Project for Business Analysis and Valuation using Financial Statements

Gillette Valuation Report Proter and Gamble Acquires Gillette Case

Group Members: Junyong Zheng Adele Valentin Daniel Diesinger Jonathan Karp Harald Getrey

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Content
Part 1 History and Background ..............................................................................................1 1.1 History of Procter&Gamble.................................................................................1 1.2 History of Gillette ...............................................................................................2 1.3 Continuing of both companies .............................................................................2 Part 2 Strategy Analysis.........................................................................................................3 2.1 Gillette and P&G s Main Areas ...........................................................................3 2.2 Synergy effect and Risk Analysis ........................................................................4 2.3 Conclusion ..........................................................................................................6 Part 3 Financial Ratios Analysis ............................................................................................7 3.1 Sales ...................................................................................................................7 3.2 Profitability .........................................................................................................7 3.3 Capital Management ...........................................................................................8 3.4 Leverage Analysis ...............................................................................................9 3.5 Conclusion ........................................................................................................10 Part4 Assumptions analysis .................................................................................................11 4.1 Sales growth and EBITDA margin ...................................................................11 4.2 Tax rate.............................................................................................................15 4.3 Operating working capital to the sales ...............................................................15 4.4 Net long term assets to the sales ........................................................................16 4.5 Net debt to capital .............................................................................................17 4.6 Depreciation & amortization to sales .................................................................17 4.7 Capital expenditures to sales..............................................................................17 4.8 Conclusion ........................................................................................................18 Part 5 Valuation...................................................................................................................19 5.1 FCFF Valuation Methods ..................................................................................19 5.2 Discount rate.....................................................................................................19 5.3 Valuation as an independent firm ......................................................................21 5.4 Valuation of target after acquisition...................................................................23 5.5 Value of merger benefits ...................................................................................26 5.6 Conclusion ........................................................................................................26 Appendix:............................................................................................................................27

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Part 1 History and Background

1.1 History of Procter&Gamble
In the year 1837, William Procter and James Gamble create a new company: Procter&Gamble. In this year Procter&Gamble starts to sell only soap and candles. This are first objects which P&C sells. After 22 years, P&C employs 80 employees and made a turnover of $ 1 million. In the year 1890 P&C is selling more than 30 different types of soap and William A. Procter assumes the leadership of the enterprise. 1907, the son of William A. Procter, William Cooper Procter became the new chief of the company because his father died. 1930, William C. Procter gives the business into another hand. Richard R. Deupree will be, now, the new chairman of P&C. In the year 1931, Neil McElroy, the Company s Promotion Department Manager, gives out a new marketing strategy. This strategy should specialize every brand in a different way. The brand management of P&C was born. In the years from 1934 until 1937, the last member of the origin family, William C. Procter died. The company reinforce his engagement in the Far East with an acquisition of the Philippine Manufacturing Company. 1937, the company celebrates his 100th birthday and the sales reached about $ 230 million. Neil H. McElroy will be the next leader of P&C in the 1948. In the Sixties, the company make some more big acquisition to continue the growth of the company. 1957, Howard J. Morgens is the successor of Mr. McElroy. The Seventies are the years of the big expansion. The company creates sub-companies for example in Germany, Belgium, the Middle East, Japan and other big companies. 1974, Ed Harness will be the next chief-executive-officer of P&C. The Eighties are also exciting. The company reached a turnover of $10 billion, another CEO will get the reins for the company and the company makes new acquisitions, for example: The acquisition of Norwich Eaton Pharmaceutics. 1990, again a new chief for the company: Edwin L. Artzt became the new boss of P&C.

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

In the year 1993, the company sales reached $ 30 billion. It is the first time for the company, that 50% of the sales came from outside the U.S. John E. Pepper will be the ninth chairman of the company and Durk. I. Jager became the first Chief Operating Officer in the year 1995. In 1999 Jager will be the next chairman of the company. In the Millennium P&C gets again a new chairman, A.G. Lafley is the next President and Chief Executive. 2002, P&C celebrates the 165th anniversary of the company. P&C has $ 12 billion brands in its portfolio, this is representing more of the half of the company sales.

1.2 History of Gillette

In the year 1901 the Gillette Company is founded in Boston, Massachusetts. 1904 King C Gillette receives the US patent for razor with replaceable blade. 1905 is the first successful year for the company, because Gillette sold 90.000 razors and 12 million blades. After the year 1907 Gillette Blades will be to have in Germany. In the year 1967 the BROWN GmbH, an important manufacturer of drying electric shavers and electrical small devices, will be part of the Gillette Company. 1984 Gillette takes another big partner in to the company. !ORAL B", the company of toothbrushes and mouth care. In the year 1996 Gillette takes over ! DURACELL", the company of big batteries. 1998 is a great year for Gillette. Gillette has created a new shaving system: the Gillette MACH3Shaving-System. 2001, Gillette has got its 100.Birthday. The Company exists now 100 years and has made in this 100 years a huge success. In the year 2004/2005 there are some phrases about a big merger with another big company.

