Corporate Finance Paper : Procter and Gamble
Procter & Gamble
Procter & Gamble (P&G) started n 1837 as a tiny, family-operated soap and candle company. In twenty years, its sales have already rocketed to $1 million and after another twenty years, the company was able to create Ivory Soap. (Webb, et. al., 2007) In 1890, the family owned company was then incorporated in Cincinnati, Ohio. At that point, it was already selling more than thirty different types of soap. By the nineteen nineties, P&G was producing and marketing some of the world’s most recognizable brands such as Tide, Pampers, Bounty, Pantene, Vicks, Pringles, and Crest.
P&G built its first transnational manufacturing facility in 1915 in Canada and has established its first overseas subsidiary in 1930. This was brought by the sale of a soap manufacturer in Great Britain. In 1935, it has established itself in the Southeast Asian region, specifically in the Philippines. P&G’s internationalization process modestly started after World War II. In 1948, it also started it operations in Mexico through an Overseas Division. In 1960, P&G opened its first European office in Germany and after a year, it opened a Middle Eastern office in Saudi Arabia. P&G started manufacturing and marketing its products in Japan in 1973, through an acquisition. Despite these multinational efforts, P&G still considers itself as a local U.S. company and it is focused relatively on the global market. (Ibid.)
It officially turned its attention to the global markets by the 1980s after it has calculated its strong position in the U.S. and with the support of improved infrastructures such as transportation and communication technologies and the consistent economic growth n the foreign consumer markets. Basing its boldness on the success of its Mexican subsidiary, the company bought a soap business in Brazil n the late 1980s. It has also expanded into Colombia, Chile, Peru, and Argentina up to the early 1990s. It also expanded its business in Japan and in 1988 started a joint venture to manufacture products in China. It has also started its Eastern European operations in 1991, particularly in Czechoslovakia, Hungary, and Poland – and Russia. (Ibid.)
Procter & Gamble provides branded consumer goods around the world. It aims to dominate the global market with superior quality and valuable product that can improve the lives of the world’s consumers. Its products are sold in more than 180 countries, mainly through mass merchandisers, grocery stores, membership club stores and drug stores. It expands its global presence through “high frequency stores,” which is the neighborhood stores which serve many consumers in developing markets. (Yahoo Finance Website, 2010)
In fiscal year 2010, P&G earned $79 billion in sales all over the world throughout its 24 brands with $1 billion of sales each. (P&G Website, 2011) As it is, P&G is a global giant for household and personal goods. P&G compete in multiple product lines and it has three global business units (GBUs) namely, Beauty, Health and Well-Being, and Household Care. Under the U.S. Generally Accepted Accounting Principles, the multinational company’s business units comprising the GBUs are aggregated into six reportable segments: Beauty; Grooming; Health Care; Snacks and Pet Care; Fabric Care and Home Care; and Baby Care and Family Care.
P & G operates on-the-ground operations in approximately 80 countries through our Market Development Organization, which leads country business teams to build our brands in local markets and is organized along seven geographic areas comprised of three developed regions (North America, Western Europe and Japan) and four developing regions (Latin America, Central and Eastern Europe/Middle East/Africa, Greater China and ASEAN/Australasia/India/Korea) (Ibid.).
For March 2009, P & G’s net sales declined 1% to $60.4 billion. Organic sales, which exclude the impacts of acquisitions, divestitures and foreign exchange, grew by 3%. Its unit and organic volume, which excludes the impact of acquisitions and divestitures, both decreased 2% versus the prior-year period. The company’s net earnings increased 21% to $11.0 billion. Net earnings increased due to the gain on the Folgers transaction. Net earnings from continuing operations were flat versus the prior year period as lower net sales and a decline in operating margin were offset by lower interest expense, higher gains from divestitures and a lower tax rate. Its diluted net earnings per share were $3.46, an increase of 27% versus the comparable prior-year period (Ibid.)
The company’s operating cash flow was $9.9 billion, a decrease of 11% versus the prior year period. Free cash flow productivity, defined as the ratio of operating cash flow less capital expenditures to net earnings, was 71%. Generally, the business operations and sales were affected by the global economic changes, terrorist activity and political unrest. It has also affected P & G’s credit or liquidity issues, inflation, deflation or decreased demand for its products.
