Fresh off his success at Canadian Pacific, which I blogged about (here, here), Bill Ackman has purchased just over 1% ownership stake in Procter & Gamble. Mr. Ackman seems to have a nose for underperforming companies and likes to hand pick executive teams and board members for a possible turnaround. So what does he see in P&G?
Mr. Robert McDonald, P&G’s CEO – through a spokesperson – welcomed Ackman’s investment in the company and further stated “We are focused on creating shareholder value by executing on our plan to deliver top-and bottom-line growth through our $10-billion cost savings program, renewing our focus on innovation, pricing initiatives and improved execution, and reallocating resources to invest in the highest return opportunities”
Do you think this will help save Mr. McDonald?
So let’s have some fun! Yes, fun. This is what I do for fun. Let’s look at P&G through the model price math to see what is going on with P&G’s financial numbers. For comparison purposes let us compare P&G against one of its’ competitors say Colgate – Palmolive (CL).
The first thing we can review is the Solvency Ratio of P&G and Colgate. I have reproduced the Solvency Ratio equation from our “Key Concepts” tab as a reminder.
Computations yield a Solvency Ratio of 1.85 for P&G and 1.14 for Colgate. I have plotted each Solvency ratio on our Solvency curve for comparison purposes. What this is saying is that Colgate’s balance sheet in terms of assets and liabilities is more efficiently structured then P&G’s.
Does This Matter?
Equity markets give valuation for effective use of the company’s resources in relation to what the company earns. Debt, if used correctly, can make the company’s balance sheet more efficient, thereby yielding more market valuation, however there are limits to what debt can do. As indicated on our Solvency Curve, the peak efficacy is 0.689. Once past the point the company is venerable to any internal or external shock, which may happen from time to time.
P&G could use more leverage, to move up our Solvency Curve. More debt is obviously a simplistic solution, which the equity markets, may recognize with increased valuation. The more important question is what should the increased debt be used for?
Enter Theoretical Earnings
Another one of our “Key Concepts” comes into play as well and that is Theoretical Earnings. I have reproduced these comments, from the “Key Concepts”, Theoretical Earnings section of my blog.
“The calculation of theoretical earnings and its evaluation can give investors useful information of the production performance of the company. TE can give insights not only on past investment returns but also a strong predictor of future performance.”
So let’s look at a long-term graph of the calculated theoretical earnings (TE) versus the EPS (12-month Forecast) contained in our database. Note the big increase in TE after 2005, so what occurred for this to happen?
The Purchase of Gillette
P&G announced the purchase of Gillette for $57 billion on January 28, 2005. Interesting on the day the acquisition was announced, P&G stock fell 3% on the announcement. The usual platitudes are pronounced at the announcement of these mega deals – “Creating a Juggernaut”, “I’m a great believer in scale.” said the Vice Chairman at the time – however what does our model price math say?
Nearly one year later after the announcement, after approvals, transacting the deal, and finally seeing what the balance sheet looks like we see P&G’s theoretical earnings skyrocketed from $0.78 cents to $1.85. A whopping 137% increase, without a similar increase in earnings. You can see why P&G shares traded downward on the announcement. As the graph illustrates theoretical earnings settles in at $1.36 in the middle of 2006, and slowly builds to $1.68 as of the March 30, 2012 balance sheet.
Ratio of EPS versus Theoretical Earnings
Maybe this graph is more relevant. We look at the ratio of earnings per share (EPS) divided by Theoretical earnings per share. As you can see, the acquisition of Gillette “crushed” this ratio and in the subsequent periods after this mega purchase this ratio hasn’t come close to where it was prior to this acquisition.
As I state under “Key Concepts”, Theoretical Earnings
By observing theoretical earnings over time we can infer how management manages its balance sheet. For instance, if management transacts a large acquisition, theoretical earnings can increase significantly as the size of the balance sheet (R+P) increases depending on the size of the acquisition and the way its financed (R/P). If the multiple of earnings, differential between theoretical earnings and the new consensus earnings post acquisition, hasn’t at least stayed the same (multiple) or has deteriorated, the acquirer’s stock price usually declines on the announcement reflecting the compression differential between theoretical earnings and pro forma earnings post acquisition.
For fun (remember we are having fun here), let us have a look at Colgate – Palmolive (CL).
First, here is the graph showing Theoretical Earnings and EPS (12-month Forecast) separately.
Then, showing the two variables as a ratio to each other.
More importantly, how have the two companies faired since 2000 in terms of market performance. No surprise that CL has out performed P&G not only in the last 12 years but also when Mr. Robert McDonald became CEO of P&G some 4 years ago.
So what is Mr. McDonald to do?
1. His $10 billion in cost savings is a good start. This will increase earnings per share, over time, and help restore our EPS/Theoretical Ratio marginally. If this is all he focuses on, I believe he will still lose his job.
2. In order to save his job, Mr. McDonald needs a two-prong strategy. Along with his $10 billion in cost savings program, Mr. McDonald needs to focus on P&G’s balance sheet. (The R+P if you will)
3. Goodwill on P&G’s balance sheet represents a whopping 67% of total assets. Goodwill is recorded at $90 billion. (Obviously P&G has been purchasing companies other than Gillette) Can Mr. McDonald write-off any of this? At least in the old days of purchase accounting goodwill was amortized over a twenty-year period. Unfortunately under today’s rules, goodwill is means tested, and if deemed to have value can stay on the balance sheet forever.
4. Start selling off underperforming companies and/or divisions. This will help, hopefully, reduce goodwill and P&G can use this cash to pass along to shareholders.
5. P&G can initiate a giant share buyback program with increased debt levels. This can help two fold. First, the increase debt level will move P&G’s Solvency Ratio to a more optimum level – say to Colgate’s. This increased debt level should be used to repurchase P&G’s shares, to shrink the amount of capital within P&G’s business, thereby reducing TE.
There are multiple small alternatives and strategies, however the big challenge is to lower Theoretical Earnings (TE) in a meaningful way to make a material difference in the market value of Procter & Gamble. I guess the other big negative is that management of P&G, has had nearly a decade to manage their Theoretical Earnings lower (increasing the EPS/Theoretical EPS higher) by managing their balance sheet in a more efficient way. Has time run out?
Can Mr. McDonald pull this off?
Radical change usually happens from the outside. As you can see from my graphs, especially comparing model price numbers for P&G to Colgate’s, P&G will have to undergo a major cost cutting exercise as well shrinking their Theoretical Earnings/balance sheet. Obviously, a company the size of P&G is like watching an oil tanker in the middle of the ocean turn around – in other words this will take time. Will Ackman/shareholders give McDonald time? I think not!