Decline of Linear TV and Gillette’s Profit Margins

Tren Griffin of 25iq put out a tweetstorm with some insight on why Procter & Gamble’s (PG) high margined grooming business, Gillette, is getting nicked (pun’s always intended) by new online competitors like Harry’s and Dollar Shave CLub.

This tweet above really stood out to me.

Podcasting is a great new entertainment medium. I listen to them in car and at home.

Harry’s is one of the more common podcast sponsors I hear. And it worked. I bought a Harry’s subscription to test out the competition. I also bought the subscription because I knew it would help pay the bills for one of my favorite podcasters, Mike Duncan. For reals, go listen to his podcasts The History of Rome (THoR website) and Revolutions (Revolutions website).

What I don’t hear is ads for Gillette’s shave club. Tren is right. The disintermediation of linear TV is opening up the door for smaller companies to build their brand cheaply. Harry’s is embracing podcasting. Dollar Shave Club built its brand harnessing the power of viral YouTube videos.

Tren finishes off his tweetstorm with the same thoughts we had yesterday. High costs plus a worsening consumer experience breeds competition.

Procter & Gamble’s Bad Quarter for Grooming Division

One of our concerns with Procter & Gamble, we still own it, is disruption by the shave clubs, Harry’s and Dollar Shave Club. PG’s latest quarterly earnings report did not belie our concerns.

Organic sales were down 6%.

Click image to enlarge.

The U.S. is the most profitable part of PG’s grooming business and it lead the decline.

From the Q&A portion of Procter & Gamble’s quarterly earnings call.

so all the reduction is being driven by the U.S. and as you know, those are our most profitable cases and higher price cases. So that’s simply what’s going on there.

Is Procter & Gamble Having its Netflix Moment with Harry’s and Dollar Shave Club?

Blockbuster dominated the movie rental business. It had stores all over the U.S. Renting movies was a good business with good margins.

The big drawback was when the movies were not returned on time. With a DVD sitting in someone’s house it could not make more money for Blockbuster. To prod renters to return the DVD on time, Blockbuster charged high late fees. If you waited too long you paid more in late fees than buying a brand new copy of the DVD.

It was a hassle to make an extra trip to return the movie on time. Then it was another hassle to drive back and rent another movie later in the week. But if you didn’t your wallet suffered. It wasn’t the best consumer experience.

Then came Netflix.

Instead of paying for each individual rental, you paid a monthly fee and received the DVD in the mail. You could keep the movie for as long as you wanted. You wouldn’t receive the next movie in your queue unless you returned the previous disc. And Netflix made this easy by including a prepaid pre-addressed envelope.

The user experience was much better. You didn’t pay huge late fees and it was much easier to return the movies. You simply dropped them in the mailbox.

Netflix was a threat but Blockbuster didn’t realize it until it was too late.

Marginal Costs vs Total Costs

Blockbuster did a marginal cost analysis on competing with Netflix when Netflix was still small. Blockbuster decided that the benefits did not justify the cost.

From Clayton Christensen’s How Will You Measure Your Life.

Blockbuster looked at the DVD postal business using a marginal lens: it could only see it from the vantage point of its own existing business. When viewed like this, the market Netflix was going after did not look at all attractive. Worse, if Blockbuster did go after Netflix successfully, this new business was likely to kill Blockbuster’s existing business. No CEO wants to tell shareholders that he wants to invest to create a new business that’s going to be responsible for killing the existing business, especially if it’s much less profitable. Who would go for that?

Blockbuster needed to view Netflix through a total cost lens.

Instead, Blockbuster should have been thinking: “If we didn’t have an existing business, how could we best build a new one? What would be the best way for us to serve our customers?” Blockbuster couldn’t bring itself to do it, so Netflix did instead. And when Blockbuster declared bankruptcy in 2010, the existing business that it had been so eager to preserve by using a marginal strategy was los anyway.