1.3 Continuing of both companies

01.02.2005 Procter and Gamble is nearing a deal to purchase Gillette in a stock swap value at about $ 55 billion. Under the terms of deal, P&G is offering 0,975 P&G share for each share of Gillette outstanding. That would value Gillette shares at $ 53,94 based on P&G s Thusrday closing price of $ 55,32, the Journal said. The offer represents a 17,6% premium to Gillette s closing price of $ 45,85.

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Part 2 Strategy Analysis

P&G works in 5 main areas: House, Personal Beauty, Baby, Health & Wellness and Pet Gillette works in 2 Gillette s traditional sectors: Personal beauty with the Gillette Range and Health & Wellness with the Oral B Toothbrushes brand. Gillette is also working in the batteries sector with the Duracel brand.

2.1 Gillette and P&G s Main Areas

Gillette and P&G s main areas

Procter & Gamble works in 5 traditional sectors:

House

Personal Beauty

Baby

Health & Wellness

Pet

The 3 gilette s sectors will be considerate as 2 P&G s sub-sectors "

Razors, blades, personal products Gillette brand

Oral Care: Toothbrushes," Oral B brand

"and one new sector:

Batteries Duracel brand 2 from the top 100 world brand

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Will many references be suppressed ?

Gillette products portfolio

All Gillette s brands are strong brands which will ad value to the P&G!s portfolio We can suppose that most of Gillette's references will be conserved
P&G products products portfolio portfolio

2 of the 5 P&G sectors will be impacted:

Personal Beauty: P&G and Gillette have exactly the same products into the Men s deodorants segment. The Gillette notoriety is so high on this segment that P&G may suppress 1/3 of its Men deodorants activity Health & Wellness: P&G and Gillette sell exactly the same products for Childs on the Tooth Brushes and the Toothpaste market. Each One pay big licenses (Spiderman & Disney) for a product. They can do big economies with the suppression of one of it

Few brand suppressed but 2 P&G s sectors enlarged will enable economy of scale

2.2 Synergy effect and Risk Analysis

Thanks this analysis we can assume that Synergies will be realized though: Similar Brands Cutting in the Child toothpaste and in the Men s deodorant sector. Suppression of Similar jobs in the company The worldwide brand Gillette s knowledge So we can assume that synergies anticipated by the P&G s analyst are good.

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

A Great opportunity for both companies

An An opportunity opportunity for Gillette Gillette

The new shareholder will enable Gillette to develop their brands with more resources They will have benefits from the P&G marketing strcuture
An An opportunity opportunity for P&G P&G

The most important benefits for the P&G group are

More Bargain power:
The biggest group of its sector: No one can deal without them 2 news for the top 100 brands : Gillette & Duracell: Retailers can not afford them not to sell its A higher share in 2 department and a new department: the batteries

Economy of scales: Job cuttings into central functions, some expensive segments and products will be suppressed, R&D, marketing and communications expenses will be reduced
Bargain Power and Economy of Scale are the most important factors about a merger in the goods industry. We can say that there is a good completion between both companies and there differences can lead to a new strength.

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

A risk for P&G: the Gillette's integration

Gilette Gilette structure Global Marketing approach: 1 product for the world market 1 team working for the world market Innovation culture, how to be the most competitive though technologies P&G Structure Structure Diversity and regional approach: quite the same product declined in 10 brands Patchwork of team for each region Social responsibility approach + ++ Impact Impact P&G can realize economies of scales thanks the gillette "world brand# knowledge but they must not impose theirs own methods to gilette structure P&G can have benefits from the Gillette R&D structure and use its technologies in some project

P&G can have benefits if they adopt an hybrid structure (keeping the Gillette's structure and use it for big world projects) but this changes has a cost, and they will have to do integration effort

2.3 Conclusion
As a conclusion, we can assume that : 1. This merger seems to be very positives: l Some Synergies are possible l Many Economy of Scale will be realized l The bargain power of the group will be much important l P&G will learn from the Gillette s Technology knowledge and R&D efforts l And P&G will invest in some new Gillette's high value projects 2. But Many effort have to be done to do this merger a success: l They have to create a new organization which not destroy the Gillette s structure l They have to integrate the gillette s methods to lauch new ! world product l They have to invest a lot to manage the change and have only one business culture

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Part 3 Financial Ratios Analysis

