By Shawn Tully
October 9, 2017

In its dramatic proxy battle with Trian Fund Management—due to culminate in a closely watched shareholder vote on Tuesday—Procter & Gamble is portraying itself as a fount of creativity. In a mid-September presentation designed to block Trian’s co-founder, Nelson Peltz, from winning a seat on the board, P&G extolled its leadership in “innovation,” spotlighting the term in the headlines of no fewer than four consecutive slides—for example, “P&G Innovation Drives New Brands and Blockbuster New Sub-Brands.”

In reality, P&G’s most obvious exercise in innovation is the highly creative numbers it’s advertising to rebuff Trian, and to bolster its claim that mediocre-looking results are really good, if you just view them the P&G way.

Never in U.S. corporate history has an activist launched a proxy contest versus a player the size of P&G, a $235 billion-market-cap colossus. P&G (pg) is the world’s largest marketer of consumer products, managing a roster that encompasses such famous names as Tide, Pampers, Gillette, Crest and Bounty. Trian, owner of a $3.5 billion stake, argues that P&G is a fading, cumbersome giant suffering from stifling bureaucracy, a dearth of exciting new products, and eroding market share in its aging brands. P&G counters that it’s rebounding strongly under CEO David Taylor, and that Peltz aims to upend a winning strategy.

The eight-month duel will reach the decisive showdown at P&G’s annual meeting on October 10. Retail investors have been voting for months; the big institutions mostly waited for verdicts from the three big proxy advisory firms in late September, ISS, Glass Lewis and Egan-Jones—all of which backed Peltz—before casting their ballots. The vote is now too close to call, and last-minute ballots could still be presented at the meeting by shareholders in attendance. By noon on Tuesday, Taylor is expected to announce one of three results: Peltz wins, P&G prevails, or the count is so tight that the outcome can’t yet be determined. In that case, it could take many weeks to certify the vote and declare the victor.

The best way to pierce the barrage of claims, counter-claims, and counter-counter claims is to determine whose numbers reveal the real P&G. The best gauge for the two sides’ positions is their widely-contrasting views on perhaps the most important measure: P&G’s record at growing what investors prize most, earnings-per-share.

What counts as “core”?

In its anti-Trian presentations and recent financials. P&G presents not earnings-per-share as originally reported in its financial statements, but “core” EPS, adjusted for such special non-recurring items as gains or losses on asset sales, restructuring costs and the shuttering of its subsidiary in Venezuela. Using adjusted numbers is widely accepted, including by Trian.

What’s questionable is that, in highlighting its results from its fiscal 2011 to 2017 (ended in June), P&G also reaches back to exclude all past profits from businesses that it’s sold over those six years. And it’s axed a heap of businesses and and along with them, profits. The long list includes Duracell, Pringles, Folgers, IAMS in pet foods, and its beauty franchise featuring Clairol and Cover Girl.

P&G argues that this methodology displays how well it’s managed the businesses it still owns, and hence provides a guide to how well those anointed brands will perform in the future. In its presentations, P&G shows core EPS growing from $3.48 to $3.92 from FY 2011 to 2017, for a total of 12.6%, or an annual growth rate 2%. That’s darn good, claims P&G, given the tough global market in consumer products and strong headwinds from a surging dollar.

But do those results really show that P&G’s been growing profits from its core portfolio? Or is the supposed improvement really the result of gigantic share buybacks, a lot of which P&G shouldn’t even be counting?

So let’s separate the two factors that determine growth in EPS, the expansion in the numerator—the underlying profits from those businesses that P&G still owns, and the trend in the denominator, the decline (in this case) in the number of shares outstanding. If P&G is doing a great job managing those core businesses, the numerator, the profits number, should be growing briskly.

But that’s hardly the case. By its own measure, P&G’s core earnings rose from $10.44 billion in FY 2011 to $10.749 billion in 2017, an increase of just 3%.

