Procter and Gamble F2Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (PG)

Procter & Gamble (PG)
Q2 2006 Earnings Conference Call
January 27th 2006, 8:30 AM.

Executives:

Clayton C. Daley, Jr., Chief Financial Officer
John P. Goodwin, Treasurer

Analysts:

Bill Pecoriello, Morgan Stanley
Bill Schmitz, Deutsche Bank
Amy Chasen, Goldman Sachs
Wendy Nicholson, Citigroup
Jason Gere, A. G. Edwards
Chris Ferrara, Merrill Lynch
Joe Altobello, CIBC World Markets
John Faucher, J.P. Morgan
Elena Mills, Atlantic Equities
Sandy Beebe, HSBC
Linda Bolton-Weiser, Oppenheimer
Lauren Lieberman, Lehman Brothers
Bill Chappell, SunTrust
Alice Longley, Buckingham Research

Presentation

Operator

Good morning and welcome to Procter & Gamble’s Second Quarter 2006 Conference Call. Just a reminder, today’s call 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 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 impacts of foreign exchange and acquisitions and divestitures 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 to provide additional clarification. Now I would like to turn the call over to the Chief Financial Officer, Clayt Daley. Please go ahead, sir.

Clayton C. Daley, Jr., Chief Financial Officer

Thank you and good morning everyone. A. G. Lafley, our CEO, and John Goodwin, our Treasurer join me this morning. As usual I will begin the call with a summary of our second quarter results. John will cover our business results by operating segment, and I will wrap up with an update on the Gillette integration and our expectations for both the March quarter and the fiscal year.

A.G. will join the call for the Q&A’s, and as always following the call John Goodwin; Chris Peterson, our IR director, and I will be available to provide additional perspective as needed.

Now onto the results. The strength of our innovation program and the breadth of our portfolio enabled us to deliver another strong quarter of balanced top and bottom line growth, despite numerous challenges, including the impact of hurricanes Katrina and Rita, higher commodity and energy prices, continued high competitive spending behind competitors’ restructuring charges, and a tough base period comparison. Diluted net earnings per share were $0.72, in line with the prior year, and $0.03 ahead of our previous guidance and the consensus estimate. This included Gillette dilution of $0.06 to $0.07 per share. Excluding this dilution, diluted net earnings per share were up 8 to 10% versus a year ago.

The results were better than expected as the result of stronger top line growth on both the P&G and Gillette based businesses. Now, note that we are reporting Gillette dilution as a range given the inherent difficulty in tracking all of the acquisition related impacts on the P&L. And keep in mind that this reporting will get increasingly difficult as the P&G and Gillette operations become more integrated. Total sales increased 27% to 18.3 billion. Organic sales growth, which excludes the impact of foreign exchange as well as acquisitions and divestitures, came in at 8%, well ahead of our long-term organic sales growth target.

Total shipment volume increased 27% driven largely by the addition of Gillette. Organic volume grew a strong 6%. The growth was broad based with every global business unit delivering solid organic volume growth, household and family health each delivered 7% organic volume growth, while the Gillette GBU and beauty care each delivered 5% organic volume growth. All regions grew organic volume during the period. Developing markets continue to set the pace with volume growth in the mid-teens, led by strong growth across Asia and Central and Eastern Europe. Price mix was up 2% versus year ago, primarily as a result of pricing actions to recover higher commodity costs. As expected, foreign exchange was a 2% reduction to the top line, due primarily to the strengthening dollar versus the Euro, pound, and yen.

Next, on to earnings and margin performance. Operating income was up 31% to $3.9 billion due to strong results on P&G’s base business and the addition of Gillette. The operating margin was up 60 basis points versus year ago, as we continue to benefit from volume leverage on our SG&A costs. Gross margin was flat versus year ago at 52.4%. Higher commodity costs hurt the base P&G gross margins by about 150 basis points in the quarter. The leverage we get from scale, cost savings efforts, pricing, and the mix benefit from the addition of Gillette, offset the commodity cost impact. Selling, general and administrative expenses improved by 50 basis points. This was primarily driven by strong sales growth, sales growth simply outpaced our SG&A costs as sales grew well above both our long-term targets and short-term forecasts.

