Analyze This: P&G Shortfall Raises Credibility Question for Analysts

Procter & Gamble's (PG) announcement Tuesday of a looming earnings shortfall pummeled the stock. But it's not just the consumer-goods giant that is suffering a credibility problem today. What about the Wall Street analysts who were unanimous in recommending the stock? Why had none of them raised questions about P&G's mounting problems -- many of which the analysts could have tracked in the daily newspapers?

But there's an even bigger question: If the analysts who follow P&G aren't asking the right questions, does that mean that analysts up and down the Street are also skipping fundamental analysis, taking their cues only from the companies and leaving themselves -- and their clients -- in for other P&G-style surprises?

A little bit of basic analysis might have made all the difference to P&G shareholders. In its Tuesday statement, the company said that higher-than-expected pulp and petroleum costs, higher costs associated with a large number of new initiatives in Europe, a delay of FDA approval of a new drug and pricing pressure from Unilever (UL) in South America are the primary profit thieves.

All these factors in P&G's fall were actually well documented over the past few months. Oil prices have been front-page news, rising 21% over the last three months. P&G uses hefty amounts of petroleum-based materials for packaging, and higher fuel prices raise the cost of getting those packages to market.

And pulp is the raw material for products such as Bounty and Charmin, and is used for the boxes that Tide, Vicks and Crest come in.

Another warning sign surfaced publicly when Unilever, one of P&G's biggest rivals, said at the end of February that it would slash 10% of its workforce by 2005 and sell off 100 manufacturing and distributions sites to cut costs. The maker of Lipton tea, Dove soap and laundry detergent also said that it was engaged in an expensive price war with P&G over laundry detergent in South America.

Even if analysts were not closely following the paper industry, the damning details were in P&G's last quarterly filings with the SEC. In its Jan. 27 report, the company said that earnings in its papers division, including Bounty and Charmin, fell 15% because of rising pulp prices and investment in new initiatives.

Big paper company Weyerhaeuser (WY), a major supplier to Procter & Gamble, had announced two increases in the per-ton price of pulp since early October, says Brian McDermott, director of communications for pulp, paper and packaging at Weyerhaeuser.

Weyerhaeuser raised its pulp price to $690 per ton from $620 at the beginning of November. In early February, Weyerhaeuser announced that, effective April 1, it would raise prices yet again, this time to $730 per ton, says McDermott, who declined to say how many tons of pulp the company supplies to P&G.

P&G also said it was counting on the notoriously slow FDA approval of Actonel in the near future, but the company did not elaborate. Analysts usually scrutinize P&G's health care division since it's the fastest-growing business within the company.

Another warning buried deep in the report said that earnings growth may be more concentrated in the April-June quarter, given heavy initiative spending planned for the January-March quarter. In the next breath, P&G said that profit, as well as sales revenue and volume, should increase for the rest of the year.

Ignoring or dismissing these warnings, analysts at Morgan Stanley Dean Witter, Donaldson Lufkin & Jenrette, Merrill Lynch, J.P. Morgan, Credit Suisse First Boston and Banc of America Securities all placed buy recommendations on the stock. DLJ even gave P&G its Top Pick rating. The firm had not returned calls seeking comment on Tuesday and Wednesday.

Analysts Buy Into P&G Story
Date	Report Issuer	Recommendation
Feb. 7	PaineWebber	Buy
Feb. 4	Goldman Sachs	Buy
Jan. 26	PaineWebber	Buy
Jan. 25	Olde Discount Corp.	Buy
Jan. 24	Merrill Lynch Global Securities	Buy
Jan. 20	PaineWebber	Buy
Jan. 19	Merrill Lynch	Buy
Jan. 4	PaineWebber	Buy
Source: Baseline

Some on Wall Street say that the analysts are simply too inclined to cast things so that customers keep buying a stock -- and are willing to accept whatever rosy scenario the companies suggest. "Analysts can go out and say whatever the hell they want, so they reiterate their buy rating," says Scott Bleier, chief investment strategist at Prime Charter.

Ratings, he says, are gleaned mostly from a company's guidance. "And some companies are really good at it, and some are really bad at it." Says another investment manager, who asked not to be named: "There is this whole thing about the banking side of research in bed together with companies. In the event that a company has bad news, very few analysts will bad-mouth it. Analysts have to get their business because there are secondary offerings."

So, are the P&G analysts chastened? Banc of America reiterated a strong buy and a price target of 125 on Feb. 4. "The basis [was] that if you look at this company's top-line growth, it's better than anyone else's out there at that time," says William Steele of Banc of America, which has done no underwriting for the company. P&G looked like even more of a strong buy because of the falling stock price after it walked away from the chance at acquiring both American Home Products (AHP) and Warner-Lambert (WLA). "In retrospect, was it a good call? No. The price that they paid to generate that top line was more than anyone expected."

After the Tuesday debacle, Steele's rating reverted to buy from strong buy.

A.G. Edwards & Sons had also upgraded P&G last week. It now rates P&G an accumulate, up from maintain.

A.G. Edwards analyst Michael Ruesy would not discuss the reasons behind the upgrade. "That's really reserved for our clients," says Ruesy, who adds that he has a personal policy of not talking with the media. (In August, Ruesy gave an interview to a reporter with P&G's hometown newspaper, The Cincinnati Enquirer, in which he discussed the company's plans for Iam's pet foods.)

P&G's news caught Merrill Lynch analyst Heather Hay by surprise. Prior to yesterday, she rated the company a short-term accumulate, then switched to a neutral rating after.

"I was surprised by their inability to recoup revenues for rising raw material costs," says Hay, who re-evaluated her ratings on the whole consumer-staples sector following the P&G fall. "When you have one of the best companies is the industry saying business ain't how it used to be, it's not good."

Hay adds that Unilever's reorganization wasn't a glaring signal to her. She points out that many competitors in the sector had enacted similar cost-cutting measures. "A lot of those companies have done very well internationally. But these markets are becoming more mature, and that means more competition and more pricing pressure." Her firm has done no banking for P&G. "Over the last year, one had to question whether these companies could sustain these growth rates, and it's just not there anymore."

One analyst, who would not give his name for attribution, says that Procter & Gamble's relationship with analysts is symptomatic of an underlying languor of the whole analyst community. These days, a conference call with the company passes as research, he argues. "There is a huge conflict of interest there."

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