Sales growth is not exactly a financial ratio as it has no immediate link to the balance sheet however it is quite a useful way, at least to start with, of looking at how the company has performed.
20,00%

3.1 Sales

15,00%

10,00%
Gillette P&G

5,00%

0,00% 2001 2002 2003 2004

-5,00%

Profitability is the core measure for a firm in order to determine its past and future performance. So in this first section I will try to determine how well both companies have performed in terms of profitabiltity. First I let us consider the ROE. Gillette has had in the four year period averaged an ROE 54,5%. Compared to the average of American firms (that stands at 12%), this is at first sight a very impressive figure. Initially that means that they have compared to other companies rewarded their shareholders with more profits that other companies, and that revenues have been much higher. However how did Gillette arrive at this number? They might have used a leverage effect and put lots of debt in the company so that ceteris paribus the ratio would have increased or they might have used some accounting cosmetics that would have increased profits. Compared to other companies Gillette has actually had quite a high leverage of about on average 3.6 debt/equity. This becomes especially significant as P&G which has a significantly lower leverage also has got a lower ROE. On average Gilette has had 1,5 times the debt to equity ratio than P&G.

3.2 Profitability

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Also the share of equity in the balance sheet (or the proportion of total assets) has been 1,5 times higher for P&G. Taking account of this P&G has averaged an ROE of about 47% over this period. Compared to the average this is quite an impressive number. As ROE is pretty similar next thing to look at is operating profit margin. It takes only into account the profit that has been generated from operations that means there is no influence of non $ operating factors. Here Gillette has had an average operating profit margin of 21,3% whereas P&G was 16,5%. A very important strategic issue for both companies is advertising expenses. As they both produce consumer goods not industrial goods this will naturally be a high percentage of sales. Examining this figure more closely is important as it shows on average how much $ of advertising was necessary to generate 1$ of sales. Here the both companies have roughly the same percentage, P&G at 9,6% and Gillette at 8,7%. Concluding it can be said that Gillette has been slightly more profitable over the examined period.

Here we will look at first at accounts receivable turnover. This ratio indicates how much money one receivable is worth on average. The higher this ratio, the shorter the money collecting period. This has also a significant impact on the cash flow. There is a significant difference between the two. Gillette stands at 8,8, P&G at 13,3, so P&G is more efficient. However as the below diagram shows Gillette has become more efficient doing this.
Receivables turnover
14,00

3.3 Capital Management

12,00

10,00

8,00 Reihe1 6,00

4,00

2,00

2001 2002 2003 2004

The next ratio to look at is inventory turnover. This is an indication how often company turns over its inventory.

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

P&G has a value of 6,3 whereas Gillette only achieves 3,5. Again P&G is more efficient. The next area to look at is the long term performance of capital. The net long term asset turnover. This measure evaluates how good a company manages its long term assets. The higher the ratio the more efficient the use of it. For P&G the ratio stands at 1,5 for Gillette at 1,7 suggesting no big differences between the 2 companies.

Leverage Analysis takes account mostly of how well a company has been able to meet its obligations, and how it could finance them if it would have to. For the short run the obvious measure to look at are the current ratio as well as the quick ratio. Here I will use the quick ratio as it is a more ! strict" approach of measuring a companies short term ability of paying back debt. For example it doesn t include deferred income tax as this is a really unsafe asset, often influenced by optimizing the firms tax payments. Gilette has an ratio of 57% whereas P&G has 50%. This is somewhat surprising given the fact that Gillette overall has got a much higher debt/equity ratio. This might be a stragegic issue as Gillette wants to increase their leverage by taking on a lot of long term debt whereas they want to be ! save" paying off their short term liabilities. The second part of debt is to look at the long term debt. As stated earlier Gillette has had on average 1,5 more debt as P&G, which is mainly composed of long term debt. The next ratio to look at is the ability of the company to cover interest payments out of the cash flow (interest coverage ratio). Gillette%s average stands at 49 whereas P&G stands at 17. This number is suggesting that Gillette is having a very strong cash flow, given its higher leverage.

3.4 Leverage Analysis

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Interest coverage
90,00 80,00 70,00 60,00 50,00 40,00 30,00 20,00 10,00 0,00 2001 2002 2003 2004
Gillette P&G

From these simple numbers the following can be derived: l Gillette has a high leverage, leading to a high Return on Equity i.e. Gillette is a profitable company, more that P&G l Gillette has a strong cash flow i.e. sound financial fundamentals All these factors could explain a high possible net present value.