We repurchased 3.5 billion of P&G stock during the December quarter as part of the previously announced Gillette buyback program. This brings the total amount repurchased under this program to 12 billion. We now expect to repurchase about 20 billion in total under the program and to complete it by mid-calendar 2006. The tax rate for the quarter was roughly in line with prior year as favorable Gillette business mix was offset by temporary tax friction associated with the acquisition. Hurricane Katrina’s impact on our coffee business negatively affected results by about a penny a share in the quarter. Earnings per share included $0.02 of stock option expense, in line with both year ago and previous guidance. Additionally, earnings per share included $0.03 of one-time charges related to the Gillette acquisition, again in line with previous guidance.

Now, let’s turn to cash performance. Operating cash flow in the quarter was $2.6 billion, up more than 500 million from the same period last year. The improvement was largely driven by the addition of Gillette earnings and Gillette growth, and earnings growth from the P&G base business. Working capital was about neutral on cash versus year ago. Inventory days, excluding Gillette, were down about 6 days versus a year ago, due to continued focus on inventory reduction. Payable days, again excluding Gillette, were down about 3 days versus year ago to both timing effects and our efforts to take advantage of supplier term discounts. Receivable days excluding Gillette were about flat versus the same period last year. Free cash flow for the quarter was $1.9 billion. Capital spending for the quarter was 3.4% of sales. Free cash flow productivity came in at 76%, roughly in line with year ago, but importantly we remain on track to deliver our target of 90% free cash flow productivity for the entire fiscal year.

To summarize, these are strong quarterly results. Both the P&G and Gillette based businesses continue to deliver good results. P&G continues to drive balanced top and bottom line growth, even through this challenging cost and competitive environment. And, we continue to benefit from our balanced portfolio and robust initiative program.

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

John P. Goodwin, Treasurer

Thanks Clayt. The beauty business delivered 9% volume growth for the quarter, including 4 percentage points gain from acquisitions and divestitures, sales of $5.4 billion up 7% excluding both acquisitions and divestitures and foreign exchange. Organic sales grew 5% versus a strong base period with 8% organic sales growth. Net earnings increased 7% to $848 million. Earnings growth was driven by the addition of Gillette and solid top line growth. Scale benefits from growth more than offset increased marketing investments behind new initiatives and the impact of higher commodity costs. In response to cost increases, the US FemCare business has announced a price increase of about 6%, the increase will be effective in May.

P&G’s skin care business delivered strong results for the quarter with global volume up in the teens. In the US, the Olay brand posted value share gains in facial cleansers, facial moisturizers, and hand and body lotions. These gains were driven by new product innovations such as regenerist thermal polish treatment, and microdermabrasion, and peel system kits, and new Anti Aging cleansers in the total effects lineup. The feminine care business delivered another quarter of solid volume growth behind the top sheet softness innovation, scent line extensions, Naturella expansion and continued growth of Tampax Pearl. Past three months Always value share in the US feminine pads segment is 52%, up nearly 5 percentage points versus the prior year. Tampax US value share of the tampon segment is nearly 50%, up almost 3 percentage points versus year ago. In Western Europe, FemCare share is now over 51%. The Naturella expansion in Russia continues to progress well, adding about 7 incremental value share points to the business. P&G now has nearly 44% value share in Russia FemCare. Retail Hair Care volume was up mid-single digits led by developing markets and double-digit growth of hair colorants. This was partially offset by a slight decline in developed market shampoos, due mainly to loss volume from discontinued minor brands in the US. The hair colorants growth came behind the innovations on the Koleston and Wellaton brands.

In the US, value share is now over 36%, up about a point versus prior year on the strength of the Nice n’ Easy Root Touch-Up innovation. The cosmetics category had lower shipment volume versus prior year against difficult comparisons that included pipeline volume of significant new initiatives.

