All right, we're gonna start up again. So up next we have Andre Schulten, Procter's CFO, and John Chevalier, Procter's SVP of IR, joining us on stage. Now, prior to assuming his role as CFO in 2021, Andre was the SVP of Procter's North America Baby Care business and has served in several key leadership positions at the company over his nearly 30 years of experience. Now, Procter's has been one of the most resilient CPG companies over the past several years, even as the industry faced a challenging backdrop with COVID-led supply chain disruptions, geopolitical tensions, record high inflation levels, and a rising rate environment.
So we're really excited to have both Andre and John here to talk us through the secrets behind the company's operational excellence as it navigated, really, through this volatile environment and its ultimate path forward. Thank you again, both of you, for joining us. I guess, Andre, when you sit here today, I wanted to ask you, when you first looked at the company from a CFO's perspective about three years ago, what, in your view, was really working well, and then maybe what did you see as some of the areas of improvement that you ultimately identified?
Sure. Morning, Bonnie. Thanks for having us. Look, let me pick up on the resilience point because I think it's true. The team has been able to deliver outstanding results, I think, prior to the pandemic, during the pandemic, in an inflationary environment, and now as we're coming out of that inflationary cycle. And I think it's all grounded in the execution of the strategy. If you think about the categories that we operate, we intentionally chose categories that are non-discretionary. They are daily use, and consumers value product performance. Consumers are willing to pay for products that actually deliver the benefit. If you think about diapers, my previous job, you don't want your diaper to fail. And if you get reassured that the diaper works, you're willing to pay a few pennies more. Same is true for laundry. Same is true for Fem Care products.
So performance actually matters to the consumer a lot in these categories. And the team has done a fantastic job building something we call Irresistible Superiority. And what that simply means is that across the dimensions of product performance, the way we package the product, the way it's presented in store or online, the way we communicate the benefit to the consumer, and the way that we provide value to the consumer is superior to the next best offering in the market. And as we expanded that level of superiority from 30% in 2016 to 80%, you saw the business results go with it. T he teams have been able to deliver productivity even through the toughest parts of the supply chain crisis.
And that is a core element of how we keep the cycle going because that allows us to reinvest in superiority and drive that growth. They've been looking around the corner. If you think about the developments of where the consumer was going, what we needed to do in order to be distributed in all the channels where the consumer would ultimately shop when value becomes a bigger topic for the consumer. And ultimately, we've got teams that are accountable, but they also have the decision rights at the right level where they can drive the decisions that are relevant for their consumer. So that strategy has worked. The best part about it, Bonnie, is it's market constructive because it grows categories. That's really the idea behind it. Nothing in this company gets changed by one person, right?
We have an incredibly capable group of Sector CEOs and of market leaders. And when we looked at the company's trajectory three years ago, when John took his role, I took my role, we basically said there are strategies working, but there are a few things we want to double down on. And among those things were really redefining Irresistible Superiority. And the simple way to express that is we were looking at, are we superior versus the next best offering in the market, which is great. But if you think about the constructive nature of a strategy, we really want to be superior to the next best solution that the consumers are using and that keeps them from using our solution.
So when you think about a consumer who's using a mop and a bucket today, how can we make Swiffer so irresistibly superior for that consumer that they shift into the category? How can we make laundry users trade up from powder to single unit dose? So that's really the idea. How do we build Irresistible Superiority that more directly builds the category? And as we did that, we basically reset the superiority from 80% back down to 30%, illustrate to the organization, that's the new challenge that we want you to go after. In sync with that, we increased the focus on productivity. And most importantly, we decided to look at productivity at the same planning horizon as we do for innovation.
