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Procter & Gamble (PG)

Recommendation: Hold October 16, 2008

Summary - The macro environment is the trump card and right now that picture is

not pretty. Procter & Gamble (PG) will continue to deliver innovative productsand leverage its organizational structure, but they will still be hurt as consumerscontinue to clamp down and buy the cheaper Private Label Brands. While notapparent on the surface, sales growth has already slackened due to the weak economic environment. Sales grew 9% during FYE 6/30/2008, but 5% of that wasdue to foreign exchange and only 4% due to actual volume growth. If the dollarhad appreciated rather than depreciated by an equal amount, then sales growth is anegative 1%. The company is diversified across price levels and different marketsegments, which means that it is positioned to survive the downturn, but notthrive. The majority of their exposure is to premium and mid-tier products and23% of their sales are derived from their Beauty unit (a highly discretionary areaof consumer spending). These two facts indicate that they will be hurt in anenvironment of slackening consumer demand.

Highlights to both sides of the argument for PG:

Bullish :

Strong market shares in its brands Diverse and balanced portfolio of brands across segments and price tiers Strong product innovation resulting from large investments in R&D Strong management team If input costs (oil, natural gas, pulp) go up then that is paradoxically good,

as long as the increase is due to pull from demand rather than a supplypush.

They have paid dividends for 118 years with increases in the last 52 years The company has a tendency to buy back stock when they feel it is cheap Compelling valuations at current levels using historical P/E valuation

Bearish :

Poor macro environment with slack demand and uncertain outlook Intense competition for its products from other companies and from

retailers Private Label Brands Uncertain foreign currency outlook (PG is hurt by an appreciating dollar) Declining sales growth and profit margins Fairly valued at current levels using relative P/E valuation Technical Analysis indications indicate a short to medium-term

consolidation at best and a sustained downtrend, at worst.

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Fundamental Story

Overview - PGs business is focused on providing branded consumer goodsproducts of superior quality and value. Their products are sold in more than 180countries primarily through mass merchandisers, grocery stores, membership club

stores and drug stores. They continue to expand their presence in other channelsincluding department stores, salons and high frequency stores, the neighborhoodstores which serve many consumers in developing markets.

Their market environment is highly competitive, with global, regional and localcompetitors. In many of the markets and industry segments in which they sellproducts, they compete against other branded products as well as retailers private-label brands. Additionally, many of the product segments in which they competeare differentiated by price (referred to as premium, mid-tier and value-tierproducts). Generally speaking, PG competes with premium and mid-tier productsand often leads or has a significant market share in the industry segments in whichthey operate.

Financial Highlights 2008 2007 2006 2005 2004Net Sales (amounts in millions) $83,503 $76,476 $68,222 $56,741 $51,407Operating Income 17,083 15,450 13,249 10,469 9,382Net Earnings 12,075 10,340 8,684 6,923 6,156Net Earnings Margin 14.5% 13.5% 12.7% 12.2% 12.0%Basic Net Earnings Per Common Share $ 3.86 $ 3.22 $ 2.79 $ 2.70 $ 2.34Diluted Net Earnings Per Common Share 3.64 3.04 2.64 2.53 2.20Dividends Per Common Share 1.45 1.28 1.15 1.03 0.93

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PG is organized into three Global Business Units (GBUs): Beauty, Health & Well-Being, and Household Care. These GBUs are further aggregated into sixsegments, which are outlined in the chart below.

GBU Segment

% of Net

Sales%of NetEarnings Key Products

Billion-DollarBrands

BEAUTY Beauty 23% 22%

Cosmetics, Deodorants,Hair Care, PersonalCleansing, PrestigeFragrances, Skin Care

Head & Shoulders,Olay, Pantene,Wella

Grooming 10% 13%

Blades & Razors,Electric Hair RemovalDevices, Face & ShaveProducts, HomeAppliances

Braun, Fusion,Gillette, Mach3

HEALTH &WELL-BEING

Health Care 17% 20%Feminine Care, OralCare, Personal HealthCare, Pharmaceuticals

Actonel, Always,

Crest, Oral-BSnacks,Coffee & PetCare

6% 4% Coffee, Pet Food, Snacks Folgers, Iams,Pringles

HOUSEHOLDCARE

Fabric Care &Home Care 28% 27%

Air Care, Batteries, DishCare, Fabric Care,Surface Care

Ariel, Dawn,Downy, Duracell,Gain, Tide

Baby Care &Family Care 16% 14%

Baby Wipes, BathTissue, Diapers, FacialTissue, Paper Towels

Bounty, Charmin,Pampers

Source: P&G 2008 Annual Report

Additionally, as the market leader they benefit from pricing power with suppliers.They have an organizational structure that works to leverage their knowledge andscale at the global level with a deep understanding of the consumer and customerat the local level. They generally maintain a long-term focus, concentrating oncapturing a consumer early and then keeping him or her for life. In order to drivegrowth and diversification, they acknowledge the need to grow disproportionatelyin developing markets and with value-conscious consumers. (P&G 2008 AnnualReport)

Emerging Markets P&G has been taking steps towards increasing global salesand market share by establishing footholds in emerging markets. For the past fewyears they have grown revenue in developing markets at close to or above 10%.They have a solid foothold in China, India, Brazil, Mexico & Russia, althoughmarket share figures have slipped a bit in Brazil & Mexico. According toCitigroup, PG has less exposure (when compared to other competitors such asColgate and Avon) to faster-growth emerging markets. There appears to beample room to expand in this space and PG is committed to tripling their businessin these areas, which now account for 27% of sales. (P&G 2008 Annual Report) In

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order to drive growth going forward, they must execute on their goal of significantly growing their revenue and market share in these markets.