Hence, most of that increase in EPS over those six years came from a shrinking denominator—driven by buybacks. (Buybacks tend to improve earnings per share, because there are fewer shares across which to spread profits.) And most of those EPS-swelling buybacks may not belong in P&G’s adjusted numbers at all. From FY 2011 to 2017, P&G deployed an ambitious program of repurchases to lower the share count from 3 billion to 2.742 billion, a reduction of 258 million. Hence, it was that 9-point reduction in the shares outstanding that accounts for three-quarters of the 12% rise in EPS. To be sure, 12% over 6 years is hardly great. But the modest progress P&G achieved is mainly attributable to buybacks, not the puny contribution from earnings.

Although the failure to grow underlying profits is troublesome, raising EPS via buybacks may be a good thing, if, as P&G asserts, its looming comeback proves that its shares have been deeply undervalued. But here’s the gap in P&G’s credibility: A big chunk of the funds used to repurchase shares, and drive EPS, didn’t come from earnings generated by those current, core brands at all. Over those six years, according to its cash flow statements, P&G raised $9.8 billion from selling businesses. It also collected an additional $5.6 billion in profits from those divested brands while it still owed them. So in effect, those bygone businesses generated over $15 billion in extra funds available for purchasing shares. By Fortune’s rough estimates, those funds paid for three quarters of the 258 million shares that purchased from FY 2011 to 2017.

Put simply, P&G is saying, here’s how we would have done if we’d never owned all of these now-divested (and poorly-performing) businesses. But in presenting our results, we’re including $15 billion in proceeds from the sales of those businesses that we “never owned.”

So let’s be consistent, and add back the shares P&G repurchased with the cash reaped from those departed brands. Under that scenario, EPS rose not 2% but less than 1% annually, or 5.5% over six years, less than half the advertised amount. In the most basic terms, that 5.5% is the sum of the 3% total earnings growth over 6 years, plus the 2.5% reduction in the share count that didn’t come from the brands it axed along the way.

So shareholders should ask whether that 5.5% gain over six years supports management’s claim that businesses that constitute the new, slimmed-down P&G are prospering. (By the way, that 5.5% didn’t come close to matching inflation.)

A better yardstick

In fact, Trian is right: The best yardstick is the core earnings as originally reported, numbers that include all businesses, divested and current, and all buybacks. That number provides a pure measure of the earnings its businesses contribute to every share of P&G stock. And that number hasn’t moved in six years.

Indeed, in its report endorsing Peltz’s candidacy, Glass Lewis was harshly critical of P&G’s methodology. “By combining the favorable EPS impact of disposal-funded share buybacks with downward adjustments to historical earnings attributable to divested businesses, P&G is able to show more favorable Core EPS growth over time, despite an effective loss of operational earnings power,” writes Glass Lewis, concluding, “We are concerned that management’s presentation of earnings growth is inflated.”

Albert Meyer, a forensic accountant and founder of Texas portfolio manager Bastiat Funds, also finds P&G’s approach misleading. “They want to have their cake and eat it too,” says Meyer. “When you make these adjustments, you need to be consistent. It isn’t consistent to leave out the businesses you sold, and include the proceeds from selling those businesses. Using consistent numbers shows why P&G’s stock had done so poorly.”

Of course, P&G claims that its results would look stellar if it weren’t for the dollar surge that pounded overseas earnings when converted to greenbacks. That argument doesn’t impress Meyer. “If you make a decision to go abroad, you take that into account,” he declares. “My experience is that it evens out over time. If you make a smart investment, forex is no big factor. If forex is a factor, it may be that it wasn’t a good business to start with, or it wasn’t executed properly.”

P&G maintains that it’s eagerly embracing change, and that the best course is for management to pursue today’s strategy unfettered by Peltz, at their own pace. The proof, say the board and brass, is that an historic transformation is well underway. But their own “adjusted” numbers, when re-adjusted to erase the gimmicks, prove just the opposite. The best hope for shareholders is that Peltz wins, peace is made, and a voice of an owner and outsider helps reinvigorate a sleeping giant.

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