We generally do innovation planning on a three to five-year master plan. It was only logical to say, why don't we plan our productivity efforts on that same cycle to ensure we have sufficiency over that three- to five-year period, and we can better synchronize productivity savings with the need for investment in innovation? The last element the team decided was to build environmental sustainability into the company's strategy. The way we deliver sustainability is easily described as three pillars: reducing our own footprint, scaling technologies that we have in the marketplace when we can't scale them ourselves, and monetizing them, like polypropylene recycling, for example. The last one, which is most important, is to reduce the consumer's footprint because that's really where 80% of the footprint is of these products. It's in the water usage and in the heating of the water in the laundry cycle, for example.
Once we reframed the idea that way, it became a value-creating and market-growth strategy. If we enable consumers to bridge that gap between environmental sustainability and product efficacy, they don't feel bad about using more. They don't feel bad about doing the job more often. That grows the market, and it grows value in the market because they're generally willing to pay up for that proposition. So if you look at Ariel for cold water liquid pacs in Europe, which is high performance in cold wash, which is the claim, we were able to reduce the wash temperature, deliver a packaging that is recyclable and sustainable, and the business grew more than 20%. So that's the idea. So long-winded answer. At the end of the day, it's about executing the strategy, enhancing maybe, but not fundamentally tweaking.
No, that's great. Then as you describe that, do you think you as an organization are better about sharing best practices? The example you just provided, how can you leverage some of the learnings from that, ultimately bringing that into other markets and vice versa?
Yeah, for sure. I think the organization has learned the not-invented-here phenomenon is largely gone. And we've all learned that cross-fertilization across these sectors is critically important and can accelerate. And John does a very good job of incenting that and celebrating these examples across the organization, which is a big thing.
Then you touched on this a bit earlier, but your company certainly was a big beneficiary of the superior supply chains that you have, especially during COVID. Certainly, many of your peers struggled to keep their products on the shelf. Now, as you think about today, competition really hasn't stayed still, and supply chains really have recovered, and competition has intensified. Could you talk to us a little bit about the steps you're taking to sustain this superiority going forward?
Yeah. I think the most important recognition of our supply chain is what our retail partners are saying. They've voted us number one supply chain in the industry on a global basis now for nine years in a row. That's no need to stand still. It's actually motivation for the team to go further. And they are driving every element of the supply chain, very simple things. First of all, we've learned, I mean, it took us a while to catch up to the level of demand we were able to create over the last five years. And what we've learned is that we need a higher capacity-to-demand ratio. Number one , there's more volatility in the demand pattern than there ever was. Number two , when we get all 5 vectors of a proposition right, we are almost always surprised by the size of the upside.
So the first thing we did, and we are doing right now, is continue to invest in capacity so we have that flexibility to deal with the volatility and to deal with the upside that our propositions are generating. The second element was to further build on the resiliency that we had started to benefit from in the supply chain crisis. What that means for us is have formulation flexibility. We have great digital capabilities to reformulate products, meaning reformulate ingredients, model that digitally, and then deploy it digitally to the production facilities, which allows us to reformulate in a matter of weeks instead of doing it for over six months or 12 months, which it took us before we had that capability.
That, combined with a supply chain where we have very intentionally moved from global, limited number of suppliers to more regional suppliers and local suppliers, allows us to source differently if there's an availability issue for a material or if there's a cost arbitrage to be had. So that capability we're still building and expanding. Digital and automation is a big topic in what we call Supply Chain 3.0. It's the enabler of resilience, but it's also the enabler of productivity and quality improvements. Simple example, typically in a diaper production line, we would sample batches of products. Pick a diaper. If there's a defect, you have to scrap the batch. Now we have sensors and cameras on every line that basically checks every diaper that moves through that line. It avoids the batch issue. It avoids the scrapping.
It improves quality, and it reduces manual labor as we don't have to do that offline anymore. Last element, I think our colleagues in the manufacturing sites and in the distribution centers are our biggest asset. The work that they have done and are doing every day is critically important. Making sure we provide the right value equation to them to ensure we can attract the right talent and retain the right talent is critically important. But you'll hear more about it. We will talk about Supply Chain 3.0 in more detail at our investor day in November. I'm quite excited about.
