is being spent.

Operator

Your next question comes from Linda Bolton Weiser - Oppenheimer.

Linda Bolton Weiser - Oppenheimer

A specific question on the Health Care business. Prilosec OTC is a huge part of your business, and my understanding is that there has been an agreement reached between AstraZeneca and the patent challenger, Dexcel. Do you have any knowledge of what that agreement has to do with? Has AstraZeneca informed you of any of that?

Clayt Daley

That agreement is confidential. Sorry, I can't be more specific.

Operator

Your next question comes from Bill Leach - Neuberger Berman.

Bill Leach - Neuberger Berman

Full year guidance includes about $0.10 a share in restructuring charges, and I was just wondering how much it was in the first quarter?

Clayt Daley

We're not disclosing it, Bill. First of all, your assumption is right. We have said $300 million to $400 million after-tax in restructuring, and therefore, the centerline on that would be about a dime a share. Again, the spending tends to occur reasonably consistently throughout the year. So I think the safe assumption is that we are spending about 25% of the annual number in the first quarter.

Operator

That is all the time we have for questions today. Gentlemen, I will go ahead and turn the conference back to you for any additional or closing remarks.

Clayt Daley

Thank you for joining us today, and as I said at the outset, we will be around for the rest of the day to take additional questions on the phone as needed. Thank you very much for joining us.

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Source: Procter & Gamble F1Q08 (Qtr End 9/30/07) Earnings Call Transcript
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