3.5 Conclusion

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Part4 Assumptions analysis

After strategic analysis has allowed us to understand the underlying objectives for P&G s acquisition of Gillette; while financial analysis has helped identifying both companies strenghths and weaknesses, conclusions must be drawn out of this to assess the benefits for P&G of merging with Gillette. It has two aspects, and it involves the valuation of the firm in different ways. The first step is to assess the value of Gillette as an independent firm. Indeed, this is the starting point for analysing what it represents as potential value for an acquiring firm. The second step is to include in this analysis the expected benefits of the merger. This will eventually lead us to comment on the 18% premium offered by P&G for Gillette, which is 28 times projected 2005 earnings. The value of Gillette as an independant firm can be derived from the free cash flow valuation method, using a set of assumptions about Gillette s future. These assumptions depend on the previous learnings about the firm accounting practices, about its strategic choices and from the ratio analysis. Some key drivers are needed for the forecast of Gillette s future cash flows, being: l Sales growth l EBITDA margin l Interest rate on beginning debt l Tax rate l Operating working capital to the sales l Operating long term assets to the sales l Debt to capital

4.1 Sales growth and EBITDA margin

What must be taken in account is that sales growth is usually ! mean reverting", which means that a very high path of growth (that is, way above the average) will eventually return to a more normal level in the long run. However, situations may allow companies to keep a high growth rate when they have a sustainable competitive advantage, which is Gillette s situation. 1. Business segments

Let us examine separately Gillette s business segments and projected evolution of sales. Impact of exchange not taken in account (1) Blades and razors This segment represents Gillette s core business. It holds 70% of market shares. This position is supported by regular launching of high-technology new products and high advertising. In 2004, thanks to the launching of new products such as razor M3 Power, sales grew 12%, especially in the domestic market and in the UK. Growth in 2003 was 13%.

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

This is also a highly profitable segment, thanks to premium-priced products and incentives for consumer trade-up to premium brands. In 2004, operating profit was 37.6%, with an increase of 14% from 36,8% in 2003. This trend is consistent with Gillette s strategy to keep its position on this segment with technology leadership and advertising. As for sales, even though the main part of sales are located in mature markets, we can expect them to keep on growing at this rate because of the new products and geographical expansion in developing markets. Moreover, the 40% increase in total advertising expenses in 2004, primarily focused on this segment, will only have its full effect one year later. Therefore we can expect sales growth to be 14% in 2005, and 12% the following years. As for the operating profit, tow main factors account for its probable evolution. First, the advertising efforts aim at increasing consumer trade-up to premium products with higher margins. Second, Gillette set up in 2003 the Manufacturing Realignment Program aimed at reducing costs, improving operating efficiency and streamlining manufacturing, packaging and warehouse operations for the European blades and razors manufacturing and distribution. Once completed, starting from 2006 it should lead to annual cost savings of 50-60 million. In this context we can expect operating margin to remain at a high level and the operating profit to keep the path with the growth of sales. We thus assume an operating profit up to 40% for 2005 and thereafter. (2) Duracell In 2004, sales in the segment of battery grew 11% thanks to strong demand, as opposed to 6% in 2003. However, there is a strong competition of low-priced and low-performance batteries, and Duracell kept its market share thanks to lowered prices after the price-realignment program in North America and to the double-digit advertising expenses. The industry of battery gives Gillette a good margin thanks to its big efforts for manufacturing efficiencies in 2004. It grew 41%, from 17.2% to 22% of sales. Different facts have to be taken in account for the forecast. The sales are primarily located in the US and in Europe, which are mature markets. The objective for Gillette is to keep its market share in those regions, while it keeps its industry margin. But there is strong competition, and demand in 2004 was influenced by unusually active hurricane season in the US. Yet, in 2003, Gillette acquired a majority interest in the Fujian Nanping Nanfu Battery Company in China. Sales are thus expected to grow in such a developing market. Indeed, it only contributed about 2% of the sales growth in 2004. This part should increase. This should compensate the probable decrease in growth rate in domestic market. Moreover, advertising efforts should also foster sales. We can therefore expect a reasonable 9% in 2005 and 10% after. As for operating margin, the continuing efforts of Gillette in Cost saving programs, with the Company s Strategic Sourcing Initiative and the Functional Excellence Program set in 2002, should t least allow for a stable operating margin, consistent with the strategy of the

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

firm, in spite of the probability that the firm will have to keep on lowering prices. We can thus forecast a 22% of sales operating margin for 2005 and after.

