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Daily Interview: Evaluating P&G's Growth Prospects as It Restructures

Procter & Gamble (PG) is going through a host of changes to move it into growth mode. The company is restructuring its business, eliminating 17,400 of its 100,0000 employees during the next three years, divesting itself of many of its food brands and acquiring Clairol from Bristol-Myers Squibb (BMY) for $4.95 billion.


Tim Drake
Senior equity analyst,
Bank One Investment Management
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Tim Drake, senior equity analyst at Bank One Investment Management (ONE) thinks the moves could help P&G -- one of the 30 stocks in the Dow Jones Industrial Average -- achieve its goal of delivering double-digit earnings-per-share growth six to 12 months from now. P&G closed at $64.28 on Friday, off its 52-week high of $79.31. The company trades at 23.9 times its earnings.

Drake discusses why he has a neutral rating on P&G and why he thinks the company's moves are pointing it in the right direction.

TSC: What do you make of P&G's gradual exit from the food business, leaving Folgers as its only major food product?

Drake: I think it's appropriate at this point in time because of changes that have taken place in the relationship between food manufacturers and the retailing side of the food business, particularly the entry of bigger players and consolidation of the grocery industry of Kroger (KR), Albertson's (ABS), Safeway (SWY) and so forth. This has really changed the dynamics between the manufacturers and the retailers, making bigger better. If you have more breadth across the grocery chain you have a better way to deal with the consolidation of the food retailing industry.

And so, for P&G to gradually move out of most of their food lines except for Folgers, Crisco and Jiff, is a very good move at this point in time because their strength lies elsewhere. I expect that Folgers will continue to be under review also, and there's every potential that at some point that may be sold out of the portfolio also. I come away positive at their work on rationalizing the food portfolio.

TSC: So, what is the company focusing on now, and what products are its strengths?

Drake: P&G is focusing on three or four major areas: hair care and skin care, health care, fabric and home care, and the baby/feminine/family area. They also have the joint venture of the drinks and snacks business with Coca-Cola (KO), which will be launched this fall. I take a very positive view of this joint venture for Procter & Gamble. I think it has tremendous potential from their viewpoint of putting Sunny Delight and Pringles businesses through that joint venture with Coca-Cola's products -- getting more distribution points and better growth than probably Procter & Gamble could do internally.

TSC: Do you think P&G is wise to get into the hair-coloring business through its acquisition of Clairol?

Drake: I have questions about that and, as a result, have been neutral to negative on the acquisition of Clairol because it has been losing market share in the hair-color market. It is my understanding that P&G acquired it to get into the hair-coloring business, and it's pretty clear in the marketplace that L'Oreal has been much stronger in the hair-coloring business, much more on target with its products and new processes.

It's almost as if P&G is buying a turnaround situation here. Granted, it's also a situation where Clairol being underneath Bristol Myers is almost a forgotten business and didn't really get the emphasis it needed to grow appropriately. I think it's going to take a lot of work on P&G's part to make Clairol pay out for them. It's going to take investments in product, product innovation, marketing and promotion to reinvigorate the brand and compete effectively with L'Oreal, and that is going to limit the upside potential of this whole process over the next several years. It's going to be a real challenge for the Clairol acquisition to pay off for Procter & Gamble.

TSC: What about the company's restructuring plans? P&G is consolidating its three paper divisions, merging its health and beauty units, shaving its research and development budget, and reducing its workforce by 17,400 jobs over the next three years. How effective will all of these moves be for a company with $40 billion in sales and more than 100,000 employees?

Drake: Clearly, the company was going in a lot of different directions over the last five years. It had taken on so many new initiatives and needed a clearer focus. That's what has been undertaken in exiting some of the marginal businesses and brands. It's clearly what is involved in this restructuring. The company had become lazy and allowed the employee base to expand, and controls over that had become lax. The fact that they have to go in and reduce the workforce substantially and tighten up the internal controls is all well and good.

However, no doubt, this will create chaos in the short term, while people are adjusting to numerous employees leaving the company and the ones that are remaining adjusting to new jobs and new functions that they are taking over from the people who have left. There are a lot of adjustments that have to go on at the company during this period of transition. But I think tightening up the organization -- reducing the number of plants, facilities and distribution points and product to get more efficient manufacturing and their cost structure in line -- is the right thing to do.

This will allow P&G to take some of those savings and plow them back into marketing and promotions for existing and new products to begin to build the top line. That's where the real challenge is going to lie over the next year or so for P&G -- shifting the mentality of the company from cost-cutting to growth. We see this in a lot of companies that get the entire focus of the company on cutting costs and controls, and then all of a sudden the day comes and top management starts talking about moving the company forward, growing the business and attracting new customers. This takes some time, to reorient that kind of thinking.

We know some of this firsthand at Bank One going through the same type of process under Chairman Jamie Dimon. He's going through some of the same challenges, reorienting the thinking from a cost-cutting base to a growth base. That's reflective just this week with Bank One preannouncing that the second-quarter numbers, our June quarter numbers, are not going to meet consensus estimates. It's still a struggle to get growth going. It's going to be relatively flat from a year ago.

This is the kind of thing Procter & Gamble is going to face through this restructuring. It's a big, big company and it's going to take some time to turn it around, and I think that puts estimates at risk over the next six to 12 months for this company as they attempt to move through this process.

TSC: So how effective do you think P&G President and Chief Executive A.G. Lafley has been in his first year in office?

Drake: I'm impressed with A.G. Lafley's moves so far. He's identified what needs to be done at Procter & Gamble and has stepped up aggressively to make the moves. From what I understand, and looking at the history of Procter & Gamble, the company has been very slow to make these kinds of moves in the past. They didn't like laying off people. They tried to do cost-cutting through attrition and retirement, and they didn't achieve as much as they should have. I think Lafley has been very aggressive in saying: "We are going to cut the costs. We are going to get the ship turned around, and we are going to make this thing work."

He's also instituted a focused program of concentrating on major points of strength in the company, identifying areas where it's worthwhile to exit brands and products where they don't have that strength to try to get the whole thing moving forward.

TSC: How important and unusual is the $300 million cross-media advertising/promotional pact that P&G signed with CBS parent Viacom to advertise across 12 different TV properties, including CBS, UPN, BET and Nickelodeon?

Drake: It looks like an interesting process. It may be more the wave of the future of these large companies that do cross-media advertising. Obviously, P&G is a huge user of advertising. It looks like an interesting program to guarantee space in different media, particularly in different TV mediums as cable has broken down the viewing audience, allowing them to more specifically target different demographic groups with their products.

TSC: In sum, what is your rating on this stock right now and what's your general outlook for the near and the long term?

Drake: We currently have a neutral rating on P&G because there are so many moving parts right now. I see a risk of negative surprise in earnings, rather than a risk of positive surprise, unless I've really missed something here on the upside. There are so many things happening on the cost side and things they have to do on the marketing side in stepping up spending on that side that I think there is a chance over the next 12 months -- which is essentially their fiscal '02 -- of them missing numbers on the downside.

For that reason, we are remaining neutral at this point in time. The valuation is pretty fair, given the earnings outlook at the moment. So we are really focusing in on just the earnings number potential and feel there could be some risk there.

Long term, it's looking more and more attractive the further into this whole process they get. As the restructuring is completed over the next six to 12 months, and P&G gets to focus clearly on growing the business again, I think the targets they have laid out of top-line growth of 4% to 6% and bottom-line growth of consistent double-digit growth in earnings per share -- that will be within reach. If they start to deliver that, I think the stock will begin to reflect that.

At some point, I think we will be turning more positive on the stock. But at this point, we are remaining neutral.

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