Unilever – a share for all seasons?

However, it hasn’t been plain sailing for the company. It has been criticised for being too complicated, too sluggish and not performing as well as some of its peers. A takeover approach from Kraft backed by Warren Buffett and his friends in February 2017 was quickly rebuffed, but has served to shake up the company in its quest to become more profitable.

A strategy to grow sales and improve profit margins seems to have gone down well with investors, but Unilever and consumer goods companies in general face many challenges, which means any gains made will be hard to keep.

Unilever shares were very volatile in 2018 and ended the year broadly unchanged. The key question that investors need to try to answer is whether this giant has done all its galloping or whether it can move on to fresh heights.

A business that is easy to understand

If you are investing your money in individual shares, one of the best bits of advice you can act on is to buy shares in businesses that you can easily understand. Unilever should meet this criteria for most people as they will probably have at least one of its branded products in their home.

Knowing what you own a slice of is good advice because if you understand the business you are invested in, you are less likely to be thrown off course by fluctuations in share prices and other things that don’t matter.  That said, just because you understand a company’s products or services and how it makes money doesn’t automatically mean you will end up with a profitable investment.

Along with US giant Procter & Gamble (US:PG), Unilever is a global consumer goods powerhouse. It has more than 400 individual brands spread across beauty products, personal care, home care, food and refreshment markets. These brands are managed for global and local markets. It has 12 brands with annual sales of more than €1bn (£0.9bn) and total sales of more than €50bn. Its sales and profits for the year to June 2018 were made up as shown in the table below. Nearly 60 per cent of its sales currently come from emerging markets.

The beauty and personal care business has leading market positions in hair products, skin cleansing, deodorants and oral care. It has five brands in the form of Axe, Dove, Lux, Rexona and Sunsilk that have annual sales of more than €1bn, complemented by other leading brands such as Tresemmé, Signal, Lifebuoy and Vaseline.

The home care business has big global brands such as Persil and Surf, which have annual sales of more than €1bn, as well as other prominent brands such as Comfort, Domestos, Sunlight and Cif.

Having sold its spreads business, Unilever has a more focused food and refreshments business. The food business is dominated by the megabrands of Hellman’s and Knorr, and backed up by an impressive portfolio of ice cream brands including Walls, Magnum and Ben & Jerry’s. Unilever also has very strong tea brands in Lipton and Brooke Bond. It also makes the iconic Marmite spread and has recently bought the Horlicks brand from GlaxoSmithKline.

The beauty of Unilever’s business is that it contains hundreds of different products that consumers buy regularly throughout the year. This gives it regular and quite predictable sales and cash flows – the type of characteristics that are highly sought-after by investors and corporate raiders such as Kraft and Buffett.

Consistently good financial performance with growth

A look at Unilever’s historical financial performance highlights how it has been able to grow its profits and cash flows over the past decade. This, in turn has allowed it to pay an increasing dividend payout to its shareholders.

With perhaps the exception of its free cash flow (FCF) margin, Unilever has many of the hallmarks of a very high quality business. It consistently turns its profits into cash flow and earns high operating margins and returns on capital employed (ROCE).

The level and stability of its profit margins and ROCE can be interpreted as a sign that Unilever has some form of economic moat – a business that is good at fighting off competition and preserving its high rates of profitability.

The source of Unilever’s economic moat is its enduring brands. These brands are supported by very high levels of marketing expenditure (Unilever spent 14 per cent of its sales on advertising in 2017) and research and development into new brands and products. The distribution relationships with retailers across the world can only be matched by a few of its peers.

While high margins and ROCE are welcomed by investors, they also spell opportunity for competitors who want to grab a slice of a market. Retailers with wafer-thin margins may also try to take a bite out of their suppliers’ profits.

High margins are all well and good as long as they can remain high or go higher. In order to turn those margins into sustainably higher profits, a company has to be able to grow its sales in the years ahead. This is easier said than done.

Weighing up Unilever’s business strategy – opportunities and threats

Unilever has been moderately successful at compounding growth over the past decade by reinvesting in its business. Yet, it has taken a failed takeover attempt by Kraft in February 2017 to force the company into a more aggressive growth strategy based on the following targets out to 2020:

• 3-5 per cent organic sales growth
• €6bn of cost savings to be achieved by efficiency gains and adopting policies such as zero based budgeting (where the annual budget for many cost items starts at zero every year)
• Exiting its spreads business.
• €6bn share buyback.