Thank you for that. Switching gears a little bit, I wanted to touch on the consumer, right? And as we sit here today, love to hear your perspective on the consumer, especially the low-income consumer, as we're really seeing some softening in some of the macro data. So have you seen any shifts in consumer behavior as a result of these dynamics?
We have not. We continue to see the same stability of our consumer that we've really observed over the last two, three years. I think it partially comes back to, Bonnie, the categories we're in. Consumers don't stop doing laundry. They don't stop buying diapers. They don't stop buying fem care products. So non-discretionary is a huge asset for us. Number two, I think, again, driving Irresistible Superiority so they understand, consumers understand, the value that we're offering. And we've built a portfolio of brands that cover both premium ends of the market and the value end of the market. We've built a pack-sized portfolio that covers price points from $5-$50. So there's choice for the consumer to find their value proposition within our portfolio.
What that means for us, if you aggregate it all up in North America or in the U.S., in our categories, private label share is stable. Nothing really, no movement in absolute private label share. And we continue to grow volume share, which means we have more consumers trading into our portfolio than trading out, obviously. And once they come into the portfolio, we continue to see trade-up into higher value propositions. The same is true in Europe, only difference being in Europe, private label is growing as well. So there's more of a bifurcation of the consumer. But even within that, we are able to grow share, and we are able to drive market growth in Europe.
So at the macro level, we don't see trade-down. Is there some trade-down when we don't get things right? Yes. So on a couple of brands, we don't have the value equation right. And that's specifically value-tier brands when you think about Luvs and diapers. And we know how to fix it. So the team is then very quickly thinking through, what's the innovation I need? What's the product upgrade I need to fix that value equation? But there's no broad trend in our consumer base that is shifting down.
Think as an organization, you're faster. As I think back a few years ago, and certainly the different price tiers, just more laser-focused, ability to nimble in the market as the example you just described.
Yeah, I agree. And I think the nimbleness is driven by having the accountability and the decision rights aligned at the right level. So if you run the North America baby care business, you own the innovation. You own the go-to-market execution all the way to the customer. So you're enabled, empowered, and encouraged to make those decisions way more quickly than if you have to enroll a global organization all the way back down. I think that's helping us. I think the culture has also shifted. And David was a huge advocate of transparency and straight talk. That has continued to embrace the fact that if something's not working, it's not working. And I think embracing one of our leaders calls it embracing the red. So look for the red because then you can fix it.
And then thinking about the price tiers and how you've successfully navigated that and limited trade-down, also think about in the context of promotional levels, which have remained below pre-COVID levels. And curious to hear, based on discussions with retailers, do you see structural factors that support these subdued levels? And then, or if not, do you think promotional levels are going to kind of creep back up maybe towards the back half of this year? And in the context of that, how do you manage that while protecting margins moving forward?
Yeah. The promotion levels remained remarkably stable below pre-COVID levels in the markets where we have the best visibility, which is the U.S. In Europe, we saw frequency come up to pre-COVID levels, but not depth of promotion. So all of those indicators are healthy. And I think they are a result of everyone should be building margins at this point in time as we come out of the pricing cycles. You see the commodity easing is reversing. So you see some commodities coming back up. So the cost pressure, I think, is increasing again.
And generally, I think the more you see many of our competitors adopting part of our philosophy of being market constructive and actually driving growth instead of taking share, I think that's a great development for the marketplace, for retailers, for the consumer. It means better products, better options. We see pockets of that not holding true. There are some heavy promotions going on in some categories. Look, it always happens. I think our response is we will be competitive, but we'll ultimately win via delivering superior products to our consumers. We will.
Speaking of driving growth, something that we've been hearing about with investors is when you look at your organic growth in the last couple of quarters, it's been good, but maybe a little bit below expectations. Then in your last quarterly call, you did maintain your full-year organic growth guidance of 4%-5%, but you no longer are targeting that top end of the range. With half the quarter-ish behind us already, just trying to get your sense of how comfortable you feel with that guidance and ultimately the growth.