HealthCare delivered another quarter of strong results and benefited from the addition of the Oral-B franchise. Volume was up 31% versus the prior year including 23 points of growth coming from the net impact of acquisitions and divestitures. Pharmaceuticals and P&G’s base oral care business, excluding divestiture impacts, both delivered double-digit volume growth. Sales were $2.6 billion, up 29%. This includes a 1% negative impact from foreign exchange. Excluding the impact of foreign exchange and acquisitions and divestitures, organic sales growth was 8%. In addition, mix lowered sales by 2%, due mainly to rapid growth of developing markets and the addition of the Gillette oral care business, which has a lower average selling price than the balance of the segments. Net earnings were $427 million, up 41%, driven by the addition of the Gillette oral care business and solid top line growth and margin expansion on P&G’s base business.

Actonel had another very good quarter globally, with volume up more than 20%, and global value share of the bisphosphonate segments up a point to approximately 33%. In Oral Care, Crest toothpaste past three months all outlet value shares in the US, was 35%, up 2 points versus the prior year. In the Rinse business, Crest Pro-Health Rinse has over 10% value share of the mouthwash segment, with 9 points incremental to the Scope brand. Value share in the US toothbrushes is 49%, up more than 4 points versus prior year, led by Oral-B share gains in all segments: manual, battery, and rechargeable brushes. Oral Care volume in developing markets grew double-digits behind continued good results in China and Turkey.

Prilosec OTC volume growth moderated as expected due to the previous quarter customer pre-buy ahead of the mid-September price increase. However, consumption remains strong, with US value share of heartburn remedies now 39%, up 9 points from last year.

Baby and Family Care delivered solid top line growth in a difficult, competitive, and commodity cost environment. Volume grew 5%, with Pampers and Bounty up high single-digits. Sales were up 2% to $3 billion. This includes a negative 2% drag from foreign exchange and a negative 2% from geographic and product mix. Organic sales, which exclude acquisitions and divestitures and FX impacts, were up 4%.

Net earnings for the quarter were $330 million, down 5%. The earnings decline is versus a very strong base period where earnings increased 29%. Also, December quarter earnings reflect lower volume in North America Baby Care and a spike in energy costs, mainly natural gas, which followed the hurricanes in September. Recall that P&G has announced a 6.7% list price increase across the US Bounty and Charmin businesses, effective January 31, to recover the impact of sustained higher energy costs.

Global Family Care organic volume grew mid single-digits for the quarter, which excludes the impact of the Korea tissue divestiture. In the US, all outlet value shares for Bounty is 42%, in line with last year, and Charmin is 27%, down a point. The global Baby Care business delivered high single-digit volume growth driven mainly by developing markets. Pampers value share in China is now approaching 60%, and in Russia, Pampers value share is now over 50%. The rapid growth in Russia is behind the contour fit and absorbency improvement initiative.

In the US, past three month of all outlet value share for P&G diapers is 37%, up slightly versus year ago. Pampers diaper share is over 28%, up nearly 2 percentage points versus the prior year. This is being partially offset by Luvs, which is down over 1% versus year ago.

In Western Europe, Pampers diaper share is over 54%, up nearly a point versus year ago. This growth is being driven by new innovations such as the Baby Stages full motion fit and absorbency improvement initiative. While the partial rollback for pricing in the US Baby Care has received a lot of attention, pricing in the US is still up versus year ago. Also the global pricing trend is increasing. We have already taken pricing up in several developing markets to recover higher costs, and new pricing is coming in select Western European markets.

Fabric Care and Home Care delivered strong top line growth with volume up 7% and sales up 8% to $4.1 billion. Foreign exchange impacts reduced sales growth by 2% while price increases, to offset higher commodity costs, helped sales growth by 2%. Organic sales, which exclude acquisition and divestiture and FX impacts, were up 10%. Net earnings for the quarter were $593 million, an increase of 8% versus last year, driven by volume growth, pricing, and cost savings programs, which more than offset higher commodity costs. Fabric Care grew global volume high single digits for the quarter with good performance in both developed and developing markets. All outlet value shares for US laundry business is now 61%. Tide value share is over 39%, up nearly 3 points versus last year behind the Tide with a Touch of Downy, Tide Coldwater and Tide with Febreze premium initiative innovations, which were coupled with very strong customer support.