The exit from spreads and the buyback have been done. If the company is successful with its sales growth and cost-saving targets it will achieve operating margins of 20 per cent by 2020.

True, 3-5 per cent sales growth isn’t really anything to shout about. But in a low growth world and for a business the size of Unilever it represents a realistic target. At the moment, it looks as though sales growth for 2018 will be at the lower end of its targeted range.

Life is hard for consumer goods companies just now, especially in developed markets such as Europe and North America. This is because consumers’ disposable incomes are barely growing and there is an increased focus on value for money. This is being seen in the growth in number and quality of own-label products from supermarkets. In order to keep their sales volumes stable, the big consumer goods companies are having to cut their selling prices. As a result, Unilever is not seeing any meaningful sales growth at all in Europe or North America.

Emerging markets – driven increasingly by higher sales of home care products –  are proving more fruitful for Unilever, with the exception of Brazil where the economy remains difficult, and Argentina which is gripped by hyperinflation. The growing economies of China, India and Indonesia continue to produce a growing middle class, which has been good news for both Unilever’s global and significant local brands.

What’s encouraging from my point of view is that Unilever’s growth is currently coming from selling more (volumes) and is not reliant on increasing prices, which is difficult to do. Its underlying sales growth also accelerated throughout 2018. It will need to keep on this same track in order to meet current analysts’ expectations in the years ahead.

However, many challenges remain. Consumer habits and demographics are changing. The brands that have served Unilever well for years do not have the same loyalty with younger consumers. These consumers are also more difficult to reach and inform through traditional forms of advertising.

Unilever and its peers are therefore open to attack from niche, innovative companies with different ways of selling to customers, such as through subscription models. This has seen Unilever respond with new products and by buying companies. There has been a significant push on new products such as Magnum Pints, but also more natural and premium products such as Pure Leaf loose teas, Dove Naturals and vegan Magnums.

The changing marketplace has also seen Unilever become very acquisitive in recent years and move into new product markets. This brings with it a number of risks – particularly the risk of overpaying. At the end of this day, these acquisitions have to pay off.

Unilever has been getting its chequebook out buying stakes or businesses outright, including Dollar Shave Club (which has been barely mentioned since it was bought), Italian personal care business Equilibra, and at the end of 2018 The Vegetarian Butcher and GSK’s Asian health drinks business, which includes the famous Horlicks brand. The Horlicks deal is understandable given Unilever’s significant presence in India, where Horlicks is popular, but the price paid for it looks to be very high.

Unilever is paying €3.3bn for a business with sales of around €550m. After cost savings, the company has said that the EV/Ebitda multiple will be under 20 times, which cannot be considered to be anything close to a bargain purchase. It looks as though it is going to have to deliver impressive rates of growth to make a meaningful difference to Unilever’s shareholders.

Are Unilever shares good value?

Unilever is performing satisfactorily in difficult markets. Its 20 per cent profit margin target for 2020 is already factored into analysts’ forecasts, which show profits growing faster than sales. A change of chief executive from the start of 2019 is unlikely to change much as the current business strategy remains.

It’s difficult to see scope for analysts to upgrade their profit forecasts unless sales growth accelerates. This is dependent on not only business performance, but also exchange rates, which – as always – are difficult to forecast.

If the margin progression expectations are met, there is still a half reasonable earnings per share (EPS) growth story at Unilever. At 4,099p (or €45.60 at current exchange rates), Unilever would trade on a 2020 forecast price/earnings (PE) ratio of 16.5 times and offer a dividend yield of nearly 4 per cent, which does not look too demanding and could help underpin the current share price.

On a trailing 12-month PE basis, Unilever shares are trading at similar levels to Colgate (US:CL) and Procter & Gamble.

The one thing that makes Unilever relatively attractive to its peers remains its emerging markets exposure. Providing Asian economies do not weaken significantly, its profit outlook looks to be reasonably robust compared with those with more exposure to North American and European consumers.

That said, there can be no getting away from the fact that Unilever is a lumbering consumer goods giant that is unlikely to deliver stellar rates of long-term growth. But that’s not what most people own it for. Investors like its dependability and high-quality cash flows that contribute to a rising dividend payout. If these are the type of attributes that you are looking for in a share then a slice of Unilever at its current share price looks like a reasonable investment.