Oral care The segment of Oral Care was driven in 2004 by growth of global share and strong sales growth of 20%, compared to 6% in 2003. This outstanding growth, which is the highest in all segments, is due to the strengthening of Oral-B as the number one product in global brushing market, to the launching of new products such as Professional Care 8000 and Sonic Complete rechargeable brushes, and to relevant investments, with the acquisition of Rembrandt teeth-whitening products to complete Gillette s product line. The advertising supported the introduction of the new products. In this segment the operating profit grew 14%, however the operating margin decreased from 16.4% in 2003 to 15.7% in 2004, which means the segment is less profitable. For the forecast we should keep in mind that Gillette s strategy in this segment is to extend its global share through investments and innovation. Concerning sales, there is a high competition in the segment and especially from batterypowered products. Therefore, Gillette plans to increase its market share with the introduction of new products and with consumer trade-up from manual to power products. In parallel, Gillette also pursues its geographic expansion. As Gillette is having an offensive strategy on this market and has launched a number of new products supported by advertising we can expect a 25% growth in 2005 and after. In terms of operating profit, this segment can be seen as cost-consuming, because of the important innovation and advertising efforts Gillette makes for growing its market share. Therefore, although new products have higher prices, it will be difficult for the company to keep the path with sales growth and we can expect the operating profit s growth to be lower than the sales growth. Thus we can assume the operating margin to decrease to 14.5% in 2005 and after. (3) Braun In this segment, Gillette has diversified a lot and holds a full product line. Thanks to the introduction of new products and geographic expansion, sales grew 16% in 2004, compared with 11% in 2003. However, Gillette has decided to refocus on its core business with dry shaving systems. This segment is highly capital intensive and operating margins are low. However, due to product rationalization, product sources changes and manufacturing efficiencies, operating profit for this segment went 94%, from a 4.1% margin to a 7% margin in 2004. Braun operates on quite mature markets. The company s objective on this segment is to keep margins higher than the cost of capital. Therefore we can expect the company to continue its effort of refocusing on core products and of launching attractive new products.

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Sales can therefore be expected to decrease for certain products and increase for others. The company s strategy on this segment is not very offensive and focuses more on improving operating profit. We can assume the growth rate to stay at a 15% level. Operating profit should keep on growing as efforts are made to suppress non profitable products and for cost savings. We can assume the operating margin to increase 50% more thanks to the remaining effects of rationalization, and to refocusing on products with higher margins, up to a 10,5% margin for 2005, which should remain stable thereafter, taking in account the specific capital-consuming level of this segment. (4) Personal care The last segment, the personal care products, was driven in 2004 by the high sales growth on outside markets, in Europe, Africa, Middle East and Eastern Europe, making an 11% increase in sales compared to 6% in 2003. In 2004, Gillette has reinforced its global share in shaving preparations in key markets. While the segment only accounts for a small part of the total operating profit of Gillette, operating profit grew 30% in 2004, from a 8.4% margin up to a 9.9% margin thanks to manufacturing savings and overhead cost lowering. This evolution is consistent with the firm s objective, which is to achieve modest growth and increase margins. l The sales can be expected to continue growing at the same rate because of geographic expansion and introduction of new products, without any major action planned for this segment. We can therefore assume a 11% sales growth for 2005 and after. l Efforts in cost savings can further increase operating profit, however at a lower rate. We can assume this growth in operating profit will maintain a 10% profit margin. 2. Synthesis Assumptions about sales growth Pondered % of Pondered % of net Sales' growth Sales' growth sales' growth projected sales' growth sales 2004 in 2005 after 2005 2005 sales 2005 after 2005 Blades & Razors Duracell Oral Care Braun Personal Care Total 41,32% 21,30% 15,17% 13,04% 9,17% 100,00% 14,00% 9,00% 25,00% 15,00% 11,00% 5,78% 1,92% 3,79% 1,96% 1,01% 14,46% 41,15% 20,29% 16,56% 13,10% 8,90% 100,00% 12,00% 10,00% 25,00% 15,00% 11,00% 4,94% 2,03% 4,14% 1,96% 0,98% 14,05%

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Assumptions about EBITDA margin Pondered % of Pondered % of PFO Profit margin Profit margin profit margin projected profit margin in 2005 after 2005 2004 2005 PFO 2005 after 2005 Blades & Razors Duracell Oral Care Braun Personal Care Total 63,68% 19,16% 9,73% 3,71% 3,71% 100,00% 40,00% 22,00% 14,50% 10,50% 10,00% 25,47% 4,21% 1,41% 0,39% 0,37% 31,86% 64,32% 17,44% 9,38% 5,37% 3,48% 100,00% 40,00% 22,00% 14,50% 10,50% 10,00% 25,73% 3,84% 1,36% 0,56% 0,35% 31,84%

4.2 Tax rate

The effective tax rate has been decreasing 1% every year: 32.2% in 2001, 31% in 2002, 30% in 2003 and 29% in 2004, due to the possibility of making a favourable mix of earnings to countries taxed at rates lower than the US statutory rate. Table 6.3 Reconciliation of the statutory Federal income tax rate to Gillette s effective tax rate

Source: Gillette Annual Report 2003 Form the above Table, we can see the effective tax rate of Gillette in 2003 is 30%. So we forecast its stable and keep 30% in the following years.