Foreign Exchange (FX) Risk Management Policy.
Foreign exchange risk management has received additional attention in corporate finance practice. This is because a thorough and a contextual understanding of foreign exchange risk management are essential for multinational company’s management. This is especially true for P&G in today’s global business market and inconsistent foreign exchange rates. This will contribute to a company’s increase or decrease in exports or imports.
At present, multinational companies such as P&G is eyeing the emerging markets. This is because it is one of the major growth areas for them in a global scale. P&G already secures large and growing market shares in emerging markets of China and Russia. Its Downy Single Rinse, low-water volume detergent, and Naturella, a cheap feminine protection product especially target emerging economies. In light of the growth strategy on emerging markets, it opens up to almost 20 new manufacturing facilities outside its mature markets.
Having diversified products, P & G are greatly exposed to various risks in the market such as interest rates fluctuations and changes in the exchange rates and commodity prices. It assesses these various risks on a systematized basis to benefit from the regular exposure correlation and netting. P&G chooses to take care of its volatility related to net exposures. It comes into several financial transactions which it records for applying respective accounting consultation for instruments of derivatives and for hedging activities. P&G’s financial accounts are ruled by its policies covering acceptable exposure of counter party, other types of instruments and other hedging practices. (P & G 2009 Annual Report, 2010)
At inception, P & G formally designates and records respective instruments as hedges of several exposures. It normally evaluates at both the incurrence and at least every three months, if the said instruments applied in hedging transactions are successful in offsetting the alterations in either fair market value or cash flows of the directed subsequent exposure. The changes in the values of these instruments are usually offset by alterations in the flow of cash or fair market value of the sbseqent exposures being hedged. The offsetting is de to the high level of effectiveness between the exposure being hedged and the instrment used for hedging. The unsuccessful part of an alteration in the fair market value of a respectve instrument is rgently acknowledged in income. The amount of ineffectiveness merited is unijmportant for all periods presented.
Manufacturing and selling its products in various global markets, the company is exposed to foreign currency exchange rates fluctuations. Its program for foreign currency hedging aims to control the volatility associated with short-term fluctations in the rates of exchange. To control this risk in excange rates, P & G has traditionally used a proportion of currency swaping, forward contracts and options. The Company has also utilized options and forward contracts to reduce the impact of the changes in exchange rate on projected sales, buying of inventory and internal P&G royalties pegged in international currencies (Ibid.). The alteration in value of specific non-qualifying instruments applied to control the exposure to foreign exchange of internal P&G financing accounts, earnings from multinational operations and other headings in the company’s balance sheet are scrutinized to revaluation and are rgently acknowledged in income, particularly reducing the foreign currency effect of the subseqent exposres from one market to another. As per P&G’s 2009 financial statement, the net earnings impact of these instruments was a $1,047 loss in 2009 and an erarnings of $1,397 and $56 in 2008 and 2007, respectively. (Ibid.)
As early as 1996, P&G’s Treasury had linked itself with various investment banks. By the 1990’s, they have imbibed new techniques to significantly improve ther cost of capital methodology. Interestingly, the Treasury and Corporate Finance of P&G work independently. Their new meetings recommended that the company use sovereign spreads in the emerging bond market as a country risk proxy, with the spread referring to the difference between the maturity yield on a specific country’s dollar-denominated bonds and the US-Treasury bond yields with comparable maturities. (Webb, et. al., 2007)
Arguments centered on the new procedure’s differentiated investments. The other managers were concerned that this would result in increased costs of capital in less stable economies, hence, discriminating against investments in them. Because emerging market are generally more volatile and volatility, in a way, creates opportunity, forcing a higher cost of capital there would likely result in unrealized opportunities. (Ibid.)