This is almost always how it plays out. Because failure is often at the end of a path of marginal thinking, we end up paying for the full cost of our decisions, not the marginal costs, whether we like it or not.

Weakening Consumer Experience

With the rise of Harry’s and Dollar Shave Club is the razor blade industry having its Netflix moment?

Gillette and Schick dominate the razor blade market. Procter & Gamble (PG) owns Gillette and Edgewell Personal Care (EPC) owns Schick.

For years Gillette would add another blade to their razors and raise prices. Consumers begrudgingly paid up and Gillette’s margins remained fat.

At the same time, the buying experience worsened. Higher razor prices enticed people to steal them.

Stores responded by putting the cartridges behind locked cases. Or they put cards on the shelves that you then took to customer service to redeem for a cartridge after paying for it.

High margins and inconvenienced consumers opened the door for new competitors.

Harry’s and Dollar Shave Club The Netflix of Shaving?

Harry’s and Dollar Shave Cub are subscription services. Both send razor blades to you through the mail on a regular schedule. Both offer their blades at a much cheaper price than Gillette. Both of their business models are much lower margin than Gillette’s. But both companies are OK with that, they’re starting from zero.

Like Netflix, both Harry’s and Dollar Shave Club focus on a small niche and provide a much better experience. It’s a similar shaving experience at a lower cost without the hassle of buying new razors.

To be fair, buying razor blades is not the same hassle as returning movies. Returning a DVD to Blockbuster meant getting in your car and going out of your way to get it done.

Buying razor blades is an add-on to your shopping list. You’ll be at the store anyways. It will take a few extra minutes to deal with the security precautions.

However, it is enough of an inconvenience that the subscription razor blade business model has taken off. Harry’s and Dollar Shave Club have a combined 12.2% market share in 2016 up from 7.2% in 2015.

Procter & Gamble Finally Taking Total Cost View?

Is Procter & Gamble finally taking the total cost view?

For the last 6 years Gillette has lost market share. Gillette had more than 70% market share in 2010 and now it is down to 54% at the end of 2016.

A couple years ago Gillette launched their own subscription service. This month Gillette did something more drastic. They announced they are cutting prices by 20%.

Procter & Gamble finally recognizes the existential threat the new razor subscription services pose. Procter & Gamble could have gone the Blockbuster route. Procter & Gamble could have continued to ignore Harry’s and Dollar Shave Club but Procter & Gamble would continue to lose market share. Eventually its razor blade business would hit a tipping point.

The question we have to ask as investors with Procter & Gamble is it too late? Has Procter & Gamble waited too long to make its move? In going after Harry’s and DSC what does that mean for the profitability of Procter & Gamble’s grooming division? The most profitable division, based on profit margins, for Procter & Gamble (PG).

Harry’s Muscles into Procter & Gamble’s Turf

The shave care industry is important to Procter & Gamble (PG). It is included in its Grooming segment and operates under the Gillete brand.

Shave Care is a $15 billion industry with Gillete holding a 60% share.

Gillete Market Share
From P&G Analyst Day. Click image to enlarge.

This is why the following image is worrisome.

Harry's Razors
Image from WSJ. Harry’s moves from online to brick & mortar. Click image to enlarge.

Razor Blade Sales Disruption

Even the famous Razor/Razor Blade business model isn’t safe from disruption.

Two new companies, The Dollar Shave Club and Harry’s, saw an opportunity to sell razor blades direct to consumers at a cheaper price and comparable quality to Gillette. The online shaving club subscription services took off. They were the fastest growing part of the shave care industry over the last couple of years.

Online razor sales are still the biggest opportunity for growth. According to Euro Monitor, in 2016 only 5% of men in the U.S. belong to shave club. It is why Unilever bought The Dollar Shave Club for $1 Billion and it is why Procter & Gamble created The Gillette Shave Club. Competition is only expected to increase with more entrants.