4.3 Operating working capital to the sales

Gillette has been pursuing a policy of improvement of its working capital management. Operating Working Capital related to the sales decreased from 16% in 2001 to 8% in 2002, and 2% in 2003 and operating working capital turnover grew from 12 million in 2002 to 54 million in 2003. This is primarily due to a better management of Accounts receivable, which decreased 8% in 2003. This trend was even stronger in 2004 with a 23% decrease in Accounts receivable, and combined with a higher average day sales in the last quarter, let Day Sales Outstanding go down 32 to 24 days in 2004.

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Working capital management 2004 Operating working capital Day Sales Outstanding
2 3 4 5 1

2003 170 2% 32 108 57 54,42 10,06 3,39

2002 708 8% 43 97 60 11,94 7,03 3,78

NA NA 24 110 NA NA 12,55 3,30

6

2001 1333 16% 55 108 43 6,06 5,49 3,37

Operating Working Capital/Sales Days Inventory On Hand

Days Payable Outstanding

Operating working capital turnover Accounts receivable turnover Inventory turnover

7

Assessing the evolution of this trend needs to take in account different factors: First of all, management of working capital should further improve because of the company s statement to follow this strategy and due to the effects of the programs (Functional Excellence program and Realignment program) aimed at optimizing inventory and supply chain management. Another factor to take in account is the product mix, that influences DSO. It is traditionally lower for blade and razors, manual oral care and personal care, and higher for Duracell, Braun and power oral care. As pondered sales growth shows, sales in the segment of blades and razors should be the highest, then product mix should support this trend. Although we don t know the evolution of 2004, we can assume the operating working capital to go down 1%.

4.4 Net long term assets to the sales

Long term assets management 2004 Net long term assets Net long term assets/Sales Net long term assets turnover Capital expenditures Capital expenditures % net sales
9 8

2003 na na 5614 1,65 408,00 4%

2002 4968 1,70 405,00 5%

2001 4979 1,62 624,00 8%

na 60,68% 58,77% 61,59% 616,00 6%

Since 2001, Gillette has had a quite stable fixed assets management, with a net long-term assets turnover ranging around 160% to 170%.

(Current assets-cash and marketable securities) - (current liabilities-loans payable and current portion of longterm debt) 2 Receivables/Average daily sales (3 last months sales/90) 3 Inventory/(Cost of sales/365) 4 Accounts payable/Cost of sales/365 5 Sales/OWC 6 Sales/Accounts receivable 7 Cost of goods sold/Inventory 8 Sales/ net long-term assets

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

We know from the firm s statement in the annual report 2003 that the company expects over the long term capital spending will average 7% of net sales. We can expect this growth of capital expenditures to be aimed at maintaining the favourable long term asset turnover, and we assume net long term assets to the sales will remain average 60% of sales.

4.5 Net debt to capital

Embedment 2004 3195 2003 2984 1,60 2002 2984 1,67 2001 2082 1,95

Long term debt Net debt/equity rationa

The company has had a net debt/equity ratio revealing a very healthy financial structure. We can assume the level of net debt to capital to remain stable, around 1,60.

4.6 Depreciation & amortization to sales

Depreciation & amortization to sales percentage 2003 2002 2001 2000 Depreciation & Amortization 578 500 509 535 D&A/Sales 6.25% 5.92% 6.30% 6.44% 1999 464 5.11% Average 6.00%

We can assume the level of Depreciation & amortization to sales percentage, around 6%.

4.7 Capital expenditures to sales

Capital expenditures to sales percentage 2004 2003 2002 2001 Capital expenditures 616 408 405 624 Capital expenditures/Sales 5.88% 4.41% 4.79% 7.72% 2000 793 9.54% 1999 889 9.80% Average 7.02%

We can assume the level of Capital expenditures to sales percentage, around 7.02%.

Sales/ net long-term assets

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

4.8 Conclusion
The following assumptions can thus be used to calculate Gillette s value as an independent firm: Assumptions for the valuation 2005 Sales' growth rate EBITDA margin Tax rate Operating working capital/sales Net long term assets/sales Net debt/equity 14,86% 31,86% 30% 1% 60% 1,6 After 2005 14,05% 31,84% 30% 1% 60% 1,6

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Part 5 Valuation
5.1 FCFF Valuation Methods
To value Gillette, we will use the Free Cash Flow Approach. The free cash flow to the firm (FCFF) is the sum of the cash flows to all claim holders in the firm, including stockholders, bondholders, and preferred stockholders. A simple way of getting to free cash flow to the firm is to estimate the cash flows prior to any of any of the above claims. Thus we could begin with the earnings before interest and taxes, net out taxes (then we get NOPAT, net operating profit after-tax) and reinvestment needs, and arrive at an estimate of the free cash flow to the firm: FCFF = NOPAT + depreciation&amortization $ changes in NWC $ Capex Comparing to other valuation method, FCF has the following advantages: l l l Capture the firm s future growth system instead of final result logically; Suited for growth firm with low or zero dividend payout ratio; Absorb important assumption which include sales zgrowth rate, EBIT/sale ratio, tax rate, depreciation&amortization portion, working capital percentage to sales, discount factor, etc. So, we will use the FCFF model to value Gillette.

