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Emerging Markets Trim Gillette's Profit Margins

Posted
1/4/2013 9:00:00 AM
By: Trefis
Referenced Stocks:AVP;CAGR;CL;PG;UL

Procter & Gamble ( PG ) is slowly discovering that emerging economies are an entirely different proposition than developed markets. Its shaving division, which largely comprises sales from Gillette's shaving equipment, is a perfect case in point. Despite dominating the western markets for years, the company is finding it difficult to convince consumers to move away from traditional shaving devices to disposable razors and cartridges. Price is the main issue here but the obvious solution (lower-tier products) means the company will have to move away from its traditional range of high-end designs with which it has managed to garner high market share and earn high margins from customers in the developed world. Add to this the increasing cost of goods and services in emerging economies and Gillette's entry into developing markets begins to seem as much a risk as it does an opportunity.

See our full analysis for Procter & Gamble

When it comes to shaving, Gillette has been the go-to brand for men across the western world. The company's range of razors and cartridges command a near monopoly on shelves across the US and Europe with market share of nearly 70% in most of the developed countries where it operates. The closest competitor, Schick, seems to have settled for second-best - the dynamics of the market have remained largely unchanged over the past few decades.

Gillette's meteoric rise in the world of shaving devices is a story of innovation. The company has routinely invested in upgrading product design, consistently maintaining an edge over competitors when it comes to attributes such as razor safety, handling and - most importantly - the number of blades. Realizing that design is perhaps the only real differentiation among men's shaving devices, the company can also be credited for doggedly protecting its design patents. Apart from R&D, Gillette is also famous for its extensive marketing - something it used quite effectively to move people away from doubled-edged safety razors (in vogue until the '60s) to the more convenient, disposable options popular today.

The company's stranglehold over the shaving market has allowed it to maintain a very strong pricing structure and consequently overall margins. Its strategy has been pretty consistent. Gillette offers its basic devices at relatively low prices, providing a low entry point for a new customer, but really milking it when it comes to cartridge refills. This has allowed it to operate at EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) margins close to 30-35%, something rarely seen for disposable consumer products.

It was precisely the combination of strong market share and high margins which attracted the attention of Proctor & Gamble in 2005, eventually leading to the acquisition of Gillette later that year. A lot of things have happened since then, of course. The slowdown in developed economies is one of them and the rapid expansion in emerging economies is another.

But Gillette has generally found it difficult to penetrate emerging economies with its traditional range of multi-blade products such as Mach3 and Fusion.  The reason here is chiefly the high price point as well as general consumer inertia about moving away from more traditional methods of shaving, including double-edged safety razors.

In order to address these problems, Gillette turned to innovation again. In 2010, it came out with Gillette Guard, which marked a return to single-blade razors. This low-tier product, directed exclusively at low-income level consumers in emerging economies such as India, costs as little as 11 cents. Of course, Gillette's strategy with this innovation was to at least get consumers to move away from traditional shaving methods. This strategy certainly seems to be boosting volume sales - total turnover for Gillete in India, for example, increased at a cumulative average growth rate ( CAGR ) of around 20% over 2008-2012.

Where this strategy seems to be seriously hurting the company, however, is the bottom-line. Operating profit for Gillette India has actually declined at a CAGR of 12% over 2008-12, despite the rise in total sales. The emphasis on low-cost products is facing further pressure from rising cost of raw materials. Raw material expenses as a % of total revenes for Gillete India have increased from around 38% in 2008 to nearly 47% in 2012.

With rising levels of income in countries like India, China and Brazil, it can be expected that the demand for mid and upper-tier products that Gillette sells in developed economies will pick up in the near future. Until then, the only way for companies to really gain a foothold in emerging economies is to gamble on their low-tier products. We expect Gillette's margins to decline steadily in the near future, dragging its margins for the shaving division lower.

Top-line growth and a steady increase in market share in emerging economies should however place the company in a strong situation in the long term, especially when consumers in countries like India are ready to start paying higher prices for consumer goods. However, the company doesn't really face big-name competitors in the segment thanks to its dominance in developed markets. The long-term outlook remains quite positive for Gillette despite near-term turbulence.

We currently have a Trefis price estimate of $70 for Procter & Gamble , which is around 5% above the market price.

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