What I tell you is in the beginning of this conversation, I mentioned there's more volatility than ever. That still holds true. But we feel very confident in the guidance that we've given. It's arranged for a reason, but 4%-5% is absolutely where we think we're going to land. And if you look at the underlying strength of the business, A, fiscal year to date, delivery exactly is 4.5%. So if you just extract that out, I think we're going to be able to deliver that. Most importantly, what I look at is consumption, not necessarily shipments. And we had few consumption-to-inventory effects here over the past couple of quarters. And I think those will even out. So when I look at just what the consumer behavior tells us, it's right in that 5% range. So we're confident.
So on that point, the guidance also implies an acceleration in Q4. So this is more along the lines of the shipments and timing perspective for the full year?
It implies an acceleration in shipments, not an acceleration in consumption. So consumption has actually been steady around t he 5%. We saw some volatility due to shipment patterns. We don't expect that, so that basically lines up consumption with shipment.
Really, this algo is a medium and long- term. I know you're not giving guidance for next fiscal year, but it's realistic to assume.
It is. We assume the market will return to 3%-4% underlying growth. We've been pre-COVID , t ake out all the volatility during the past few years. 3%-4% is what we expect. About half of that would be volume growth. The other half would be price mix. And then our objective is to grow ahead of that by driving a disproportionate part of that market growth, which would land us in ...
You just mentioned a better balance between volume and price mix moving forward. That's still the expectation. As we think about whether it is a little bit more inflation with commodity baskets rising, do you foresee maybe price mix being a little bit more of the equation also as you look out into next fiscal year?
I mean, price mix has been a contributor to growth for P&G over the last 18-19 years, almost every quarter. I don't think that's going to change. It's built into the business model of growing markets means bringing new users in, using more, but also increasing the dollars per use. We need to have two of the three levels working to actually grow markets. So dollar per use is always a component. I don't expect that to change. I think we will continue to drive productivity very hard, as I mentioned in the beginning. That will be the first line of defense. And we will price for commodity inflation where appropriate.
I think the organization's confidence to be able to do that has gone up exponentially over the past two years because of the combination of pricing with innovation and therefore providing better value to the consumer, better perceived value to the consumer, even as we needed to price. That has resulted in market growth, share growth. I think we're confident we can handle what's coming.
You have the right to price this innovation. Okay. You mentioned productivity savings. Now, that's been a key margin driver in the past. I think it's been more than $1 billion per year in savings historically. They've stepped up in the past couple of years. Can you help us understand what are some of the areas where these savings are coming from and how we should look at that going forward and if that will continue to step up?
Yeah. It's really every part of the P&L and the balance sheet. The biggest driver of the savings bucket is in cost of goods sold. That's partially the Supply Chain 3.0 dimensions I was talking about. It's driven by the ability to reformulate for better cost. It's the ability to use a lot of the digital investments we've made, a lot of the automation investments we've made, drive productivity in our manufacturing sites. It's our ability to combine thinking on the full supply chain. So one of the main interventions we're making is to physically and digitally integrate our supplier supply chain, our own, and the retailer supply chain. And if you look at an end-to-end chain, the losses to be eliminated increase exponentially. And that's where we find the biggest value. We're just scratching the surface here.
But I do think that will become a significant contributor to our ability to sustain about $1.5 billion in annual cost of goods savings. We continue to roll out media capabilities around the world. We have first-party data. We have algorithmic solutions that allow us to build very effective forwards, cross-screen measurement for reach and effectiveness of reach. And bringing all of that in-house allows us to optimize media spend. So we estimate about $500 million of savings annually from our own media optimization efforts. And then there's always a company as big as this. There's always other processes you find. I think the most important element is every unit, every manager, every CEO understands that productivity is a core enabler to growth. So it's within the DNA. There's no discussion we have on innovation. There's no discussion we have on top-line growth without an equal part of that discussion being focused on productivity.
