Some skeptic analysts are bearish on Procter & Gamble (PG) due to the recent news that the company has been losing market share to its competitors. Some critics claim that the advertising hasn't been efficient enough or that the qualities of the products aren't good enough. They fear that P&G has lost its competitive edge, and that it is in a downward spiral. Analyst Wendy Nicholsen was especially rough in her criticism of CEO Bob McDonald, as during the earnings conference on February 22 she made the following comment:
'God, where is the mea culpa taking responsibility for the weak numbers as opposed to saying 'not our fault, it's just really tough out there?'"
What has caused this criticism from analysts? As COO Jon Moeller puts it,
Over the last few years commodity costs increased by $3.6 billion, which is nearly 25% of our core operating earnings. Letting this all come to the bottom line would have been very punishing for our shareholders and would have compromised structural economics in many markets, significantly reducing the value of future growth. We made what we believe was the hard right choice, taking pricing across our product categories, while acknowledging the market share volatility we knew would result.
So P&G chose to raise prices in response to increasing commodity costs. The question which then arises is whether it was a good decision or not. In order to answer this, we must take a closer look at the company.
Price and volume
In the below graph I have listed the percent-wise changes in volume and sales price from 2006 to 2012. It is not surprising that there is a negative correlation between the increase in price and the change in volume.
For those interested in the exact relationship, I have calculated the least square regression to be:
Predicted change in volume = Change in price * -1.35 + 0.065.
The question I am trying to answer through the use of this formula is: "What would have happened if P&G had 'only' increased prices by 1% in 2009, 2011 and 2012." In the below graph you can see the estimated change in volume for this case.
The below graph compares the effect the alternative price strategy would have had on revenue with the revenue from the actual strategy.
As can be seen in the above graph, I predict that revenues would have grown less had Procter & Gamble not raised prices. This tells me that the price elasticity of the products is less than 1.
Jon Moeller seems to agree with my estimations, as he made the following quote during the latest earnings conference:
Price elasticity at the category level is generally low in consumer staples categories.
Commodity costs and gross margin
However, we cannot see the whole picture from revenues alone-we need to take the costs of goods sold into account as well. To estimate the impact commodity costs have on cost of goods sold, I have plotted a graph showing the relationships between the agricultural commodity index (an input cost) and the adjusted gross margin. The adjusted gross margin is calculated by removing the effect of price increases above 1% from the GAAP reported gross margin.
The relationship isn't as strong as it was when I compared price and unit volume, but nevertheless there is a decent amount of negative correlation (-40%). The linear regression is:
Predicted Gross margin = -0.056*Commodity Index + 0.54.
Comparison of gross profit
In the below graph, I have plotted the expected difference in gross profit. From 2006 to 2012, I expect that the gross profit would have risen by 7.8% if the alternative strategy was used, compared to the actual rise of 10.2%. This means that earnings (according to my estimations) would have been lower had P&G only raised prices by 1% each year.
Does this mean that P&G made the correct decision when they chose to raise prices? I don't believe so for the following reasons: 1) While the chosen price strategy might have benefited the bottom line in 2012, the loss of market share might have negative long-term consequences. As a market leader P&G can reduce their costs per unit due to their scale advantage, but some of that advantage might have been lost over the last year. 2) If commodity prices decrease and P&G wants to increase its sales through lower prices, they might have a difficult time getting back lost customers.
To some extent, P&G misread the market when they initially made those price increases, as they thought their competitors would do the same. They didn't, and in return they lost market share.
What this means for valuation
Assuming that the loss of market share has a negative long-term impact on operating profit (due to loss of scale and less profit if commodities prices decline), the chosen price strategy is bad for valuation. Procter & Gamble chose a price strategy which maximized profit in the current fiscal year; however, if they want to get back the lost market share, they will have to endure a tough period where profits will be lower than what they currently are today. P&G has actually already announced that they are determined to regain the lost market share through price reductions. Here is a quote from the last earnings conference by Jon Moeller:
We have subsequently announced changes in U.S. family care. Where we will take a list price reduction on our Bounty Basic and Charmin Basic lines, and in several Beauty and Health businesses where we will be making targeted adjustments.
Does this means that P&G is a bad investment? Not necessarily, as this article only focused on the effect the chosen price strategy had on the valuation. But there are other factors to consider such as product development, the macroeconomic environment and whether P&G is capable of lowering costs. Over the coming days, I plan to make follow-up articles which take an in-depth look at those issues.