Of the few crowned jewels in the Procter & Gamble crown, Gillette razors may very well occupy a spot at the top of the list, though I suspect a strong argument can be made that Tide detergent and its related products such as the pods. Gillette did not enter the Procter & Gamble portfolio until the 2006 acquisition, making high-profile investors like Warren Buffett billions of dollars after P&G paid a substantial premium to gain control over the razor market.
The interesting thing about Gillette is that it can largely credit its success to an immense operating budget and the acquisition of patents and competitors over the years.
When Warren Buffett explains why he invested so heavily into Gillette, he spoke of the timeless demand and the frequency of the necessary use—by the time a man wakes up, he needs to use Gillette’s product.
Of course, that is only one part of the analysis. Determining whether or not the demand exists for a general product category is an important first step, but the analysis isn’t complete until you determine where you particular product fits. In other words, it is useful to know that people will always need to shave, but it is equally important to determine the likelihood that they will be using Gillette razors out of all the brand available when they decide to shave.
Many people have looked to the rise of The Dollar Shave Club in recent years, observed the fact that Gillette has forfeited almost fifteen points of market share, and concluded that something is deeply amiss about the company. While that may be true, Gillette has been here before.
Back in 1926, Gillette Stock was on top of the world. Other than railroads and utilities and General Electric, you could very well have argued that it represented the “bluest” of all blue-chip stocks available. It controlled 82% of the safety razor and blade market in the United States. It had built out 50 agencies outside the United States dedicated to becoming one of the first American multinationals.
Later that year, Henry Gaisman began to commercially sell two-edged razor blades that held a continuous strip through his AutoStrop Safety Razor Company. Autrostrop proved to be prickly competition, as Gaisman only charged a penny per blade while Gillette was aspiring to raise its prices from nine cents to an even dime per blade. When Gillette tried to buy out AutoStrop, Gaisman insisted upon a $5 million sale price to transfer ownership. Meanwhile, Gillette refused to pay more than $4 million. When it became clear that neither side would budge, Gillette abandoned negotiations and began to sell razors that utilized Gaisman’s patents.
In the heart of the Great Depression, Gaisman had Autostrop sue Gillette in Ohio’s federal district court for $50 million. This combination of the awful economic conditions and a lawsuit portending extreme consequences—Gillette was earning $11 million per year so the lawsuit theoretically represented about five years worth of profits—sent the price of Gillette stock from 32 earnings in 1927 to 4x earnings in 1930.
Because Gillette in fact infringed upon Autostrop’s patent, they feared that they were going to lose the lawsuit. To try and bolster the stock price and avoid catastrophe, they agreed that they would buy Autostrop out for $20 million and Gaisman would personally receive 310,000 shares of Gillette to effect this settlement. Gaisman might be the only man in America that got four times his purchase price for an asset during the Great Depression compared to what he was asking before it.
This put Gillette in a dilemma. There would be a shareholder revolt if they issued $20 million in stock at 4x earnings. That is destruction through dilution. So they contacted a New York banker named John Aldred to sell $20 million in 5% convertible debentures.
When you try to raise capital, the aspiring investors often want to take a look at the corporate books. When this happened, investors learned that Gillette management had been over-stating earnings by $12 million cumulatively from 1924 through 1929. This led to shareholder suits accusing the company of fraud, and Gaisman threatened to reopen litigation because he agreed to Gillette shares with inflated earnings, so they ended up paying Gaisman $30 million.
By 1930, Gillette had paid out $21 million to shareholders and $30 million to Autostrop shareholders. When your earnings engine is about $10 million per year, this proved to be a great formula for taking the stock from over $150 per share to under $20.
Eventually, the shareholder ruckus enabled Gaisman to execute a hostile takeover and replace five members of the Gillette Board with executives from Autostrop. At the time that Gaisman took over, Gillette’s share of the American razor market had tumbled from 80% to 55%.
This story is repeating itself all over again with the rise of Dollar Shave Club. Per the Wall Street Journal article on Gillette’s cuts in the price of razor blades, Gillette has seen its market share decline from 70% to 55% and Gillette decided to cut its priced by a fifth to complete. Gillette typically charges around $2 per cartridge compared to twenty cents for Dollar Shave Club. It is the story of Autostrop playing out all over again in the 21st century.
A brand is valuable when it has the ability to generate a premium compared to a product with no well-known brand. The percentage price increase that you’re willing to pay for a particular brand compared to the generic value is a pretty good proxy for the intrinsic value that the name brand brings to the marketplace.
It is entirely possible that Gillette’s brand is not as strong as the pricing it has reached for. This is not a condemnation of Gillette’s brand equity. It just means that ten times the low cost competitor is likely not the sustainable premium. With the recent 20% price cut of Gillette blades, the premium is down to 8x the price charged by the low cost competitor. Only this time, it is unlikely that the Dollar Shave Club will fold into Gillette nicely and cease competing like Gaisman did when Autostrop merged its business within Gillette’s pricing paradigm rather than continuing to serve as an alternative to it.
I wonder whether recognition of Gillette’s pricing power limits, and the lengthy earnings lull as Gillette re-prices itself, explains why Warren Buffett chose to trade his Procter & Gamble stock for the operating company Duracell Battery. After all, Buffett never purchased any P&G stock outright—he came to it by means of the Gillette merger with Procter.
Because of its well-established position, and its nearly unparalleled advertising budget, Gillette will be fine. But I suspect it will be difficult for Gillette to ever capture 70% of the shaving market again while simultaneously charging a premium of ten times the low-cost competitor. Maybe it can charge 10x and flirt with half the market, or maybe it can charge 4x and recapture 70% of the market, which is still an excellent business but won’t compare favorably to what Gillette Co. was able to do from 1914-1926 and 1992-2010.
Procter & Gamble is one of the ten best businesses in the world in terms of earnings quality, and Gillette is an important reason why. People who own the stock today and reinvest the dividends will know that there will be a profitable business “there” in 2040, and not companies can pass this test. But in terms of earnings per share growth with Gillette, the legendary razor-maker is going to have a lumpy time ahead. In some ways, it has been here before.
Originally posted 2017-07-09 06:00:29.