And then in the context of that, your gross margin delivery so far has been quite impressive. So how should we think about reinvestments into A&P as well as R&D? And as I look at it as a percentage of sales, that has dropped a little bit over the past few years. Is that at appropriate levels, or do you think that needs to be elevated, especially as you drive further productivity savings, reinvesting into the business? How should we think about that cycle?
We don't think about the percent of sales as the measure. We don't think about an appropriate level. What we tell the business units is your focus is Irresistible Superiority. If you can drive better communication that drives sales via driving more investment in the business, go for it. You have to live with the consequences. You have to be sure that the investment you're driving drives ROI within a reasonable time frame. You have to do the due diligence beforehand, and you have to do the due diligence in post-event analysis to ensure it delivered. As long as that's the case, we don't put any constraints on it. Once we see that correlation break, then we'll have a different discussion. So far, that is not the case. percent of sales coming down for me is a good thing. It's not a sign of underinvestment, quite the opposite. It's a sign of the efficiencies I was talking about actually manifesting themselves in the P&L, which is what we're looking at.
Finally, on the R&D point specifically, what Andre just said applies there also specifically, right? A lot of the digital tools that we've implemented in all other facets of the business are happening in R&D also. We're actually getting more innovation ideas vetted much earlier digitally now that helps increase the speed but lower the cost of that innovation. So the efficacy is not going down because the percent of sales is going down. In fact, I think it's getting better because we're focusing on fewer, bigger innovations, but vetting those ideas out much faster.
That's helpful. That's going to ultimately drive the top line. And then as I think about going back maybe to gross margin, it's been, again, a driver of your strong results over the year so far. So thinking about your guidance, which implies a step up of the top-line growth in FQ4 that we talked about and the favorable cost environment, is there any reason why we shouldn't expect gross margins to sustain at that 51% level we saw in FQ3, or do you expect it to step back down, thinking about what we're seeing for the rest of the year?
Yeah. I will refrain from giving any margin guidance, growth, or operating. But look, what we've said all along, I think the tailwind on the gross margin is easing a little bit. We had very favorable commodity tailwinds in the front half of the year. And we had a little bit of foreign exchange rate headwinds in the front half. But that's reversing. So the net of those two, we now see commodities coming up. Now, it will be a limited impact on this year, but it's no longer a tailwind in quarter four. And we have foreign exchange moving against us. So you put those two together, offset by strong productivity and the fact that the pricing annualization has largely happened in Q3. So the price mix contribution is going to ease in Q4. You can see mathematically, there's going to be some pressure on the gross margin in Q4. I mean, we're very pleased with where we end up structurally on the year from what we can see. I think that's perfect for maintaining momentum both on the top line and bottom line next year.
You just mentioned that on the COGS bucket, it's no longer a tailwind. How are you covered in terms of your costs when you look out over the next fiscal year? Do you have visibility, and do you hedge on some of your cost buckets?
We don't hedge. We generally use spot prices to forecast for the following year. Our ability to offset commodity fluctuation in our total exposure basket is the way we deal with the first level of volatility. You look at our commodity basket, you look at our currency basket, and you look at our interest rate basket. Those combined offset about 70% of the earnings impact at any given point in time at 95% confidence. So that's a pretty good first level of hedging that we don't have to pay any money for, which we like. And then the most important thing for us is to continue to push that productivity muscle. I honestly believe not hedging is actually a big incentive for our businesses to deal with the issue ahead of them, which means you can't offset it with productivity, take the pricing when the market needs to take the pricing, which is, I think, the approach.
That makes sense. I wanted to circle back on just growth and top line and drill down a little bit on China, which has been soft for the past several quarters. Several investors we've talked to about this have expressed some concerns in general about China's long-term growth potential given the macro challenges in the region. So could you maybe talk through how your strategy in the region has evolved and then ultimately what underpins your expectation for return, I believe, to mid-single-digit growth in the market?