Harry’s Moves Offline

With Gillette moving into Harry’s online turf. Harry’s decided to move into Gillette’s territory by garnering itself shelf space at the 1,800 stores Target operates. So far it has been a success.

Within weeks, Harry’s grabbed a 10% share of the retailer’s cartridge sales and about 50% of razor handle sales, according to Nielsen data covering the four-week period after the displays launched in August. Procter & Gamble Co.’s Gillette sales in Target stores declined in September from a year ago, according to Target spokesman Joshua Thomas.

Those are outsized numbers given that Harry’s had a 2% share of the overall market for men’s razors last year in the U.S., according to Euromonitor.

Harry’s & PG’s Future Dividend Growth

Procter & Gambles grew its dividend by only 2% from last year. P&G’s payout ratio is 70%. Above average dividend growth won’t come from increasing the payout. It will come from increasing sales of high margin products that generate excess returns on capital where the excess capital not needed to maintain and grow the business is returned to shareholders. Losing ground to discount online razor blade companies does not help.

AMM Dividend Letter Vol. 27: How to Measure and Know Your Risk Level and a Look at Procter & Gamble

This is from the AMM Dividend Letter released March 11, 2016. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

Consider this proposition:

You are offered a gamble on the toss of a coin.

If the coin shows tails, you lose $100
If the coin shows heads, you win $150
Is this gamble attractive? Would you accept it?

The above problem is taken from Nobel prize winner Daniel Kahneman’s book Thinking, Fast and Slow. His book has become a kind of unofficial behavioral finance bible here at AMM. As we’ve often said in jest, “investing isn’t rocket science, it’s harder”. Harder, not because of the need for advanced math (a basic understanding of arithmetic is generally all that is necessary to read a financial statement), but because markets are composed of individuals who make decisions for a variety of reasons, not always rational and often driven more by sentiment and emotion than anything else.

The above proposition highlights this quandary. As Kahneman puts it, “to make this choice you must balance the psychological benefit of getting $150 against the psychological cost of losing $100. Although the expected value of the gamble is obviously positive, because you stand to gain more than you can lose, you probably dislike it – most people do. For most people the fear of losing $100 is more intense than the hope of gaining $150. We concluded from many such observations that people are loss averse.”

The Loss Aversion Conundrum

Since investing is always about foregoing consumption today in the hope of having more in the future, and since the future is inherently unknowable (i.e. you may hope for more, but in fact receive less if events take a turn for the worse), then the question of risk tolerance becomes a critical component of developing an appropriate portfolio strategy. It is also important to note that risk tolerance and risk acceptance are two different beasts.

To illustrate, while stock markets have NEVER had a 20 year period of negative annualized rates of return, many investors with 20 year time horizons have sold during periods of market decline to “manage risk, stop the bleeding, lock in gains or protect the downside”. So while the time horizon allowed the investor to accept the risks associated with investing in stocks, the investor’s tolerance for risk caused them to sell when markets moved against them.

This might seem entirely reasonable if it weren’t for the fact that this type of behavior is generally associated with poor long-term returns. A famous study on mutual fund flows from Dalbar has shown that investors are terrible timers, with fund outflows reaching their highest levels at market lows, and their highest inflows at market tops. One of our favorite drawings from BehaviorGap highlights this wealth destructive behavior.

Image courtesy of Behavior Gap. Click image to enlarge.
Image courtesy of Behavior Gap. Click image to enlarge.

Reconciling Loss Aversion with Investing in the Real World

We know we must accept risk as part of the investment process, but we also know that we will constantly be tested by the market – feeling confident and risk tolerant when the market goes up, and insecure and risk averse when the market declines. Perhaps the most important thing for any investor to do is to accept and understand this very real psychological obstacle to their long-term investment success. Only by being cognizant of the loss aversion conundrum can one overcome it and sustain the discipline necessary to stick to their investment strategy.