New Product Development PGs portfolio of products includes 24 brands thateach generate over $1 billion in annual sales and 20 brands that each generate

between $500 million and $1 billion. Despite the difficult macro environment, PGhas not shied away from investing in innovation. They realize that in order tocombat the risks and the threats inherent in the industry, they must continue todevelop innovative and differentiated products, as they have successfully done inthe past. Their consumer demand research and the connect and developstructure enable them to better understand the unique needs of the consumer andcater to them. Chairman & CEO, A.G. Lafley, has said in interviews that whileconsumers rarely give them the idea for a product, they do provide key insightsinto what stimulates them and what convinces them to buy or not buy products.Through Connect & Develop ( www.pgconnectdevelop.com ) consumers and

potential business partners can submit product ideas and input over an online web-portal. This has led to successful collaborations all over the world withuniversities, individuals and even competitors. Among other successes, Connect& Develop has resulted in the development or acquisition of new products(Bounce), product improvements and packaging improvements (Secret deodorant).This venture should continue to add value as online collaboration is increasinglyprolific.

Rob Steele, Vice Chairman Global Health & Well Being, identified a number of innovations that are either already on the market or will be available pretty soon.Three examples of these products include: Always Infinity (feminine pads with

superior protection, priced at a 65% premium to regular products), Always Envive(light incontinence product), and Crest Pro-Health Whitening toothpaste.(JPMorgan) In Fabric & Home Care, they are coming out with a concentratedlaundry detergent which is twice as concentrated as current liquid laundrydetergents. By offering the same amount of laundry cycles with half the volume,they can significantly reduce packaging and transportation costs.

Industry

Over the last decade a small group of low priced retailers have captured a largershare of the US market, which has increased their pricing power with consumerproduct companies. Additionally, these retailers have created their own PrivateLabel Brands, which directly compete with the brands from PG and otherconsumer product companies. Retailers are close to consumers and haveimportant sales data on consumer behavior, which helps them to develop the rightproducts and better place them. Both of these developments, the rise of PrivateLabel Products and the consolidation among large retailers, have contributed to the

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high levels of competitive activity in the environments in which (PG) operate(s).(P&G 2008 Annual Report) A.G. Lafley has explicitly stated that he expects some of PGs leading brands to see some share weakness to private label, but believes thecompany has prepared the portfolio for a slowdown through multiple price tiersand products with diverse consumer targets.

The Macro Environment

Input Costs the majority of the companys production expenses go to commodityinputs: oil, natural gas and pulp. These input costs have eased significantly in thelast quarter but remain at historically high levels. Perhaps more important is theuncertainty of where these costs are headed. Given the recent volatility of thecommodity markets, it would not be unreasonable to assume these costs will goback up.

Simply dismissing higher input prices as a negative and lower prices as positive,misses a larger more critical cause and effect. Oil and other input prices haverisen significantly since the beginning of this century and PGs earnings and stock price have also. Input prices moved up on the back of increased economic activityand higher global demand. PG was hurt by the higher input costs, but this was faroutweighed by the positive impact of increased demand. Thus, if input costs go upthen that is paradoxically good, as long as the increase is due to pull from demandrather than a supply push.

Weak Consumer The weak economy has led to declining consumer demand,

both domestically and abroad. Furthermore, it could be that we are only in thebeginning stages of a global economic contraction. The mantra for the last fewdecades has been to not bet against the US consumer. That trend may be reversingitself now as consumer balance sheets are in miserable shape and unemploymentcontinues to tick up as housing prices continue to drop. Economic activity andglobal demand do not look much better. And, while long term projections showtremendous growth in emerging or developing markets, the short and mediumterm appear highly uncertain.

In such an environment PG benefits from their multi-tier offerings as strappedconsumers can trade down and still purchase PGs products. For example, PG isseeing some trade down from Tide to Gain laundry detergents. The company hasindicated in a meeting with JPM analysts that mid-tier products are the onesgetting squeezed while basic and premium products are still growing. (Source: JPMorgan) Nonetheless, the company still has exposure to discretionary spendingthrough its Beauty segment and its Snacks, Coffee & Pet Care segment, whichaccount for 23% & 6% of Net Sales, respectively. Net sales in the Beautysegment increased 9%, but only 2% came from volume growth with the majority

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Valuation

Historical Using the 10 year average P/E of 21.94 and the estimates for calendar2008 EPS ranging from $3.73 to $4.31, we calculate an implied price range of $81.84 - $94.56. Based on a historical P/E valuation PG appears to be

undervalued. Relative For the relative value calculation I use the current average P/E of theHousehold Products Peer Group, which is 14.22. Based on a relative P/Evaluation PG appears to be fully valued.

