Amongst other things Gerstner got rid of Big Blue’s “untouchables” culture – at the time many employees felt IBM was too big for clients to mess with; eliminated the internecine divisional rivalries; aligned performance incentives of division managers with the performance of the whole firm – rather than with individual divisions; and took a gamble to make Big Blue a more services-oriented company – services is now the biggest and second most-profitable division!
Big Apples and Oranges
No, PG is nowhere near where Big Blue was in 1993 when Gerstner took the helm, and the two companies are obviously not in the same line of business. It’s just that Gerstner’s tale reminds me of the danger of complacency that iconic firms face when they get very big.
By any measure PG was already big in 2005. For instance, 16 of its brands each generated at least $1bn annually in global sales. The acquisition of Gillette in January 2005 made the firm even bigger. However, it made investors somewhat skittish.
When a big company gets even bigger through a major acquisition Wall Street starts to wonder if the acquisition is a signal that organic growth, which excludes mergers and acquisitions, has lost steam. For a multinational with commanding market share a lack of organic growth may be symptomatic of complacency because such growth really speaks to how innovative a company continues to be.
Unloved Staples
Anyway PG has underperformed the S&P over the two years since the announcement of the acquisition. From January 28, 2005, when the deal was announced, to January 16, 2007, PG has returned about 20%, compared with 22% for the S&P and 3% for competitor Johnson and Johnson (JNJ), which sports a higher dividend yield.
However, large cap consumer staples have not been in favor on Wall Street over the past two years so it is unclear whether PG’s underperformance has been due largely to concerns about the digestion of Gillette - would it go smoothly and can management really squeeze out revenue and cost synergies of “about $14bn to $16bn”? - or to a general snub of consumer staples (also called non-cyclicals) - as the table of price appreciation for the S&P and consumer staples below indicates.
| 2006 | 2005 | |
| S&P 500 | 13.6% | 3.0% |
| Consumer Staples | 11.8% | 1.34% |
Whatever PG’s malaise has been since the $57 billion purchase of Gillette the consumer staples giant has started to “dance” over the past six months or so, and “late-to-the-party” analysts and investors have taken notice. What has got investors salivating over PG? I think it’s these three factors: Deeper foray into the health-care sector, faster-than-expected integration of Gillette, and a renewed emphasis on collaborative innovation.
Notice I don’t mention falling oil prices. That falling oil prices will benefit PG – in form of lower raw material costs - is a no-brainer. But falling oil prices come and go so it’s not a fundamental, strategic benefit.
A "Healthy" Blue Chip
PG is a “blue chip”, which means it’s one of these big companies that investors have come to rely on for slow but steady growth, stable earnings, and stellar dividend payments in a bull or bear market – just think the Dow Jones 30! What do you get when you add a fast-growing sector such as health-care to a blue chip? You get moolah – bigger earnings and dividends.
Competitor JNJ has better gross and operating margins than PG because of its health-care operations. By health-care I don’t mean Olay or Band-Aid. I’m talking pharmaceuticals and medical devices. As I see it JNJ is primarily a health-care company with a personal care business – pharmaceuticals and medical devices accounted for over 80% of revenues in 2005. On the contrary PG is primarily a personal care company with a health-care business – health-care accounted for about 1.5% of 2005 revenues.
Since margins in health-care are higher than margins on personal care products, PG could improve its margins by expanding its health-care business. And that’s exactly what it’s been doing. Recently in December it formed a multi-million-dollar joint venture with a leading global developer of advanced diagnostic devices to develop and manufacture medical diagnostic devices, which is a huge money-making business for JNJ. Then just two weeks ago it bought a stake in a private provider of health-care services in Florida. As PG expands its health-care business expect competition with JNJ to heat up.
Razor-sharp Integration
The merger of two conglomerates is never easy, even when there are few overlaps: it's now widely accepted that the merger of AOL and Time Warner in 2001 was a huge blunder. According to observers “familiar with the matter” the integration of Gillette has been much faster than anticipated, bearing in mind that PG operates in over 80 countries while Gillette operated in just as many if not more countries.
To me what really signaled the rapid pace of the integration was the announcement last week or so to fold Gillette’s Blade and Razor and Braun businesses into the Health and Beauty business unit, and the Duracell battery business into Household Care, effective July 1 – nine months after the official completion of the merger on October 1, 2005! This can only mean one thing: that $14bn in revenue and cost synergies that PG touted way back in January 2005 should start to really fatten the bottom line from the latter part of this year. Can I get an Amen?!
Innovate or Die
Finally investors are salivating over PG because of a growing emphasis on “collaborative innovation”. In the consumer products business you have to innovate or die and PG is already big on innovation. Now, rather than depend heavily on products developed entirely in-house the firm plans to partner more with suppliers, entrepreneurs and even competitors to develop new products that can be brought to markets faster.
This strategy was adopted six years ago under the pseudonym “Connect and Develop” but lately some Wall Street analysts have dubbed it the “Go-to-Market (GTM)” approach. I think the successes of the newest “Mr. Clean” lines, which employed GTM, have made PG management really take notice of the potential of this strategy. More products should emerge from the GTM “academy” in the foreseeable future, some of which will probably end up as global billion-dollar brands like Pampers or Gillette; I just hope quality is not compromised.
Like I said before, investors have held off somewhat on PG over the past few years due to concerns about the integration of Gillette and/or a general rotation out of staples. With Gillette almost fully digested the company has started to dance again.
Historically PG’s been viewed as a slow-growth, “defensive”, not too sexy, stock. But its health-care division is expanding fast. This may make PG a little more volatile in the distant future – with a corresponding rise in its Beta (or measure of volatility relative to the S&P) – but it certainly could give it more oomph to command a higher valuation than JNJ. When PG reports fiscal Q2 2007 results on Tuesday, January 30, keep an ear out for some dance tunes!
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