In Japan the launch of the Bold Liquid Detergent led Fabric Care to volume growth of over 20% for the quarter. Home Care delivered modest global volume growth for the December quarter. This is versus a base period that was helped by initiative pipeline volume on Febreze and followed a strong quarter that helped by forward buying ahead of the dish washing price increases in September. Past three month US all outlet value share for Dawn hand dishwashing is up 2 points to 42%. Cascade auto dishwashing is up a point to 59%, behind the strength of the action packs initiative. And hair care is up more than 3 points to 20% behind continued growth of Febreze air effects.

Home Care volume in Japan was up high teens behind the continued success of the great Fruitjoy initiative and launch of Febreze solid air freshener. Snacks and coffee results for the quarter were again heavily impacted by the effects of Hurricane Katrina. Unit volume grew 3% despite a modest decline in coffee volume. Sales of $927 million, an increase of 10%, this includes a 9% benefit from pricing to recover higher green coffee costs. Net earnings were $95 million, a decrease of 20%, driven primarily by the decline in the coffee business due to shipment disruption and higher costs associated with Hurricane Katrina.

Folgers past three month US all outlet value share was 28%, about 5 points lower than prior year. Consumer product availability for Folgers was significantly disrupted in October and November, two of the highest volume months of the year. Pringles past three month all outlet value shares was over 14%, up slightly versus last year. Finally, moving to the Gillette GBU, as you know these businesses were not included in P&G’s results last year. So on a reported basis the sales and earnings are totally incremental to P&G. However, to assist investors, we have published historical pro forma results for the new Gillette reporting segments and will discuss trends versus those estimates.

Blades and Razors continued its strong momentum in the December quarter. Volume mix grew 6% versus prior year and sales were $1.2 billion also up 6%. Pricing added 2% to sales growth and foreign exchange reduced sales by 2%. Organic sales, which exclude acquisitions and divestiture and FX impacts, were up 8% versus prior year pro forma results. Earnings before taxes were $375 million, up 11% versus pro forma results for the prior year. Excluding the impacts of purchase accounting related adjustments, earnings before taxes were $491 million, an increase of 46%. Approximately one third of this percentage increase was caused by non-recurring costs in the base period. These costs were primarily related to charges for the European manufacturing realignment and the functional excellence program. The balance of the earnings increase was driven by strong sales, a more profitable product mix, price increases, and lower overhead and manufacturing expenses.

Reported earnings, net of taxes for the segment were $272 million. Global trade up to premium systems continued in the December quarter. The combined Mach3 and Venus blade franchises grew by 2 share points versus year ago and now represent half of Gillette’s global 72% blade share. In the US, past three month all outlet value shares for Gillette Blades and Razors remained over 70%, despite heavy competitive spending behind the new product launch. Mach3 share of blades improved by about 1.36% on the growth of M3Power. M3Power remains the top selling razor with an 18% share of the global razor market. Venus Vibrance remains the top selling female razor in the US Past three month US all outlet value share of Venus blades grew 1.29% driven by Venus Vibrance and disposables.

The Duracell Braun business delivered strong volume mix growth of 4% despite the prior year’s, versus the prior year’s pro forma results. Sales were $1.3 billion, up 1%, including a negative 2% impact from foreign exchange. Organic sales, which exclude acquisition and divestiture and FX impacts, were up 3%. Pricing was down slightly on a global basis. The shift to larger pack formats in the US factories caused a modest negative sales impact. Importantly, Duracell pricing in the US continues to trend upward, following the list price increase taken in August and the rollouts across trade accounts.

Earnings before taxes were $243 million up 46% versus pro forma results for the prior year. Excluding the impact of purchase accounting related adjustments, earnings before taxes were $286 million, an increase of 71%. Approximately one half of this percentage increase was caused by non-recurring costs in the base period. These costs primarily related to charges for the functional excellence program and other asset write-downs. The balance of the earnings growth is driven primarily by favorable volume, lower manufacturing expenses, and reduced overhead costs. Reported earnings net of taxes for the segment were $165 million.