P/E E Est - Low E Est - High Low Price High PriceHistorical 21.94 3.73 4.31 $ 81.84 $ 94.56Relative - Household Prod 14.22 3.73 4.31 $ 53.04 $ 61.29

Source: Bloomberg & MSN.com

Technical Analysis

Introduction - At times Technical Analysis can seem to be a bit of Hocus Pocus.Nonetheless, there is some validity and significance to trend, support andresistance, price formations, and sentiment indicators. For example, if one isbullish on the fundamentals of a stock and yet the price breaks through a criticallevel of support, then Mr. Market is disagreeing and the bullish thesis may be duefor reexamination. In short, it can serve as useful supplemental information toother analysis.

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Long Term - Below is a long term, 10 year weekly chart displaying an up trendline off the 2000 and 2001 lows. The recent down move has broken that trendline, suggesting a sideways consolidation at best or the beginning of a long termdown trend at worst. Given the volume and severity of the recent decline, it isunlikely that the price turns abruptly and heads north to new highs. More probableis a consolidation after any possible bounce and at least one re-test of the $60support level before any possibility of an uptrend resumes. This is typical of abottoming in any stock and is similar to what played out after the high-volumedecline in 2000.

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Medium Term - Price is at medium term support around $60, which is displayedon the weekly 4 year chart below. This support was created off the highs back inSeptember 2004 and the subsequent lows on consolidations throughout 2006, 2007and 2008. Last week there was a fast move through this support but price endedup closing the week just under at $59.56, hardly a definitive break. Volume onthis recent down move has been 2 or 3 times the daily average (see chart),suggesting a large amount of distribution by institutions.

A point of concern is the two peaks in price made over the last year, the first inDecember 2007 around $75 and the second in September 2008 around $73. Thefacts that the retest of Decembers high failed and the subsequent high-volume

decline, are reasons to believe that at best the stock is in a phase of consolidationand at worst, this is the beginning of a sustained downtrend (should it break support at $60). A definitive break through support at $60 would confirm thedouble top formed over the last year and project a move down to the $45 level.

Sentiment - In general, sentiment is used as a contrarian indicator; i.e. sell wheneveryone is bullish and buy when everyone is bearish. Yet there are a lot of pitfalls to such a simplified interpretation and a lot of people know just enough

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about sentiment to get themselves in trouble. Perhaps the first rule is to never usesentiment in isolation, but rather as a confirmation to other aspects of analysis(both technical and fundamental). Secondly, sentiment is generally only useful atextremes.

It is easiest to measure sentiment on the market as a whole, yet the analysis canalso be carried to individual issues, such as PG. For example, if you see a stock moving up in price and outperforming the market, while all or most analystscovering that stock have a sell rating, then that is good. Likewise, if price isbreaking down through support levels and all or most analysts have a buy on thestock, then that would be bad. Below is a chart of the analyst recommendations onPG right now.

Source: MSN

This would be interpreted as being slightly bullish sentiment for PG, which wouldbe contrarily bearish. But this is not at an extreme and, thus, sentiment is notgiving us a very clear signal right now (which is perhaps also useful to know).

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PG Talking Points

What to look for:

Continue to deliver new & innovative products

Provide more innovation to the value-conscious consumer Execute on their goal of growing markets share in emerging markets, while atleast maintaining current position in other markets

Bullish arguments:

Strong market shares in its brandso Their portfolio of products includes 24 brands that each generate over

$1 billion in annual sales and 20 brands that each generate between$500 million and $1 billion.

Diverse and balanced portfolio of brands across segments and price tiers Strong product innovation resulting from large investments in R&D

o Consumer demand research and Connect & Develop help them tocontinue creating innovative products.

Strong management team If input costs (oil, natural gas, pulp) go up then that is paradoxically good, as

long as the increase is due to pull from demand rather than a supply push. They have paid dividends for 118 years with increases in the last 52 years The company has a tendency to buy back stock when they feel it is cheap Compelling valuations at current levels using historical P/E valuation

Bearish arguments:

Poor macro environment with slack consumer demand and uncertain outlook o Exposure to mid-tier and premium products and discretionary spending

(Beauty) intensify the pain of slow consumer demand Intense competition for its products from other companies and from retailers

Private Label Brandso CEO, A.G. Lafley acknowledges that he expects some of PGs leading

brands to see some share weakness to private label. Uncertain foreign currency outlook (PG is hurt by an appreciating dollar)

Declining sales growth and profit margins Fairly valued at current levels using relative P/E valuation Technical Analysis indications indicate a short to medium-term consolidation

at best and a sustained downtrend, at worst.o Broken long term (8 year) up-trend lineo High-Volume distribution recentlyo Resting on critical support at $60 and a potential double-top formation