Unilever is massive and laden with goodies, but the plain sailing is behind it, says Phil Oakley.
There are two main reasons why a sensible investor might want to buy a company’s shares. One is that they are very cheap and oversold. The other is that profits in the years ahead look set to grow very quickly. If you can find a share with both of these attractions – usually hard to do – that’s even better.
But since the financial crisis, many people have been investing in shares for another reason – because there’s nowhere left to invest. With interest rates being screwed down to lower and lower levels by central banks, the dividend yield on shares is often viewed as a better alternative to sitting on cash or putting your money into government bonds.
I reckon that this third reason has been the main driver behind the rise in Unilever’s share price – and that of many other consumer companies – over the last five years. Unilever owns a stable of leading consumer good brands, including Dove, Ben & Jerry’s ice cream, Domestos, Hellmann’s and Tresemmé. That makes it the sort of share that defensive investors have flocked to. People feel that their money is relatively safe (by the standards of the stockmarket) because Unilever sells the sorts of goods – food, soap powder and toiletries – that people will have to buy, whatever the economic climate.
There is some logic behind this. But I can’t help feeling that money invested in Unilever is becoming rather less safe as time goes by. That’s because investors have become ever more willing to pay a higher and higher price for every pound of Unilever earnings – in other words, they’re driving the price/earnings (p/e) ratio up.
In years gone by, you could regularly pick up Unilever shares at a mid-teens p/e. Now you are being asked to pay over 21 times 2015 expected earnings. A high p/e usually implies high expectations of future profit growth. That’s fine if higher profits actually come through – but it often results in big share-price falls if earnings disappoint.
This elevated p/e might be fair in a world of near-zero interest rates, where investors are happy to pay higher prices for any sort of growth at all. Alternatively, though, you could say that investors are being complacent. After all, even if interest rates don’t rise, sooner or later Unilever will have to start growing its profits at a healthy rate to justify this share price. So is it time to sell up?
Unilever is a very decent business. It owns and makes a lot of branded products that consumers trust and keep on buying. Its return on capital employed (ROCE) was nearly 23% in 2014 – a good sign – while the business generates plenty of free cash flow comfortably to pay dividends to shareholders. The trouble is, there’s an essential ingredient missing here that stops Unilever from being a really great business: sustainable profits growth.
This wouldn’t matter so much if the shares were half their current price. But at the current price, growth matters a lot. Last week’s results announcement for 2014 didn’t give much to cheer about. Unilever’s underlying earnings per share (EPS) grew by just 2%.
Now, this would have been a very respectable 11% if exchange-rate movements hadn’t been so unfavourable – but if you take a deeper look at the business, you find that it’s struggling to grow. Its markets are not growing at all. Unilever is doing slightly better than the markets it operates in, but it’s hard to see how profits will expand any time soon. In 2014, underlying sales grew by 2.9%, while underlying trading profits didn’t grow at all.
This weak growth explains why Unilever has made a big bet on emerging markets, which accounted for 57% in 2014. But growth is slowing there too – sales in China fell by 20%, while a good performance in Latin America was diluted due to currency weakness. There’s no reason to expect these markets to bounce back soon.
If you drill down into the company’s product divisions, only the personal care business (accounting for just under half of profits) grew its underlying profits. The food business remains a big problem. The company has been selling weaker brands but its spreads business (things like Flora margarine) remains weak as consumers cut back. The ice cream brands, such as Ben & Jerry’s and Magnum, are good assets, as are the home-care products, such as Domestos and Cif. But these businesses aren’t big enough to move the Unilever supertanker and there’s lots of competition squeezing selling prices.
(Lack of) growing pains
So how is Unilever going to grow? It has been cutting costs and trying to do more with less. Lower oil prices should lead to consumers having more money in their pockets – but whether they use it to buy more Unilever products is another matter.
Then there’s the issue of the euro. It is getting weaker as the European Central Bank creates money out of fresh air. The good news is that this could help Unilever, because its overseas profits will be worth more in euros. But even so, the company remains quite downbeat. It thinks 2015 profits will be similar to 2014’s – and that depends on business picking up later in the year.
It might just be being cautious or being honest and telling investors how tough it is to grow. This is a shame, because Unilever would be a nice share to own in an individual savings account. But without profit growth, the current price looks too rich.
Unilever (LSE: ULVR)
Share price: 2,854p
Market cap: £80.9bn
Net assets (Dec 2014): £11.08n
Net debt (Dec 2014): £7.7bn
P/e (prospective): 21.3 times
Dividend yield (prospective): 3.3%
EBIT/EV (latest): 6.5%
Interest cover: 14.5 times
Dividend cover: 1.4 times
Target price: 2,715p
P Polman (CEO): 284,000
J Huet (CFO): 91,500
M Treschow (Chair): 15,000