Duracell all outlet value shares in the US reached 48%, up almost 2 points versus the prior year. Growth in Latin America was very strong driven by a successful Christmas season in consumer programs. Also the China battery business delivered volume growth of more than 25%, behind increased outlying market penetration. The good Braun results are driven by 360 complete and Contour shaving innovations and the expansion of the Tassimo on demand coffee system into Germany and the US.

Given the strong earnings results from the Gillette GBU in the quarter, I want to provide some additional perspective going forward. We expect earnings before tax indices to moderate significantly in the second half of the fiscal year, versus the exceptional December quarter results. This is due to Lakme at the functional excellence program benefits investments behind the Fusion launch and tough base period comparisons.

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

Clayton C. Daley, Jr., Chief Financial Officer

Thanks, John. I would like to start by providing a brief update on the progress of the Gillette integration. The December quarter was an important period as it was our first quarter operating as a combined company. We’re making very strong progress on both the revenue and cost synergies. And we remain on track with our three year commitment to return P&G to the pre-Gillette double-digit compound earnings growth trend line by fiscal 2008.

The integration is progressing very smoothly with minimal business disruption due to excellent work by each of the Gillette integration sub-teams around the world. And I want to particularly recognize the dedication of the Gillette people, who have worked tirelessly now for a year to make this deal a success. To highlight a few of the milestones we achieved during the quarter, we realized our first revenue synergies by executing a number of company-marketing promotions between P&G and Gillette brands such as Venus razors coupled with Always and Olay total effects.

In addition, we expect revenue synergies from distribution gains to ramp up over the next several quarters. We also realized our first cost synergies during the quarter by combining our purchasing efforts and several areas including media, brand saver coupon inserts, and a few raw materials. As part of our ‘field the best team efforts’ and our people strategy, we have now completed the staffing decisions for the top 1,000 Gillette managers and are on track to complete the rest by the end of March. Retention rates of key personnel are in line with our plans, providing continuity of leadership during this critical integration period.

Finally, on the divestiture front we closed the previously announced SpinBrush and Rembrandt divestitures on October 31st and December 21st respectively, in compliance with the FTC requirements and we are on track to complete the Right Guard divestiture, in line again with FTC requirements. In summary, we remain on track with both the integration and acquisition economics.

Now, let me move onto guidance. Before getting into the details, I want to give you a brief update on several topics that will affect the numbers. First innovation, second commodity costs, and finally, pricing. With regard to innovation, the combined company has a robust pipeline of recently launched innovation that should continue to fuel strong top line growth going forward. Some of the bigger innovations include Tide Premium initiatives, Tide Coldwater, Tide with a Touch of Downy, and Tide with Febreze, which continue to drive strong growth on laundry detergents. The Olay Regenerist Thermal Polisher, Microdermabrasion, the Quench Body Care line and Olay Ribbons Body Wash, which are driving strong growth on Olay. The Crest Vivid White Night and Expressions Lemon Ice SKUs are driving strong growth on the Crest dentifrice business. Lacoste Essentials, Hugo Energize, and the recently announced Dolce & Gabbana license, should continue to drive strong growth on our fragrance business. Finally, Gillette Fusion and Fusion Power started shipping in the US and Canada earlier this week and are off to an excellent start with over $100 million of shipments on the first day, driven by very strong customer support. Both Fusion and Fusion Power products significantly outperformed Quattro Power in consumer tests, and we expect Fusion to be a billion dollar brand of the future.

Now, turning to commodity costs, we continue to expect pressure from higher commodity energy costs through the end of the fiscal year, although we expect the pressure to moderate, as we begin to lap higher base periods in the March quarter. To mitigate these cost increases, we are aggressively pursuing cost savings projects, reformulating our products with lower-cost ingredients, driving innovation with the resulting volume leverage on fixed cost. And where needed, we are pricing to recover higher costs. During the past year, we have taken pricing in many of our categories. Most recently, we announced pricing plans for Feminine Care in the US, where we increased prices an average of 6% effective May 1, in our razor blades where we will increase prices by 3% to 4% both in Europe and North America over the February/March period. In instances where costs are up for all industry participants, our expectation is that pricing relationships between brands and private-label will remain about the same over time. Importantly, to date we have not seen any significant reductions to market sizes or major shifts away from premium priced products as we have priced up to recover higher costs.