5.2 Discount rate

The discount rate to be used for Gillette s valuation would be the company s weighted average cost of capital. To get the WACC of Gillette we need to figure out by the following steps: (1) cost of debt The Company s investment grade long-term credit ratings of AA from Standard & Poor s and

Aa3 from Moody s and commercial paper ratings of A+ from Standard&Poor s and A1 from Moody s. So we can simply find out the spread on newly issued AA- rated bonds is. And adding the benchmark yield, we can get the cost of debt for Gillette. For the spread, we can find it from table 6.2. For the debt structure of Gillette, the weighting average of the debt term to maturity is almost 5 year. So we choose the 5 year treasuries note yield as the benchmark and the 5 year spread to get the cost of debt. The average weekly yield for 5 year t-note yield is 3.735% from Table 6.2. So we can get the cost of debt for Gillette is 3.735%+0.46%= 4.295%.

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Table 5.1 Spread for bond with given ratings Rating Aa3/AAA1/A+ 1 year 20 39 2 year 34 43 3 year 35 47 5 year 46 53 7 year 59 67 10 year 69 81 30 year 97 105

Source: bondsonline.com

Week 1 2 3 4 5 6 7 8

Table 5.2 Weekly 5 year T-note yield in 2005 Close date 2005-01-07 2005-01-14 2005-01-21 2005-01-28 2005-02-04 2005-02-11 2005-02-18 2005-02-25 Average weekly yield

Yield (%) 3.71 3.72 3.7 3.71 3.72 3.66 3.77 3.89 3.735

Source: finance.yahoo.com

(2) Tax rate Table 5.3 Reconciliation of the statutory Federal income tax rate to Gillette s effective tax rate

Source: Gillette Annual Report 2003

Form the above Table, we can see the effective tax rate of Gillette in 2003 is 30%. So we forecast its stable and keep 30% in the following years. (3) cost of equity We can get the cost of equity form CAPM model. Since Gillette lists in NASDAQ, we calculate the NASDAQ index average yearly return from 1985 to 2004 as the market return and we get 16.53%. As for the current risk-free rate, 3m

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Treasuries bill yield is trading at 2.70% per year. For the beta, we get 0.700 from finance.yahoo.com. So the cost of equity of Gillette is : Cost of equity = 2.70+0.772!(16.53-2.70) =12.38% (4) WACC At the end of year 2004, we get the following information from Gillette s Earning Report in Feb 3, 2005: In Dec 31, 2004, Total debt is $3,386 million, the Stockholders Equity is $2,836 million. So the WACC is calculated as:

12.38%

3,386 2,836 + 4.295% (1 30%) = 7.28% 2,836 + 3,386 2,836 + 3,386

5.3 Valuation as an independent firm

From the assumption part we get the following forecast: Table 5.4 assumptions for the valuation 2005 Sales' growth rate EBIT margin Tax rate Depreciation and amortization to Sales percentage Net working capital to sales percentage Capital expenditures to sales percentage Discount rate 14,86% 31,86% 30% 6.00% 1% 7.02% 7.73% After 2005 10,00% 31,84% 30% 6.00% 1% 7.02% 7.73%

Before the valuation, we need to figure out the Terminal Value. The terminal value in this model is critical, because it must capture all free cash flow value flowing indefinitely into the future. Although the cash flows are estimated for the explicit period of 2005 to 2011, Gillette s business will most likely continue far into the future. The typical calculation of the terminal value uses a constant dividend growth model. Assuming a discount rate of 7.73% (the WACC) and a free cash flow growth rate into the future of 1.0% per year (conservative estimation) terminal value in year 11 of the analysis as:

Terminal Value =

FCFF2011 (1 + g ) = 53832.7 k wacc g

Then we can input the above input to the Excel Spreadsheet created by us. We can get the Value of Gillette as an independent firm. See Table 6.6 From the result, we see that the equity of Gillette is valued at $51.275 billion or $48.09 per share as an independent firm. 21