The Types of exposure P & G measured and managed
Since it is exposed to foreign currency fluctuations, P & G manages its exchange rates exposures through the following: transaction exposure, economic exposure, and translation exposure. To measure its transaction exposure, the company estimates its net cash flows in each currency and measures the potential impact of the currency exposure. To measure the impact of currency exposure, the company uses a series of monthly percentages changes in each currency. To measure its economic exposure, the company uses sensitivity analysis which considers different sales and expense categories, depending on various exchange rates scenarios (Madura, p. 292). Lastly, to translate its earnings, P& G follows the FASB guidelines for valuing existing currency derivative contracts.
Other Comprehensive Income
Procter & Gamble showed a decreased comprehensive income than their net income by roughly -11% in 2009. Total comprehensive income is comprised primarily of net earnings, net currency translation gains and losses and net unrealized gains and losses on securities and cash flow hedges. Other comprehensive income includes financial statement translation and hedges and investment securities (P & G 2009 Annual Report, Consolidated Statements of Shareholder’s Equity).
What hedging transactions are used for each type of exposure?
P & G uses long term forward contract to accommodate its specific needs. It also uses net investment positions in major foreign subsidiaries. To accomplish this, P & G either borrows directly in foreign currencies and designates all or a portion of foreign currency debt as a hedge of the applicable net investment position or enter into foreign currency swaps that are designated as hedges of its related foreign net investments. Changes in the fair value of these instruments are immediately recognized in OCI to offset the change in the value of the net investment being hedged (Ibid.).
Emory, Finnerty & Stowe (2007) wrote several ways to manage transactional exposure and these include the following:
Invoice currency hedging: this is an operational technique whch is less known than swap, forward contract, future and option contracts. Wth ths, P & G can share or shift or diversify exchange risk by specifically electing the currency of invoice. It can avoid exchange rate risk by invoicing in domestic currency, thus, it is able to shift exchange rate risk on the buyer. However, ths cannot be overly applied becase this may lead to the company’s loss of customers to competitors. Only an exporter with significant market power can utlize this approach. Also, if the exporter and importer’ currences are not suitable for international trade settlement, then, neither party can use risk shifting to deal with exchange exposure. (Emory, Finnerty & Stowe, 2007)
Lead and lag hedging: ths is also an operational technique to reduce transaction exposure. To “lead” means that the firm will pay or collect early, whereas to “lag” means that it will pay or collect late. As practiced, the compnay will lead soft currency receivables and lag hard currency receivables to avoid the loss from depreciation of the soft currency and take advanatge of the appreciation of the hard currency. For the same reason, the firm will attempt to lead the hard currency payables and lag soft currency payables. The extent by whch a ocmpany can effectively se ths strategy reslts to the redction of their transaction exposure. (Ibid.)
Other strategies to manage operating exposure include:
Choosing low cost production sites: companies can choose to locate ts production facilities to foreign places where its local or domestic currencies are strong or will become stronger. They can also select to build and maintain production facilities in various countries to deal with the impact of the changes in exchange rate. (Ibid.)
Flexible sourcing policy: a company can signficantly reduce the effect/s of exchange rate changes by sourcing from where raw materials or input costs are low. This can be taken advanatage by the company even when its manufacturing facilities are in the domestic country. For greater competitiveness, flexible sourcing can be used not only in materials and parts but also in low cost guest workers from foreign countries instead of high cost domestic workers. (Ibid.)
Market diversification: this is a great way of dealing with exchange exposure. A company will jst diversify its market for its products. This can be applied as long as the exchange rates move in different direction, hence, the company can maintain its operating cash flow by export market diversification. (Ibid.)
R&D and product differentiation: R&D investments can enable a company to sustain and empower its competitiveness in the face of adverse exchange rate movements. Positive R&D efforts enable the company to reduce costs and improve its productivity. Also, R&D initiatives can lead to the introduction of new and unique products that close competitors cannot match. Since the demand for unique products tend to be consistent, the company becomes less exposed to exchange risk. Likewise, it can atempt to make an impression that its product is really different. This helps firm to pass-through any negative effect of exchange rate to the customers. (Ibid.)
Financial hedging: this can be used to maintain the company’s cash flow. Also, the company can use currency forward of options contracts and roll them over if necessary. (Ibid.)
