P&G’s Acquisition of Gillette

Financial Management Assignment – 1 | Case Study

3/16/2020

Prepared by – 1. Ankul A
1. Case Background
This case talks about one of biggest merger in the history of consumer products: P&G agreeing
to buy Gillette in a $57 billion deal that combines some of the world’s top 10 brand. P&G is
already the nation’s largest consumer products company, making everything from Pampers to
Tide, home of around 150 brands. In 2004 the company’s profit reached 6.4 billion dollars of
the total sales of 51.4 billion dollars

Gillette best known for its razor business, but also controlled 2 other brands – Oral B and
Duracell Batteries – that produced at least $ 1 billion in annual revenue. In 2004 the company
sales amounted to 10.3 billion dollars and the profits at 2.3 billion dollars.

Whereas P&G was particularly skilled in marketing to women, Gillette core segment was men.
Also, region wise, Gillette understood how to operate successfully in India and Brazil, while
P&G brought expertise in the Chinese market. This deal would give the company more control
over shelf space at the nation’s retailer and grocers, preferred positions etc.

Motives and Synergies for Acquisition:

 P&G was trying to scale: since already having expertise in marketing, it was trying to
increase the market share, and Gillette billion dollar brands would come very handy in
scaling its operation internationally.
 Acquisition will lead to reduced bargaining power for P&G’s clients and suppliers
since P&G could negotiate on better terms for the procurement of the raw materials.
 Huge advertising budget ($5.5b +$1b) available to P&G after acquisition of Gillette
provided the new company with a major bargaining power over media.

Drawbacks
 Ire of the shareholders of both P&G and Gillette; P&G Shareholders were feeling
uneasy due to dilution of their holdings; Gillette shareholder were unhappy due to
lower than expectation share value being offered by P&G.
 The new company needed to divest some of its product offerings, in order to comply
with the anti-trust regulations
 Employees were unhappy due to estimated 4% job cuts to be done after the deal go
throughs.

2. Critical Financial Problems

2.1. Estimation of Synergy benefit and cost reduction
Mergers and acquisitions are common business strategies for various reasons, such as:
 Increase of the market share and greater operational efficiency.
 Geographical expansion
 Expansion into new product categories.
 Access to new technologies.
  Building new industries

Any M&A activity is expected to bring about benefits in term of Market Power, Market Share,
Threat reduction etc. and reduction in costs in terms of overhead reduction because of
consolidation and reduction of transaction cost. Thus, estimation of these future benefits remains
a big challenge for both the target and buyer.

2.2. Estimation of Deal Price

One of the major financial problem with any Merger and Acquisition Activity always remains to
be estimation of deal price. There are many ways by which the target firm can be valued.

A few of the valuation methods are -

 Income or discounted cash flow(DCF)

 Market based
 Asset oriented
 Replacement cost, and
 The contingent claims or real options approach.

Based on these valuation methods an estimated value of the firm can be deduced. Also, M&A
activity is associated with synergy benefits and cost reduction. The valuation should consider
these benefits and costs as well.

2.3. Bridging the valuation divide (Agreement upon implied cash value or
Swap ratio)
It is a general rational tendency that the target firm tends to value its firm at a higher price and
the buyer values at a lower price. This is obvious if we think rationally, the buyer will always try
to pay as less as possible and the target will always try to create more value for the shareholders
of the firm by getting a higher price. The biggest financial problem in any M&A activity is to
bridge the valuation divide or to bring both the buyer and the target at a common price platform.
In this case also P&G initially was offering a Swap ratio of 0.915 on which Gillette did not agree
but later the investment banker worked hard to convince P&G to offer a swap ratio of 0.975 and
made Gillette CEO and board to agree on the same. From the case, it is very much evident that
consultants like McKinsey and Investment Bankers like Goldman Sachs, Merrill Lynch, UBS
etc. play an important role in reports related to valuation of the firm and in bridging this divide
and help in negotiations between the firms.

2.4. Structure of the Finance

After the pricing part is complete the next biggest issue which remains is structuring of the
consideration being paid by the buyer. The consideration may be structured in the following
ways –
  All cash
 All Stock
 Hybrid of the above two

In an all cash deal the acquiring company typically pays the target company’s shareholders a
fixed price per share in cash. In an all stock deal the acquiring company provide the target firms
shareholder with the shares of the acquiring firm. A Hybrid arrangement is a mix of the above
two. All the above structures have their pros and cons and thus becomes one of the major
challenges in front of the firms. The various terms and conditions associated also requires to be
thought off. In this case P&G and Gillette came up with an All Stock, 60/40 No Collar Deal
which is a Hybrid structure. A collar common in many M&A creates a ceiling and a floor on the
value of the shares offered to complete the transaction. By creating definitive price range, the
collar assuages shareholder’s fears regarding potential fluctuations in the acquiring company’s
share price while the transaction awaits shareholder approval. In this acquisition, no collar was
employed.

