Unilever’s Competitive Prowess Untarnished

Unilever’s Competitive Prowess Untarnished

By Erin Lash, CFA | 10-28-13 | 06:00 AM | Email Article

Unilever‘s (UL)/(UN) third-quarter update shed light on concerns that surfaced last month. The firm has stressed recently that emerging-markets growth is trending down (56% of consolidated sales), topping out at just 5.9% in the third quarter–a marked deceleration from 10.4% in the first quarter and 10.3% in the second. Conversely, developed markets posted minor sequential improvements, as sales ticked down just 0.3% compared with negative 1.9% in the first quarter and negative 1.3% in the second. North America was particularly weak, as sales tumbled 1.9%; this is even more dismal since it compares with a 3.5% drop last year. Beyond weakness in spreads and intentional pruning in its ice cream lineup, management cited increased competitive intensity in North American hair care and deodorants.Despite these pressures, we’re standing firm on our wide moat rating, which reflects Unilever’s expansive global distribution platform and portfolio of essential products. Unilever hasn’t wavered from its full-year forecast of volume growth above its markets and sustainable margin improvement, and we continue to expect the firm to generate 5% annual sales growth over the longer term and 16% operating margins by 2022–about 100 basis points above fiscal 2012 adjusted margins. Trading at an attractive discount to our valuation and with a dividend yield above 3%, Unilever should appeal to growth and income investors.

Unilever’s Not Afraid to Spend to Maintain Its Advantage
We think Unilever’s wide moat stems from its expansive global distribution platform and its portfolio of essential products. Despite these competitive advantages, the firm remains on the offensive and continues to put resources behind product innovation (launching new products that span the gamut of its portfolio with Knorr Stock Pot bouillon, Dove Repair Expertise hair care, Persil concentrated liquid detergent, and Lipton Yellow Label with tea essence), marketing, and cost-saving initiatives. In our view, this spending is driving balanced and profitable growth, in contrast to several of Unilever’s peers, as sales reflect higher prices and increased volume–a notable achievement in this difficult operating landscape.

In the past, an extremely decentralized and complex structure hindered Unilever’s ability to realize the growth and profitability that should emanate from one of the largest consumer packaged goods players. Unilever’s use of a local go-to-market strategy initially failed to generate a clear global strategy, and the firm was unable to leverage the scale advantages that should have come from its brands, facilities, and employees. However, management has sought to reduce the complexity of its operations over the past few years, by streamlining its IT systems, improving marketing efficiency, and leveraging its purchasing scale. These efforts appear to be gaining some traction, as profits have generally held up despite cost pressures.

Unilever’s status as a giant consumer product firm has resulted partly from its foresight to secure a first-mover advantage internationally, particularly in fast-growing emerging markets, where it derives 56% of consolidated sales. We would not be surprised to see Unilever pursue acquisitions in these faster-growing markets, but we caution that with several consumer product firms looking to developing markets for expansion, valuation multiples could trend to unreasonably high levels, making such deals less beneficial. We also see the potential, though, for the company to grow organically in these regions, as it did by selling Alberto Culver’s offerings into Brazil, which has been one of Unilever’s most successful launches.

Brand Portfolio and Vast Scale Make for a Wide Moat 
Unilever is the third-largest packaged food firm in the world, behind Nestle (NSRGY)and Mondelez (MDLZ), and one of the largest global household and personal product firms, with its top 14 brands each generating more than EUR 1 billion in annual revenue. The pricing power inherent in Unilever’s brand portfolio is evident in the fact that the firm has been able to increase prices across its product assortment while still expanding volume over many years. Even when the firm isn’t actively increasing prices to offset higher commodity costs, new products tend to come with a higher price tag, and in general, volume has not come under pressure. Unilever’s wide portfolio of products gives it negotiating leverage with key retailers like Wal-Mart, which are continuously pushing for lower prices. The size and scale Unilever has amassed over many years enable the firm to realize a lower unit cost than its smaller peers, resulting in a cost advantage. Unilever ensures its strong competitive position remains intact by investing significant resources behind its brands, and this spending is yielding market share gains. For instance, in the global deodorant category, management said Unilever’s value share increased roughly 310 basis points between 2009 and 2012, which is notable, in our view. Further, Unilever has consistently generated excess returns on invested capital. We forecast returns to average 18% over the next five years, well above our 8.3% cost of capital estimate.

Commodity Costs and Weak Consumer Spending Pose Risks 
Erratic changes in commodity costs for inputs such as petrochemicals, edible oils, and tea can weigh on Unilever’s profitability, and we think increased demand in emerging markets is likely to keep costs elevated over the longer term. Further, consumer spending remains weak, reflecting high levels of unemployment and austerity measures that are constraining growth in Europe. As a result, volume growth could stall if Unilever raises prices and consumers opt for lower-priced value offerings. Also, several of Unilever’s largest competitors (such as Procter & Gamble(PG), Colgate (CL), L’Oreal (OR), and Nestle) are also on the prowl for share gains, which makes it onerous for Unilever to ensure its products win at the shelf with consumers. European antitrust regulators in France fined several major household firms for price-fixing laundry detergent from 1997 to 2004, following a similar ruling that Procter & Gamble, Unilever, and Henkel (HEN) engaged in price fixing in the powdered laundry detergent aisle from 2002 to 2005. This indicates to us how tough share gains are to come by in mature markets.

Further, after years of pruning its business, Unilever is once again on the hunt for acquisitions, which could prove problematic if it has trouble digesting a purchase or pays an excessive premium. Management hasn’t shied away from paying up for acquisitions (like Alberto Culver) in the past, and wringing out the cost savings needed to make high-priced deals worthwhile is not a slam dunk. With 56% of its total sales resulting from developing and emerging markets, Unilever is also subject to changes in foreign exchange rates. This international presence also exposes the firm to political and economic risks. Finally, Unilever is undergoing a major restructuring initiative, the results of which are far from certain and could lead to instability in its operations. As a result, we assign Unilever a medium uncertainty rating.

New Products and Higher Prices Should Boost Growth
In our view, consumer spending will remain fragile, given that unemployment levels remain elevated and austerity measures are hampering growth prospects in Europe, but we expect Unilever to benefit from new product launches as well as the breadth of its distribution platform, which spans the globe. Although management has reiterated its sentiment that slowing emerging-market growth combined with intensifying competitive pressures will prove challenging for some time, we still think faster-growing developing regions will outpace sluggish prospects for more mature markets. We forecast sales growth of 3.5% in fiscal 2013, but longer term we expect that annual sales growth will approximate 5%, reflecting the benefits of new products as well as higher prices.

The commodity cost environment is more benign than in years past, but we don’t suspect that this will persist longer term, given increasing demand for raw materials in emerging markets. While we’ve been encouraged by the company’s commitment to wringing additional savings from its cost structure by leveraging its massive scale, we expect Unilever will continue to reinvest in its business. As a result, we assume that operating margins approach 16% by 2022, about 100 basis points above fiscal 2012 adjusted operating margins. Over our 10-year explicit forecast, we expect returns on invested capital to average 20% compared with our cost of capital estimate of 8.3%, supporting our thinking that Unilever possesses a wide economic moat.

Erin Lash, CFA, is a senior stock analyst with Morningstar.