Dueling Fools
Battlestar Gillette-ica
March 24, 1999

Gillette Bull's Pen
by Louis Corrigan ([email protected])

Imagine a company built around a mass market product that's driven by proprietary technology and sophisticated engineering. Let's say gross profit margins are around 62%. Its market share stands at, oh, 70%. Sounds a lot like Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>. But this is a repeat-purchase product used by basically everyone on the planet. It's backed by a widely recognized consumer brand. It even features some great ergonomic styling.

Best of all, this business enjoys pricing power, which very few companies even dream about anymore. Intel's technologically advanced new chips do basically the same job a lot better than their predecessors, but their prices do nothing but go down. Our dream company introduces sophisticated new products that do their job better and sell for more money than their predecessors. Yet, the predecessors generally don't fall much in price -- even when the new product hits the market.

Such is Gillette's razor business, which accounted for 30% of the company's sales last year but half its operating earnings. Last June, Gillette launched its much-hyped MACH3, a triple-bladed razor with ultra thin blade edges made of a special diamond-like carbon coating. Gillette spent a decade and some $750 million to develop the MACH3 and retool its manufacturing facilities. The result is pretty much the best shaving device available to man. (And soon, woman.)

Gillette asks customers to pay up for this superior quality. The MACH3 cartridges were originally priced about 50% above Gillette's previous top line product, the SensorExcel. To bridge this gap a bit, the company has decided to raise the price of the SensorExcel. Imagine Intel boosting the price of the Pentium II when the Pentium III is introduced! Gillette has spurred demand for the MACH3 by making the best alternative a little less attractive price-wise while simultaneously launching an aggressive ad campaign projected to cost about $300 million over a 15-month period.

It's worked. As of December, the MACH3 was the top blade/razor in the U.S. Of men who've tried it, 75% have stuck with it. Gillette expects about the same percent of initial MACH3 users will be switching from other Gillette products while the rest will be new customers. The numbers bandied about by analysts bear this out. The company's fourth quarter razor sales rose 27% versus 20% for the entire industry. MACH3's sales are running at three times the level seen at a comparable point in Sensor's launch. That's partly because Gillette has really geared up its global manufacturing and distribution, rolling out the MACH3 in 25 different markets by February. Merrill Lynch estimates that Gillette will have sold a billion MACH3s by year end.

Pure and simple, this is a great business. Plus, the barriers to entry are mammoth since Gillette is the only company in its industry that can afford such innovation. And innovation allows it to gain market share, squeezing what competitors are left. Gillette's worldwide share of the razor and blade market is now over 70%, up from 58% in 1989. Plus, this is the original "razor/blade business." The razor is the operating system that locks in the customer, so you sell that for cheap. The blade is the high margin, repeat-purchase product. Brilliant.

Much was made of Gillette's troubles in the third quarter. The stock has since recovered, but the revenue and earnings numbers still look weak. So my opponent, Warren, will doubtless make much of Gillette's valuation. The basic numbers are daunting. Priced around $62, I calculate a market cap of $70.2 billion. Add in long-term debt net of cash, and I get an enterprise value of $73.2 billion, or about 7.3 times the trailing revenue of $10.06 billion. Even with 14.2% net margins, that's pricey. With FY98 earnings of $1.25 per share and a consensus estimate of $1.44 per share for this year, this world-class consumer franchise sports a world-class valuation of 49.6 times trailing earnings and 43.1 times forward estimates. Even if we believe Gillette can reach the 15% to 20% targeted long-term earnings growth, the current price still looks rich.

Of course, we're talking about a Warren Buffett company here (Berkshire Hathaway owns an 8.7% stake). Prior to the third quarter, Gillette chalked up 32 consecutive quarters of double-digit earnings gains. Gillette's delivered 7% compound annual growth in revenue over the last 5 years and 13% compound annual earnings growth, even after a dismal 1998, which should prove an aberration.

Like Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %>, which was also punished last year, Gillette is heavily dependent on its international business. Overseas markets account for 62% of sales, about half from outside of Western Europe. Unfortunately, some attractive markets simply dried up in 1998 due to absolute economic turmoil. For example, Gillette's Russian business abruptly fell 80% after the country defaulted on its debt. Also, because the U.S. dollar rose steadily for the first eight months of 1998, sales in foreign currencies translated into fewer dollars.

The dollar's decline since August has eased some of that pressure. Moreover, the Asia Pacific market is already improving. Sales to other regions will be down in coming months, but they have at least stabilized. Last year's weakness will eventually lead to pretty easy sales comparisons as each region begins to recover.

More importantly, Gillette's gross margins will improve as the shaving business moves toward a richer sales mix of high-margin blades over razors. Volume production and continued manufacturing improvements should also push MACH3's margins to the level of SensorExcel by year-end, on the way to becoming Gillette's most profitable product. Meanwhile, the heavy ad spending to build the brand will eventually decline a bit. In addition, U.S. retailers cut their inventories of the Sensor line last year. So sales into the retail channel were actually lower than end-user purchases by consumers. For example, Gillette's fourth quarter razor sales in the U.S. increased 13% even though end user demand reportedly rose by 30%. This convergence of negative pressures simply won't last.

Plus, the company continues to introduce new products. Gillette leads the female grooming market, and is expected to introduce an entirely new MACH3 for women this year. The company is also tops worldwide in writing instruments (Waterman, Paper Mate), toothbrushes and oral care appliances (Oral B), and alkaline batteries (Duracell), while being home to other top consumer brands like Braun (appliances) and Right Guard (toiletries).

As much as possible, Gillette hopes to replicate the segmentation strategy it's mastered in the razor market. That involves pushing higher prices for new, higher performance products. For example, the new Oral-B CrossAction brush, introduced in February, removes 25% more plaque that the current bestseller. The CrossAction sells for $5, or about 50% more than top rivals.

In the important Duracell battery segment (26% of operating profits), the company introduced the Ultra alkaline battery for high-tech devices like cell phones and camcorders last February and has already improved it. The new Ultra, due this summer, lasts 80% longer in some devices than standard copper tops and sells for 20% more. The Ultra helped Duracell claim over 50% of December battery sales in dollars, putting it a record 19% market share points ahead of the Energizer bunny and proving how well the September 1996 acquisition of Duracell has turned out.

We all need stuff like razors, batteries, and toothbrushes. And Gillette simply dominates these businesses and should continue to dominate them. For that kind of certainty, you willingly pay up. Clearly, Gillette was more interesting at the $35 a share it traded for in September. Yet, even at the current price, I think it offers a modestly market-beating return for an investor with a five-year horizon.

Next: The Bear Argument