Dueling Fools
Battlestar Gillette-ica
March 24, 1999

Gillette Bear's Den
by Warren Gump ([email protected])

This Duel is one of the more challenging that I've written. Gillette is the world's dominant shaving products company and has an extraordinarily lucrative royalty stream from the repeat business of selling blades. The company has been a leader in innovation, with the new MACH3 shaving system taking the world by storm according to initial sales data. Despite the success of this product line, I would still be inclined to stay away from Gillette stock given the company prospects and the price of Gillette stock.

You see, Gillette is much more than just a shaving products company. It also makes a wide array of other consumer products such as Duracell batteries, Paper Mate Pens, Oral B dental products, Braun appliances, and Right Guard deodorant. In fact, 71% of 1997 sales and 49% of operating profit came from these other divisions. While some of these brandnames are strong, many of them have been struggling due to intensifying competition. Despite this weakness in areas that represent over half of the company's sales, investors are paying a multiple on Gillette as if every division has the market dominance of the shaving business. I'm not willing to do that.

Here is a chart of how operating earnings for each division fared during the first nine months of 1998 compared to 1997 (in millions of dollars):

Division	1998	1997	Change
Blades & Razors	$820.00	$879.00	-7%
Duracell Products	$362.00	$302.00	20%
Braun Products	$195.00	$219.00	-11%
Toiletries	$70.00	$118.00	-40%
Oral-B Products	$62.00	$54.00	15%
Stationery Products	$58.00	$95.00	-39%
Sub-total Reportable Segments	$1,567.00	$1,667.00	-6%

These figures exclude the $535 million realignment and reorganization charge taken in last year's Q3 to help the company more effectively compete in the challenging market environment. While most people ignore these charges since they are "one time," everyone should remember that they are a write-off of shareholders capital due to mistakes the company made in prior quarters.

Looking at the above results, I'm not the least bit concerned about the decline in profits from the blades and razors segment. This decline was caused by lower sales of old products as retailers cleared out their inventory in anticipation of MACH3. In addition, the company jump-started advertising for the new product launch, which slashed near-term profits. This drop in profits was a small cost to pay for the increased profitability the division will see over the next few years. Initial sales data for the premium-priced MACH3 indicate a tremendous launch. But even if the product is not a blockbuster, Gillette should see higher profits in the years ahead. Given the company's dominance in the razor business, consumers not upgrading to the MACH3 will still likely use another Gillette product such as the Sensor. With a 35%+ price differential between those two products, Gillette has significant room to raise prices on the lower-priced product and not lose market share.

The other divisions of Gillette are not nearly as dominant as the blade business. While the remaining brands control strong brandnames, they don't command the 70% market share of the razor and blade business. Yet, Gillette appears to be attacking the categories with the same strategies that have been successful in blades -- introducing more premium priced products. Over in the batteries, the company has launched the Duracell Ultra product for high tech products priced at a premium to regular batteries. The Oral-B division has just launched the CrossAction, a toothbrush that will retail for $4.99 (whereas most competitors are $3 or less).

New products and innovation certainly drive product growth and market leadership, but I fear that Gillette has become too aggressive on its expenditures for research and development. I was actually at the drugstore the other day, looking to buy a CrossAction toothbrush to see if it was worth the premium price. Although it was available for $4.99, right next to it was a spiffy looking Crest toothbrush for $2.00. Even though I wanted to buy the CrossAction to try it out, I couldn't bring myself to pay 150% more for the new product. In batteries, toiletries, and stationary products, Gillette has major competitors that will benefit if the company overprices its products. It's not like the razor business where competition is muted.

Another situation where Gillette is vulnerable, particularly with its bevy of premium- priced products, is in a recession. When a downturn hits (while most Americans have forgotten that recessions occur, economists still insist they are a regular feature of most economies), there will be significant trading down among consumers. One only needs to look at Gillette's results in Asia and Latin America last year to see the dreadful impact economic turmoil has on Gillette's performance.

Gillette is a terrific company that has some wonderful products. If the company only consisted of the razor and blade business, which has prospects for operating profit growth of well over 20% over the next few years, I would not have as much difficulty paying the current 43x 1999 earnings. Without seeing dramatically improved prospects for the other divisions of the company, however, I can't justify paying 43x earnings for the rest of the company. I'd rather deploy my capital where I can obtain similar or better growth prospects for less money.

Next: The Bull Responds