Time frame to manage risk
Due to market diversification and sophisticated derivatives, there are various time frames used by the company in its risk management strategies to its various investments and derivatives. In order to create a coherent risk-management strategy, companies should carefully determine the nature of both their cash flows and investment opportunities. After doing this, their initiatives of aligning their supply of financial resources with the demand for funds will lead to the right strategies for risk management.
Companies may take advantage of risk management even if they have no large investments in plant and equipment. This takes on the meaning of investment to include not just the traditional investments like capital expenditures but also investments in intangible assets like highly trained workforce, brand-name recognition and market share. Indeed, companies that make these various forms of investments may need to be even more aggressive in risk management.
This is because a capital-intensive company can utilize its recently purchased plant and equipment as collateral to obtain a loan. “Softer” investments are more difficult to collateralize. (Ibid.) It may be more difficult for a company to increase its capital from a bank to fund, for instance, short-term losses that are outcomes of a low pricing policy to build market share. For companies that make these types of investments, internally generated funds are more vital. As an outcome, there may be a greater need to parallel the supply of funds with the demand for funds by managing risk.
One optional strategy is for the company to take on more debt and then directly hedge those risks in the derivatives markets. However, this strategy is riskier in terms of the ability to make good investments than the low-debt/no-hedging strategy. In various countries, however, the extra debt allowed by hedging enables a company to benefit from the tax deductibility of interest payments. (Ibid.)
Multinational companies must acknowledge that foreign-exchange risk affects both cash flows and investment opportunities. Companies must also pay close attention to the hedging strategies of their rivals. Financial managers must realize that it is not merely the case of not hedging when the competitors are not hedging. There are specific situations in which a company may have even greater reason to hedge even when its competitors are not hedging. Thus, the company should hedge to make sure it has ample cash for this investment.
As it is, the investment opportunities depend on the general structure of the industry and on the financial strength of its rivals. As such, the same forces which are required in formulating a company’s competitive strategy must also be applied when it is creating its risk management strategy/ies.
How does the company use Derivatives for funding, investing, and other price risks?
Derivatives are the instruments most commonly used in financial risk management. Because unique derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivatives that trade on well-established financial markets. These standard derivative instruments include options, futures contracts, forward contracts, and swaps.
Companies may use derivatives to transfer the risks just lie in the case of insurance. A derivative can also be used as a hedge fund, which can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk (Madera, p. 293).
What is the extent of the company’s offshore and
Euromarket funding and investing activities?
Being a large, diversified multinational company, Procter & Gamble extensively invest in offshoring activities. It has been fully integrated into the Euromarket economy. It subsidiaries hide under classified operating, investing and financing activities so that it can overcome its capitalization of Borrowing Cost and Foreign Exchange Losses.
This table provides the P&G’s percentage of net sales and net earnings from continuing operations by reportable business segment for the three months ended March 31, 2009 (excludes net sales and net earnings in Corporate):
Net Sales Net Earnings
Beauty 23 % 20 %
Grooming 9 % 12 %
Health and Well-Being GBU
Health Care 17 % 22 %
Snacks and Pet Care 4 % 2 %
Household Care GBU
Fabric Care and Home Care 29 % 28 %
Baby Care and Family Care 18 % 16 %
Total 100 % 100 %
This table represents the rise and fall of P & G’s stock and it is generally described as being lackluster in the last five years.
PG’s relative valuation appears attractive compared to other brand-management and personal care stocks such as Clorox. Its dividend and earning performances have also been good. It is a good opportunity for buy and hold investors (Repp, Weigand & Xi, p. 1).
It is very important to highlight the important of corporate finance management in the light of global market expansions and the visibilities of various companies in the global markets. Just like P&G, many global companies are now operating internationally. It must be emphasized that the extent of the multinational companies’ global concentration, global synergies and global strategic motivations indicate the MNCs more strategic motives and purpose and operations in host countries and elsewhere as related with how it entered the local markets.
Global strategies play a critical role in differentiating among distinct entry modes of each MNC in each different host country. However, collectively, the major factors are all equally considered in making the decision to enter a local market for foreign direct investments. It hinges on the importance of financial management for every multinational company.