Yeah. We've been in China for 30 years. I would say the way that the strategy evolves is China today, to us, looks much more like a developed market. While if you look at the last five, 10 years, it was all about chasing the growth, being in the right retail channel, but the consumer demand was there. Now, we have to work to create the demand. We have to work to create category growth, which we believe plays to our advantage because that's what the strategy is. That's what our capabilities are. We have dedicated R&D capability on the ground for China. Our supply chain in China is for China. We have a very strong commercial and go-to-market team in China. I think we're well set up to drive that category growth, which will ultimately be the catalyst to return to mid-single-digit growth.
The consumer at this point in time is not confident, right? And you can tell. I mean, we see improving market conditions, but we're not yet seeing optimism, which ultimately gives us some tailwind to drive category growth. We said all along this recovery will be volatile and bumpy. I think it's proven to be. So at the end, what I'll tell you, Bonnie, we're not counting on China to be a major contributor to growth over the next few quarters. But we are confident at the same time that it will return to growth and the middle class rising. Ultimately, the economy recovering will be a catalyst for that happening. And our role in that with our retail partners is to drive growth, which is the playbook we know.
And then, thinking about SK-II and that brand, especially in China, I believe the expectation is it should improve in Q4 versus sequentially in Q3. I know when you look at your skin and personal care organic sales growth, it was down low single digits. And I think that was driven by lower sales of SK-II. So maybe talk a little bit about that brand and some of the key markets. And just really wanted to understand the drivers of the improvements that are expected behind that brand going forward.
Yeah. The first thing, the brand fundamentally is very strong. If you look at SK-II growth outside of China, it's growing double digits. The brand fundamentals are healthy. So the brand in and of itself is very strong. It's impacted in China due to a general negative sentiment towards Japanese brand with a focus on. No. Second thing, we're not counting on a recovery of SK-II in Q4. I think we're leveling out. But I think it'll take a couple of quarters before the business comes back.
What we're doing to bring the business back, I think, is really just fundamental rebuilding of the brand's equity and brand trust, taking. There's a huge group of consumers that are very loyal to the brand, taking them and have them help authenticate the quality of the product, the safety of the product, the core benefit in anti-aging, and heroing the core of the brand, which is the Facial Treatment Essence, getting back on national TV, drive awareness, and so rebuilding really the brand fundamentals. We're bringing super premium innovation on the brand, which I think speaks to the segment of the market that is probably most resilient. So I think the team is doing everything right, but that takes.
And just maybe time for one more question. Capital allocation. And in the context of that, love to hear thoughts on potential M&A and how you think about that for driving further growth. And I know your free cash flow has been quite strong. You announced a dividend increase recently and certainly buying back your stock. So what else in terms of capital allocation, and how do we think about M&A in terms of a priority journey with that?
I think priority number one continues to be to fully fund the business. I was talking about capital investments and capacity. All of that can be done within the existing algorithms. So I don't think it changes anything. But priority number one is fully fund the business, which is grounded in the insight that we have enough growth potential on the core business as we have today. Those categories are growing at a 3%-4% clip. We can add 1-2 on top of that, which is right where we want to be. We have runway to do that for a number of years. We will continue to pay and raise the dividend. I don't want to be the CFO who changes that.
Good idea.
We will look at M&A more tactically, Bonnie, quite frankly. We've had great success in bringing in brands that are grounded in daily use categories, and they are built on product superiority technology, even in beauty care. When we bring those brands in, we can scale them. We can develop them. We've grown Native from $100 million, $700, $800 million. That's the type of acquisition we want to drive, nothing transformational.
All right. Thank you. We'll end there on that note. Appreciate your time. Thanks for joining us today.
Thanks, Bonnie. Thank you.