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Table 5.5

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

5.4 Valuation of target after acquisition

For Procter & Gamble, after the acquisition, they can create synergy effect. So we need to take such synergy effect into account. In a consumer analyst meeting, in describing the many strengths Gillette brings to the combination with PROCTER & GAMBLE, Mr. Kilts, Gillette Company Chairman, President, CEO, said, "Strength plus strength will equal success as a very strong Gillette combines with an equally strong Procter & Gamble. We will create a global company built upon scale, diversity and brand strength - all requisites for consistent growth in a consolidating, highly competitive global environment. This is an opportunity to help build something that Gillette has been pursuing for four years ... to become the best consumer products company in the world." Mr. Kilts discussed the businesses and capabilities Gillette has created, which will continue to deliver, strong consistent growth. He described four key growth drivers that give the Company a unique competitive advantage: Gillette's presence in high-growth, advantaged global categories; its technological leadership in these categories; its ability to drive consumer trade-up around the world to better- performing, premium products; and the Company's culture, which is defined by a constant turnaround mentality and a drive for total innovation. The synergy effect as the following: l Cost cut and EBIT margin:

Cost can be reduced in the aspects of Administrative overlap, advertisement expense, R&D, employment cost, promotion expenditure. And we estimate the above 4 aspects decrease as following:

Item Advertising costs Advertising costs to Sales Sales promotion Sales promotion to sales Other Selling, General and Administrative Expenses Other SG&A Cost of Sales R&D expenditures

Table 5.6 Selected cost item of Gillette 2003 2002 2001 827 647 576 8.9 7.7 7.1 376 319 319 4.1 3.8 3.9 2,338 25.3 3,708 202 2,206 26.1 3,511 185 2,112 26.1 3,407 187

2000 539 na na na na na 3,469 179

1999 513 na na na na na 3,486 201

Source: Gillette annual report 2001,2002, 2003

From table 5.6, we see the advertising costs, sales promotion expense and other SG&A expense are increasing sharply. And after the acquisition, since the new company can manage the 23

Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

advertising and marketing plan together and surely lower the cost for Gillette. For the sale promotion, because PROCTER & GAMBLE have created a very good organic structural and the new company with over $60bn revenue can increase the bargaining power to the retailer, such as Wal-Mart Stores, Inc. And we estimate 15% cost cut from the advertising expenditures and 20% cost cut from the sales promotion expense. So the advertising and sale promotion save should be 827!15%+2338!20%=591.65. From the labour, Gillette can lay off some employees especially some managers for administrative lay lap to cut the cost. And we estimate conservatively this cost cut will be 15%. And we reset the EBIT margin assumption 1 percentage up to 22.05% to reflect the employment cost save. l Sales growth

The similarities of the Gillette and Procter & Gamble organizations structures are remarkable, with both companies using global business units to maximize brand strength and growth, and market based commercial selling units to assure local customization and flexibility. The results should be a smooth integration that will produce the ability to move Gillette products through the existing Procter & Gamble infrastructure very efficiently. This combination will enable our businesses to create more value in more ways than would ever have been possible as a stand-alone company. The Gillette as a target after acquisition can get higher sales growth under the combining synergy effect from PROCTER & GAMBLE deal. So we reset the assumption of Sales growth to 15% since the fourth year after the deal, that is to say, the estimated sales growth from 2008 will be reassumed as 15%.

Then we can input the above input to the Excel Spreadsheet created by us. We can get the Value of Gillette as target after acquisition. See Table 5.7 From the result, we see that the equity of Gillette is valued at $65.164 billion or $64.71per share as an independent firm.

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Table 5.7

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

5.5 Value of merger benefits

Since for the M&A deal the value of target after acquisition, value as an independent firm and value of merger benefits satisfy the following equation: Value of target after acquisition=Value as independent firm + Value of merger benefits So we can rearrange the equation: Value of merger benefits= Value of target after acquisition - Value as independent firm From the above formula, we can estimate the merger benefits for PROCTER & GAMBLE from this M&A deal. Table 5.8 Value of Merger Benefits Value of Target Value as an After acquisition independent firm 65.16 64.71 51.28 50.92

Category Valuation of total equity (Billion, $) Valuation per share ($ per share)

Value of Merger benefits 13.88 13.79

5.6 Conclusion
(1) Procter & Gamble should buy Gillette because the value of merger benefits is positive and quite high to it. After the acquisition, PROCTER & GAMBLE and Gillette can share the $13.88 billion merger benefits together. (2) Under our assumptions, Procter & Gamble should pay from $51.28 billion to $65.16 billion to Gillette for buying the 100% share. Finally, PROCTER & GAMBLE paid $57 billion for this deal, which is within the above range.

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Appendix:

Appendix 1

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Appendix 2

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Appendix 3

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Appendix 4

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Appendix 5

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Gillette Valuation Report: Procter & Gamble Acquires Gillette Case

Appendix 6

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