We spend time at the beginning of a client relationship attempting to ascertain appropriate risk levels, generally taking into account things like time horizon, investment objectives and general tolerance for market volatility. In concert with these qualitative assessments, we have more recently begun using a quantitative scoring system to help further our understanding of a clients’ unique risk profile.

The benefits of this approach are:

  1. Incorporates real portfolio values in various win/loss propositions to develop an independent risk score.
  2. The risk score can be tied to actual portfolio investments to verify that your strategy is in line with your unique risk tolerance.
  3. The risk score can be used to help map a probability of achieving retirement/investment goals.

If you haven’t yet gone through this process and are interested in knowing your risk score please contact us and request your complimentary risk analysis.

By definition, the future will remain risky and is certain to be filled with unexpected surprises both good and bad. Just as certain, however, is that most savers need to generate a rate of return higher than the risk-free rate offered at the bank; which means they must take risk. For this reason, knowing your true risk tolerance is critical in helping you navigate both good and bad markets to ultimately achieve your investment goals.

Dividend Stock in Focus

Procter & Gamble (PG): $81.78*
*price as of the close March 11, 2016

William Procter was an English immigrant candle maker. James Gamble was an Irish immigrant soap maker. A little luck, both good and bad, found them both living in Cincinnati in the early 1800s.

William Procter’s first wife became ill while they traveled down the Ohio River and a few months after they arrived in Cincinnati she died.

When he was 16 James Gamble and his family were headed east to Illinois. James became ill and the family had to stop in Cincinnati and eventually decided on settling there.

William Procter eventually remarried to Olivia Norris, the daughter of a local prominent candle maker. He worked at a bank and made candles on the side to help make ends meet. James Gamble, who by this time had his own soap and candle shop, married Olivia’s sister, Elizabeth Norris.

Their new father-in-law, Alexander Norris, noticed that his two new son-in-laws were competing for the same resources and customers. Mr. Norris suggested the two work together. On October 31, 1837 the Procter & Gamble company was born with total assets of $7,192.24. Procter & Gamble now has over $129 billion in total assets, a market capitalization of $224 billion, and does over $72 billion in revenue a year.

Dividend History:

Procter & Gamble fits into our dividend stalwart category. It has consistently paid and raised a dividend every year for many years. It is a member of the S&P Dividend Aristocrat index. To qualify a company has to have paid and raised its dividend for at least 25 years. Procter and Gamble has done so for 58 years.

Over the last 9 years, Procter & Gamble has grown their dividend at a compound annual rate of 8.14%. We’re usually looking for double digit growth but we’ll sacrifice a couple of extra percentage points of growth for consistent growth. If Procter and Gamble maintains 8.14% growth its dividend, your income, will double in 8 years.

From S&P Capital IQ. Click image to enlarge.
From S&P Capital IQ. Click image to enlarge.

Procter & Gamble’s payout ratio is currently high around 85%. Procter and Gamble recently took a one-time charge to earnings as it further undergoes its restructuring. We expect this payout ratio to drift back down towards 60% as PG finishes its plans.

Catalysts for Dividend Growth and Price Appreciation:

Divestment

Procter & Gamble got too big. It had way too many brands and it distracted the company from focusing on its fastest growing brands and its very profitable core brands. P&G has been divesting itself of 100 brands.

Revenue will be lower as Procter and Gamble continues divesting itself of non-core brands. The divestment will reduce operating costs and improve profitability as the company focuses its resources on its better brands and growing them around the world.

The ultimate goal is 10 categories focusing on 65 brands.

Increasing Returns

The divestment plan is in part to improve Procter & Gamble’s returns on equity, assets, and capital. Over the last 10 years, Procter & Gamble’s brand bloat has reduced the returns it generates.

Click image to enlarge.
Click image to enlarge.

Improving the brand mix and bringing profit margins back up to old levels will increase returns and the capital it can return to shareholders.

