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P&G: Life without contract manufacturing - Views on News from Equitymaster
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P&G: Life without contract manufacturing
Feb 1, 2006

Introduction to results
Procter and Gamble Health and Hygiene (PGHH) announced its second quarter results (June ending company) recently. It must be noted that 2QFY06 was the first quarter post the transfer of the detergents manufacturing unit to the parent’s unlisted subsidiary, Procter and Gamble Home Products (PGHP). Thus, while revenues have declined sharply, bottomline has not been hit as bad, as contract manufacturing was a low margin business. Also, there was an exceptional income to the tune of Rs 47 m, which arose from the sale of property to PGHP. Barring this one off item, bottomline has actually fallen by 15% YoY. However, it must be noted here again that the 2QFY06 results are not strictly comparable to 2QFY05 numbers for the above-mentioned reason.

(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Net Sales 1,988 1,493 -24.9% 3,408 3,409 0.0%
Expenditure 1,489 1,053 -29.3% 2,542 2,634 3.6%
Operating Profit (EBDITA) 499 439 -11.9% 866 776 -10.4%
Operating Profit margin (%) 25.1% 29.4%   25.4% 22.8%  
Other Income 69 58 -16.8% 103 101 -1.8%
Interest - 1   - 1  
Depreciation 27 15 -44.8% 52 42 -20.5%
Profit before Tax 541 481 -11.0% 917 834 -9.0%
Tax 151 149 -1.3% 294 243 -17.2%
Exceptional items 29 73 151.9% 93.40 73 -21.5%
Profit after Tax/(Loss) 420 406 -3.3% 716 664 -7.2%
Net profit margin (%) 21.1% 27.2%   21.0% 19.5%  
Effective tax rate % 27.9% 30.9%   32.1% 29.2%  
No. of Shares (m) 32.5 32.5   32.5 32.5  
Diluted Earnings per share (Rs)*         36.8  
P/E Ratio (x)         24.7  
*(trailing 12 months)            

What is the company’s business?
P&G is a 65% subsidiary of the FMCG major, P&G USA. In India, the company is a focused two-product company, dominating both segments backed by strong brands, namely ‘Vicks’ in the anti-cold segment and ‘Whisper’ in the feminine care segment. The parent has two other 100% subsidiaries in India, which have a dominant shampoo (Pantene, Rejoice) and detergent portfolio. P&G undertakes contract manufacturing for its parent’s detergent portfolio (Ariel, Tide) in India.

In July ‘05, the listed entity, PGHH, sold its detergents manufacturing unit at Mandideep in Madhya Pradesh, to the parent’s unlisted subsidiary in India, Procter and Gamble Home Products (PGHP). PGHH carried out contract manufacturing of detergents for PGHP and earned a margin for the same. It must be noted that 1QFY06 was the last quarter in which PGHH carried out contract manufacturing for its parent’s wholly owned subsidiaries, as the detergents plant has been transferred to the unlisted entity effective 1st October 2005.

What has driven performance in 2QFY06?
Core business puts up a good show: The company’s key business products, comprising of Vicks and Whisper, grew by 13% and 16% respectively during the quarter. It must be noted that Vicks commands the No. 1 place on the podium, with Vicks Vaporub controlling a 30% market share, cough drops 56% and Vicks Action 500 a 51% market share. Sales of Vicks were backed by growth from Vicks Vaporub and Vicks Inhaler. Growth in feminine hygiene was due to the strong performance of the new variant, Whisper Choice, and sustained growth of Whisper Ultra.

Segment Snapshot
(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Health & Hygiene Products 1,234 1,405 13.9% 2,137 2,479 16.0%
PBIT margin (%) 35.7% 31.8%   35.6% 29.0%  
% of revenues 62.1% 94.1%   62.7% 72.7%  
Contract Manufacturing 754 88 -88.4% 1,271 931 -26.8%
PBIT margin (%) 5.0% 5.5% 98.8% 4.7% 5.5% 49.7%
% of revenues 37.9% 5.9%   37.3% 27.3%  
Total revenues 1,988 1,493 -24.9% 3,408 3,409 0.0%
PBIT margin (%) 24.1% 30.2%   24.1% 22.6%  

Margins expand: As mentioned earlier, contract manufacturing was a low margin proposition, and since this business has been hived off, margin expansion was bound to come by, which is visible during the quarter. Core business accounted for 94% of revenues in 2QFY06 as compared to 62% in the same quarter of the previous year and overall margins expanded by 430 basis points. However, all other expenditures, besides raw material costs, have increased, especially royalty charges payable to its parent, which jumped by 400 basis points as compared to the previous year.

% of net sales 2QFY05 2QFY06 1HFY05 1HFY06
Consumption of raw and packaging materials 44.2% 27.2% 44.1% 38.3%
Purchase of trading material 1.0% 1.2% 1.2% 1.5%
Staff costs 4.3% 5.1% 5.4% 5.6%
Advertising expenses 6.7% 9.2% 7.4% 8.3%
Royalty expenses 1.0% 5.0% 0.6% 3.8%
Others 17.7% 22.8% 15.9% 19.7%
Total expenditure 74.9% 70.6% 74.6% 77.2%

No more contract manufacturing: The bottomline of the company during the quarter witnessed a 3% YoY fall (including the extraordinary income). However, this has to be looked in the backdrop of significantly lower revenues owing to the near absence of the contract manufacturing business, the effect of which has trickled down to the bottomline. While the decision by PGHH to sell its plant has disconnected it from the high growth of the contract manufacturing business, it has, on the other hand, lead to improvement in profitability and return ratios for the company. As a matter of fact, the company’s operating margins are likely to witness further expansion going forward.

Over the past few quarters…
  2QFY05 3QFY05 4QFY05 1QFY06 2QFY06
Sales growth (YoY) 18.8% 25.6% 19.6% 34.9% -24.9%
Advertising as a % of sales 6.7% 9.8% 8.1% 7.6% 9.2%
Health & Hygiene growth % 6.1% 16.9% 14.5% 19.1% 13.9%
Contract manufacturing growth % 47.9% 38.1% 26.1% 62.4% -88.4%
Net profit growth % 6.7% -19.1% 202.8% -12.8% -3.3%

What to expect?
At the current price of Rs 908, the stock trades at a price to earnings multiple of 28 times our FY07 estimated earnings and market cap to sales of 3.5 times. Investors need to note that going forward, 100% of P&G’s PBIT will come from its core business. We will be updating our research report shortly as the company has sold its detergents manufacturing unit, thus putting brakes on its contract manufacturing income. Now, the focus of the company is on its core operations of health and hygiene.

Going forward, in the absence of the contract manufacturing business, the overall margins of the company would witness an improvement. It must be noted that this business had lower PBIT margins as compared to its core business. Also, the poor per capita consumption for its feminine care folio indicates latent growth potential. On the flip side, there are many international brands (imports) now available in the key metros that sometimes work out to be cheaper for consumers. In that sense, the space is getting competitive. The parent too has started charging a royalty of around 5% on its core business revenues, which will eat into margins.

At the current juncture, in our view, an investment in the stock must be avoided. In short, though P&G may benefit from an uptick in consumption and improved margins, its two-product focus, which we believe concentrates the revenues risk on the two products alone, is a risky strategy. Considering this risk, we have placed P&G at the bottom of the heap of our valuation matrix. In our view, there are better, de-risked growth stories available in the FMCG space.

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