Going forward, we will continue to assess pricing decisions with the objective of striking the right balance between recovering commodity cost increases, while insuring our brands continue to offer great value to our consumers.

Now turning to the specific guidance for sales and EPS. For fiscal 2006, we expect P&G’s base business to deliver its fifth consecutive year of growth, at or above P&G’s long-term target. Organic sales, which exclude the impact of foreign exchange and acquisitions and divestitures, are expected to grow 6% to 7%. This is an increase of 1% versus our previous guidance due to continued base business strength and strong momentum in developing markets. Within this, we expect the combination of pricing and mix to contribute about 1%, and foreign exchange is expected to have a negative impact of about 2%. Acquisitions and divestitures are expected to add 14% to 15% growth to the top line, which should result in an all-in sales growth of 18% to 20% for the year.

Turning to the bottom line, we now expect earnings per share to be in the range of 258 to 262. We are raising our EPS guidance for the fiscal year driven by the strong top line momentum on both the P&G and Gillette businesses. The midpoint of the new range is up $0.03 versus the midpoint of our previous guidance, which is consistent with our over delivery in the December quarter. Included in this we now expect dilution from Gillette to be in the range of $0.19 to $0.23 for the fiscal year, at the low end of the previous guidance range. We are lowering our estimates for Gillette dilution for the year due to the better than expected top and bottom line results in the December quarter, and a good start on the integration program. We expect one time items associated with Gillette acquisition to be in the $0.09 to $0.11 per share range, in line with previous guidance and we continue to expect stock option expensing to be about $0.11 per share.

Now to avoid confusion you should note that due to the change in the share count from the Gillette acquisition across the quarters, the fiscal year earnings per share will likely calculate to be $0.02 to $0.03 lower than the sum of the quarters. Now frankly, this frustrates those of us who like things to add up, but trust me, there are very specific accounting rules on this one that we are following.

Turning to the March quarter. Organic sales, which exclude the impact of foreign exchange and acquisitions and divestitures, are expected to maintain strong growth in the range of 5 to 7%. With this, we expect the combination of pricing and mix to contribute about 1%, foreign exchange is expected to have a negative impact of about 2%. Acquisitions and divestitures are expected to add 17 to 18% of P&G’s top line growth for the quarter, which should result in all in sales growth of 20 to 23%.

Turning to the bottom line, we expect continued pressure in the quarter from higher commodity and energy costs; we anticipate this being more than offset by volume leverage, pricing, cost savings programs, and the positive mix effect of the Gillette business. As a result, on an all-in basis, we expect the operating margin to be up 75 to 100 basis points in the quarter versus year ago. We expect earnings per share to be in the range of $0.58 to $0.61 for the quarter including Gillette. Gillette dilution is expected to $0.07 to $0.10 per share during the quarter. Now Gillette dilution will be higher than in the December quarter due to the seasonality of Gillette earnings and significant cost behind the Fusion launch. Excluding the impact of Gillette dilutions, we are estimating core P&G EPS to be up in the mid-teens, versus a strong year ago base period. This includes the impact of stock option expensing, which we expect to be about $0.03 a share, one-time items associated with the Gillette acquisition should be in the $0.02 to $0.03 per share range in the quarter.

Okay, in closing, both P&G and Gillette have strong growth momentum. We continue to benefit from our balanced portfolio and robust initiative program. We are off to a good start on the Gillette integration. All of this combined gives us the confidence to raise our earnings outlook for the fiscal year. And now, A.G., John, and I will open the call up to your questions.

Questions & Answers

Operator

Thanks Calyt, question and answer session will be conducted electronically if you would like to ask a question please tuning with us pressing “*