Splitting Procter & Gamble Up

Long-term clients and readers of the AMM Dividend Letter are well aware of our love of spin-offs. We think Procter & Gamble should be split up. Spin-off benefit both the company spun-off and the parent. Both companies reduce their operating size and become more focused on their key markets. Spin-offs have been shown to increase sales and profits at both the old parent company and the new spin-off by creating the best operating environment for each.

Barron’s recently outlined a 3-way split-up of Procter and Gamble and highlights the math that shows Procter & Gamble is worth more separate than together.

Table from Barron's. Click image to enlarge.
Table from Barron’s. Click image to enlarge.

While we would like to see Procter & Gamble embark on a spin-off strategy we think this strategy is a couple years away, at least. Management has to finish their current divestment plan, corporate restructuring, and increased efficiency plans before they really consider splitting the company up.

Pre-Mortem (Potential Risks to our Thesis):

Razor Subscription Services

Procter & Gambles highest margin business is its grooming division which houses its razor business. It was supposedly King Gillette that came up with the strategy now known as the razor/razor blade model. Sell the razor cheaply and then sell the disposable razor blade at a higher price and with high-profit margins. The story is a myth but Gillette’s business model transformed into it over the years. Grooming is Procter & Gamble’s highest margin division with consistent operating profit margins in excess of 30%.

High margins attract competition. In the last couple of years, two companies have taken on Procter & Gamble’s razor business, Dollar Shave Club and Harry’s. The cost to manufacture comparable razor blades has declined along with the cost to sell directly to consumers on a subscription basis. It allows companies like Dollar Shave Club and Harry’s to sell their razors at much lower prices and accept lower margins of profitability to grab market share in a $6+ billion men’s grooming market.

Private Label vs Name Brand

It’s not just with razors that Procter & Gamble charges a higher price when compared to competitors. For example, Tide is the highest priced liquid detergent on the market. As the chart below from UBS via Quartz highlights.

Click image to enlarge.
Click image to enlarge.

Brand loyalty and pricing power were two of the main investment themes for Procter & Gamble over the years. Consumers used to be willing to pay up for name brands because of the quality the brand name implied. Brand loyalty has reversed over the years and consumers are no longer shunning private label/generic brands.

Nearly 70% of store brand shoppers report trusting certain store brands more than others, and 64% are likely to try other store products once they’ve tried one. Brand trust is particularly strong for millennials, who are more likely to buy store brand foods in general (97% compared with 94% of all shoppers).

This trend dampens Procter & Gamble’s ability to continue raise prices faster than the rate of inflation on its name brand products.

Emerging Markets

Why does America’s leading diaper company, Procter And Gamble place a made in Japan sticker on the diapers it sells in China? Procter & Gamble misread the Chinese market. P&G believed that Chinese consumers would want value and marketed their diapers as such. Chinese parents wanted high-end diapers and the Japanese diaper maker Kao offered them. Procter & Gamble is addressing this issue with higher-end diapers that are made in Japan.

Selling a consumer good globally involves getting the branding and the value proposition correct for each market. P&G’s china misstep was a big one. China is the growth market for consumer goods right now. If P&G stumbles or fails to gain a large presence in other emerging markets then its future growth will be hindered.

Conclusion:

Our estimate of fair value for Procter & Gamble is $85 per share. We used current operating margins, a 4% growth rate, and a 10% discount rate. If Procter & Gamble succeeds in its divestment and restructuring plans then margins will improve and our estimate of fair value will increase. Increased revenue growth will increase our estimate of P&G’s intrinsic value too.

As of right now, Procter & Gamble is fairly valued. This does not mean we expect below average returns or negative returns. It simply means at today’s price we’re not expecting above average returns. A lower stock price gives us a chance to buy more Procter & Gamble at a price that offers us the potential for above average returns. This is why we like stock market corrections. It is not a time to panic but a time to look for opportunity.

As we outlined above, if Procter & Gamble can achieve its restructuring operating targets while fending off threats to its core brands then P&G’s intrinsic value is likely more than our current estimate.
All previous letters are archived here.

The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.