31 January 2011

PG: Income Statement Analysis for the December 2010 Quarter

Procter & Gamble (NYSE: PG) earned $1.11 per diluted share on a GAAP basis in the December-ending second quarter of fiscal 2011, down 26 percent from $1.49 in the same three months of the previous year.

A better view of P&G's results can be gained from Core earnings, which is a non-GAAP measure that excludes certain items and discontinued operations.  In the December quarter, Core earnings per share rose from $1.10 to $1.13. Note that the December 2009 quarter included $1.5 billion in earnings from discontinued operations, primarily the pharmaceuticals business that P&G sold to Warner Chilcott (NASDAQ: WCRX).

This post examines P&G's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates.  Reported earnings were $0.02 more than our $1.09 EPS estimate.  (This small number masks some significant item-by-item differences.)

The principal sources for this income statement analysis were the earnings announcement and the ensuing conference call (transcript made available by Seeking Alpha).

In a second article, we will report P&G's scores as measured by the GCFR financial gauges.  The follow-up post will also provide the latest figures for the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

Procter & Gamble creates and markets many well-known Household and Personal products to customers around the world.  The company, based in Cincinnati, traces its roots back to 1837.

P&G reported Net Income of $12.7 billion ($10.9 billion from continuing operations) on Net Sales of $78.9 billion in fiscal 2010, which ended in June.

The company's market value is currently close to $200 billion on a fully diluted basis, which makes P&G one of the ten most-valuable U.S. corporations.

Having raised its dividend for 54 consecutive years, P&G has certainly earned its place on the list of S&P 500 Dividend Aristocrats.  P&G is also number 6 on Fortune Magazine's 2010 list of the World's Most Admired Companies.

P&G has three global business units: Beauty and Grooming, Health and Well-Being, and Household Care.  Each GBU comprises two segments.

With such a broad product line, P&G has a lengthy list of competitors.  Colgate-Palmolive (NYSE: CL), Kimberly-Clark (NYSE: KMB),  and Unilever (NYSE: UL) are a few of the better known rivals.  Consumer products compete at large and small retailers on price, quality, features, and marketing.  P&G has long been a top advertiser

In the last decade, P&G has made an effort "to extend the availability and affordability of P&G brands to more low-income consumers, particularly in developing markets."  In 2009, 32 percent of the company's total sales were in developing markets, up from 20 percent ten years earlier.

Additional background information about P&G and the business environment in which it is currently operating can be found in the look-ahead

Please click here to see a normalized depiction of the actual and projected results for the just-concluded quarter, as well as quarterly Income Statements for the last couple of years.  P&G restated some historical financial statements to depict the pharmaceutical results as a discontinued operation.

Also note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats.  The standardization facilitates cross-company comparisons.

Revenue in the December quarter increased 1.5 percent, from $21.0 billion last year to $21.3 billion in the most recent three months.  If the growth rate is rounded up to 2 percent, Revenue just reached the bottom end of P&G's 2-to-4 percent growth guidance.

Revenue missed our $21.7 billion estimate by 1.6 percent.

P&G experienced better volume growth in developing regions than more mature areas, which is consistent with the observations of other companies.  The mix of products sold and the sales location reduced the growth rate by 2 percent.  Currency exchange rate fluctuations had a similar negative effect on sales.

Although product sales volume was up, pricing and product mix factors capped revenue growth at P&G's various business segments.  The pair of Grooming and Baby Care & Family Care led the pack with modest 3-percent growth.  Snacks & Pet Care was the laggard, with sales down 4 percent.  The Pet Care unit was negatively affected by voluntary product recalls and supply constraints.

Revenue ($M)Q/E Dec 2010Q/E Dec 2009Change (%)
Beauty$5,290 $5,217 1.4%
Grooming$2,164 $2,095 3.3%
Health Care$3,138 $3,071 2.2%
Snacks & Pet Care$798 $835 -4.4%
Fabric Care & Home Care$6,308 $6,311 0.0%
Baby Care & Family Care$3,930 $3,817 3.0%
Total$21,347 $21,027 1.5%

The Cost of Goods Sold was $10.3 billion, or 48.2 percent of Revenue in the December 2010 quarter.  This ratio translates into a Gross Margin of 51.8 percent.  When compared to the 53.7 percent Gross Margin in December 2009, the margin became a substantial 190 basis points less profitable. 

We expected the Gross Margin to be 52.5 percent of Revenue, which is 70 basis points greater than the margin actually achieved.

P&G placed most of the blame for the margin contraction on higher commodity costs and a change in the product mix.  Sales of lower-profit products rose at a faster pace than the average for the quarter.

Sales, General, and Administrative expenses increased 2.5 percent, from $6.64 billion to $6.8 billion.  As a percentage of Revenue, SG&A inched up from 31.6 percent of Revenue in the December 2009 quarter to 31.9 percent in the most recent period.

The latest SG&A expense was 2 percent more than our $6.68 billion estimate.

P&G suggested the rise in SG&A costs was to support "innovation and expansion plans."

Operating Income, calculated by subtracting the operating expenses discussed above from revenue, was $4.26 billion, 8.5 percent less than in the December 2009 quarter.  The lower Gross Margin, along with the rise in SG&A costs, put pressure on Operating Income.

Our estimate of $4.7 billion for Operating Income proved to be 10.5 percent too optimistic.  We had expected better Revenue growth and a more profitable Gross Margin.

The $200-million net expense for Interest and other non-operating items matched our expectation for the quarter.  The expense was almost $30 million greater than in the year-earlier period.

Significantly, the effective income tax rate for the quarter was only 17.9 percent, much lower than normal and greatly beneficial to P&G's bottom line.  The lower rate is partially due to a one-time benefit related to the pending settlement of tax litigation in Europe.  It is also due to a recently enacted extension to U.S. tax laws.

We had assumed the rate would be 27.5 percent.

Net Income from continuing operations, aided by the lower tax rate, increased from $3.15 billion to $3.33 billion ($1.11 per diluted share).  Our estimate was $3.27 billion ($1.09 per share).  We came close only because tax benefits balanced operational shortfalls.

Net Income including discontinued operations in the prior period was $4.66 billion ($1.49 per share).

Core  EPS of $1.13 was above the top end of P&G's guidance range of $1.05 to $1.11.  In addition to the tax benefit, EPS was also boosted by share repurchases ($500 million in the latest quarter).

Full disclosure: No position in PG at time of writing.

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