2.5. CEO compensation package and Investment Banker Fee

After everything gets decided and all the stakeholders are taken care of and the deal stands
successful, CEO gets compensation package and Investment bankers involved are paid fee. In this
case the CEO of Gillette received a total compensation package of $164 million in forms of cash,
stocks and options. The three Investment bankers received an equal fee of $30 Million each. The
CEO compensation was strongly criticized by press and media. Also, Goldman Sachs contributed
much more for the deal to turn positive but was paid equal. The problem here is in deciding the
amount of compensation for the key people and agencies involved in the M&A activity.

3. Analysis of the Problem and Interpretation

The P&G acquisition of Gillette raises several financial questions related to
1. the appropriateness of firm valuation of Gillette & the underlying assumptions,
2. the benefits awarded to the consultancy firms involved in the deal & the Gillette CEO,
3. the Deal structure.
We shall try to evaluate the first issues on financial grounds, however, other issues are
influenced largely by strategic directions of P&G and Gillette.
3.1. Is Gillette’s firm valuation for the deal appropriate?
The swap ratio of 0.975 P&G shares for each Gillette share translated into an implied offer of
$54.05 per share. Different investment bankers had prepared a series of valuations ranging from
$43.25 to $61.90.
This is shown in the football field diagram below. The average of the different valuation methods
yielded a valuation of $55.75 per shares. This implies that an offer near this valuation is
acceptable. The implied offer of $54.05 per share is slightly lower than the average valuation.

When we compare the proposed acquisition with other recent acquisitions in similar and
comparable industries, we don’t find the compensation paid to Gillette’s shareholders adequate.
Offer premium for Gillette’s shareholders is only 20%, whereas the recent acquisitions have
garnered average 50% returns for the shareholders of target firm.

Premium to Share
Acquisition 1 Day Prior 1 Week Prior
Average of recent acquisitions 49.3% 55.5%
P&G acquisition of Gillette 20.1% 20.1%

Company Valuation using DCF method:

We evaluate the valuation of the firm using DCF method over a forecasting horizon of five
years, from 2005 to 2009. The sales forecast is based on the historical data of the company. So,
by studying the company’s Income Statements of 2002-2004 we notice an increase in sales of
9.45% (from 2002 to 2003) and 13.24% (from 2003 to 2004). It is assumed that the increase in
sales for the next five years will be stable at 11% per year (slightly below the average of the
previous three years). The costs of the forecast period will be calculated as a percentage of sales
(based on average costs from 2002 to 2004 as a percentage of sales).

From the financial statements of Gillette, the long-term weighted average interest rates were
2.5% (Gillette, 2005) and the proportion of the shareholders‟ equity to the total equity with long
term debt is 44%, while the corresponding proportion of debt is 56%. The tax rate is 29.1% and
the growth rate of the company is estimated at 5%. To calculate the cost of equity we consider
the risk-free interest rate of 4% (10-year bond), the market rate of 14% and beta 0,8. So based on
the CAPM model, the expected return on equity is
Re = Rf + b*(Rm- Rf) = 0.04 + 0.8*(0.14-0.04) = 0.12 = 12%.
The weighted average cost of capital of the company is given by:
WACC= Re *We + Rd * Wd *(1-T)
= 0.12*0.44 + 0.025 * 0.56 *(1-0.291) = 0.0528 + 0.010 = 0.0628
6.28%, a percentage that will be used to discount the future cash flows. To calculate the value of
the company we use the discounted cash flows. The following table shows that the terminal
value is $ 39389 mn which is discounted to $ 29048 mn.
The total value of the company is $ 37941 mn, while excluding the value of long-term debt of
the company and add the cash it held on December 31, 2004 we reach to the value of the equity.
So, Firm’s Present Value = $ 37941 mn - Long-term Debt (as on 31/12/2004)- $ 3619 mn + Cash
$ 219 mn = $ 34541 mn. If the value of the firm is divided by the number of the shares, we have
the value of each share. The number of shares of Gillette Common Stock outstanding as of
January 31, 2005, was 991,326,243.
Consequently, each share of Gillette is only worth $34.84, while offered price is $54.05 per
share (a premium of 55%)

