A stable giant with strong cash flows and reliable dividends

What’s more, the attractiveness of consumer staples shares as ‘bond proxies’ has been hit by higher interest rates. Stability can be a virtue in any economic climate. And consumer staples stocks are stable: analysis by Verdad Research found the group had the lowest income statement volatility of any listed sector between 1996 and 2023. But steady brands and profits look less exciting when compared to soaring bond yields.

Still, take a more agnostic view of the risk-free rate, and history shows that reliable cash flows and growing dividends are an attractive combination. Enter Magnum and Marmite seller Unilever (ULVR), which reported better-than-expected half-year results last week. Underlying sales rose 9 per cent against the first six months of 2022, ahead of City consensus, while operating profits climbed 23 per cent to €5.5bn (£4.7bn). The results were in effect a continuation of what Unilever – which owns over 400 brands – achieved in 2022: namely passing on higher costs to the consumer to protect and grow its margin. This was seen in the 30 basis point uplift in gross margin and the 10 basis point increase in underlying operating margin in the half.

That margin performance has invited accusations of ‘greedflation’ in some quarters, even though the company’s profitability still sits below pre-pandemic levels. In 2019, the underlying margin was 19.1 per cent, two percentage points above the latest postings.

Either way, this looks frankly spectacular in comparison to the UK’s grocery sector, where tough competition has resulted in a never-ending price war. Unilever's quest to get margins back to pre-Covid-19 levels is in progress, and the board has guided for margin improvement across the full year, even if some analysts – including Waverton’s head of UK equity research Tineke Frikkee – expect margins to be reinvested into growth and regaining lost market share. 

Financial stability

From a strategic point of view, Unilever isn’t synonymous with stability. The company has been under pressure from shareholders after a period of underwhelming performance, with the share price almost £10 below its 2019 peak. The shares may sit above the $50-a-pop offered by Kraft Heinz (US:KHC) in its failed bid for the company back in 2017, but not by an impressive margin. And in comparison to fast-moving consumer goods (FMCG) sector peers such as Procter & Gamble (US:PG) and Reckitt Benckiser (RKT), the sales growth performance has been underwhelming. 

Another failed bid, this time by Unilever for the consumer arm of GSK (GSK), sparked another shareholder backlash last year. Terry Smith, manager of the top-10 institutional investor Fundsmith, concluded acerbically that the £50bn acquisition attempt was “thankfully dead rather than the value of our investment in Unilever”.

Although strategic direction remains a work in progress, investors can at least rely on Unilever's dividend and cash flow profile. The company is a dividend leader in its peer group, which is one reason why the stock is so popular with fund managers. 

Dividend growth is backed up by strong cash generation. Analysts expect free cash flow to grow by around a quarter from £5.6bn this year to £6.96bn in 2026, according to FactSet, which could help it match peers’ superior cash generation. Over five years, Unilever’s free cash flow margin has averaged 12.2 per cent, well short of 18.4 per cent at Procter & Gamble and 16.2 per cent at Colgate-Palmolive (US:CL). This isn’t the only way to measure operational strength, of course. Unilever’s five-year average return on invested capital of 19 per cent is notably higher than that of Nestlé (CH:NESN) and Procter – even if the cash return from capital investments lags the peer group.

Behind these numbers sits a highly defensive brand portfolio. This was evident in the flat volume performance in the latest half, with the number of items sold falling by only 0.2 per cent despite underlying price growth of 9.4 per cent. Volume growth was posted in the beauty and wellbeing and personal care divisions, suggesting consumers are happy to keep buying TRESemmé and Dove at higher prices. Underlying growth at brands which post over a billion euros in annual revenue, such as Hellmann’s and Rexona, came in at 10.8 per cent. Brand equity, and diversification, is not in doubt.

Growth drivers

The interim results were encouraging, but a key question for investors is where long-term growth will come from. One strong half doesn’t a bull case make, after all. But while the company isn’t one to own for turbocharged growth prospects, nor is it without options. 

The half-year sales and volume split highlights a critical part of the investment case: Unilever’s growing geographical footprint outside of its legacy European markets. While volume growth was posted in Asia Pacific, Africa and the Americas, units shifted in Europe fell by a hefty 6.8 per cent on price rises of 14.2 per cent. Europe was the weakest performer in sales growth terms, with the continent impacted by its high exposure to nutrition and ice cream categories, which have particularly struggled with cost inflation pressures. But with almost 60 per cent of sales now in emerging markets, Unilever is in a strong position to take advantage of huge consumer and demographic trends.

As Ioannis Pontikis, a senior equity analyst at Morningstar, argues: "Unilever has one of the largest footprints in the developing world of all the global consumer staples manufacturers, which should be a long-term volume driver for the business.”

A revamped operating model should also help. Last summer, the group was simplified into five business arms, and €600mn of cost savings are expected from the exercise. Promising board noises on inflationary pressures should also help, with under a quarter of the forecast €2bn of full-year net material inflation expected in the second half of 2023. 

And then there is new management to consider. With activist investor Nelson Peltz pushing for improvement with his Trian shareholding and non-executive director board seat, changes are afoot. A new chief executive, Hein Schumacher, will in December be joined by a new chair, Ian Meakins, followed by a new CFO after Graeme Pitkethly stands down next year. 

While we don’t expect the new leadership to herald fundamental business model changes, Schumacher placed an emphasis on "science-backed innovations" in his first CEO statement. The Dutchman, whose low profile and former post as the head of a dairy co-operative made him a surprise pick for the top job in the eyes of some investors, will nonetheless be keen to make a break from the brief tenure of Unilever lifer Alan Jope, who struggled to articulate a vision for the company following the 2018 exit of long-time chief Paul Polman.

One feature the new boss will certainly seek to improve is the percentage of Unilever’s business taking market share, which stood at 41 per cent on a rolling 12-month basis at the end of June – following a knock from a stock-keeping unit (SKU) reduction and some changing consumer preferences. Investment in "high-growth spaces and channels" is another priority.

At 18 times forward earnings, the shares sit just below the five-year average, implying that investors remain hopeful of cash generation-led growth despite a middling share price record. Nearer term, there may be scope for forecasts to rise if the company’s current guidance proves too conservative, although we think investors are better served by focusing on the long term.

With its proven defensive brands, emerging markets exposure, and new management team, backed up by better-than-expected trading, the future looks brighter for Unilever than it has done for some time. Investors, looking at the dividend and cash flow offering, should consider the attractions of stability.