We similarly obtain the valuation after synergy, assuming 15% sales growth of Gillette.
Firm’s Present Value $69530 mn
- Long-term Debt (31/12/2004) $3619 mn
+ Cash $219 mn
= Firm Value $66130 mn
So, the value of each share of Gillette from this synergy will be $66.71. The value of the
Gillette’s share and by extension the overall value of the firm is strongly influenced by changes
in growth rate. With low growth, the share value will be $53.39, while by achieving a high
growth rate of around 7%, the share value will skyrocket to $90.69.

3.2. How is P&G’s offer of “All-Stock”,60/40, No-Collar Acquisition favorable to

Gillette’s shareholders?
P&G’s offer for Gillette was a modified all-stock deal, which intended to benefit the
shareholders through advantages of “All-Cash” and “All-Stock” deals. The advantages and
disadvantages of the two structures are summarized below-

All-Cash
1. Efficiency and transparency of the
deal.
2. Cash offer creates capital gain for
Advantages the shareholders, as often premium
over market price is paid.
3. Shareholders can easily re-allocate
the cash.
1. Capital gain is often taxable; hence
shareholders lose a significant portion
of the benefit.
2. Cash deals create leverage
Dis-advantages problems for the acquiring firm. Its
debt load increases and cash reserve
decreases.
3. Possible reduction in company’s
Bond Rating.
All-Stock
1. No tax to be paid by shareholders.
2. No debt burden on acquirer firm.
Cash reserve of the acquiring firm
remains intact.
1. No immediate capital gain for the
shareholders. Many target company’s
shareholders may not want to hold
buyer company’s shares.
2. Dilution of share value of acquirer
company in market after acquisition.

However, to assuage the shareholders’ fear regarding potential fluctuations in share prices during
the period of shareholder approval, P&G and Gillette should have created a ceiling price and
floor price (Collar) on the offered value of shares.

3.3. Is the Change in Control Benefit awarded to James Kilts justifiable.?

James Kilts total compensation package amounted to more than $164 million, which represents
less than 1 percent of the total value that he had created during his tenure as Gillette’s CEO. The
“change of control” payment of $12.6 million dollar is also justifiable by the fact the deal created
substantial shareholder value for both P&G and Gillette’s shareholders.
4. Conclusion

Deal was motivated to achieve the ultimate gain of any company and that was none other than
increase in shareholder value. In this deal, share price of Gillette was hovering around $30/share
in 2004 which was purchased during acquisition at $54.05/share (Increase of around 180%
within a year. In addition to that shareholders had opportunity to continue shareholding in P&G
to avoid any capital tax gain). Acquisition of Gillette by P&G would help P&G to become
market power in CPG segment and consequently would have better bargaining power, synergy
benefits and reduction in cost.
As per the football field chart, average of the different valuation methods yielded a valuation of
$55.75 per shares. The implied offer of $54.05 per share is in that range only so the valuation can
treated technically fare. P&G created a deal structure comprising of share-swapping and stock-
repurchasing. P&G’s offer of 0.975 shares for each Gillette share avoided triggering a taxable
event for Gillette’s shareholders, and allowed P&G to retain its cash. The stock repurchasing
program provided Gillette shareholders with a wholly tax-free transaction, as well as an
opportunity to continue in the combined company or sell the stocks back for cash. This also
resulted in reduced shareholder dilution for P&G. Thus, overall the deal structure was beneficial
for both P&G and Gillette’s shareholders. Deal structure helped P&G to enjoy fourth highest
investment grade credit rating at both Moody’s Investor service (Aa3) and S&P (AA-).
Stakeholder management is one of the most challenging activity to make an acquisition
successful. In this case severance and change in control benefits were extended to top
management of Gillette. Employees and state agencies were taken in confidence that job losses
would be minimal. Few product segments/ subsidiaries were divested by both firm to get
clearance from FTC/EC and the deal got clearance from the state of Massachusetts that there is
no fraud in connection with the offer, sale, or purchase of securities.
In past, Gillette spent around $1 billion to fend itself against takeover attempts. Post-acquisition,
these expenditures could be avoided. A combined firm would capitalize on the brands, core
marketing competencies, and integrated supply chain network of both the companies which
would result in creation of better value to shareholders.