For years investors have turned to consumer goods giant Unilever (LSE: ULVR) as a safe haven investment. However, over the past five years the FTSE 100 stock has returned just 1.5% a year (including dividends) compared to 4.2% for the FTSE All-Share.
For many shareholders, including myself, this has been a particularly painful experience. The company has failed to make the most of its competitive advantages and the market has punished the stock as a result.
It earned a return on assets of 8.4% last year, compared to 11.9% for Procter & Gamble (NYSE: PG), 10.6% for L’Oréal (Paris: OR), 11.7% for Johnson & Johnson (NYSE: JNJ) and 12.8% for Nestlé (Zurich: NESN).
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It also has more debt. Unilever’s net debt to earnings before interest, tax, depreciation and amortisation (EBITDA) ratio at the end of 2021 was 2.2 compared to the peer group average of 0.85.
Unilever’s focus on financial engineering could be holding back growth
The company is facing criticism for not spending enough to reach new consumers while relying on financial engineering to boost shareholder returns. The numbers certainly seem to back this view.
Unilever’s capital spending has averaged just 2.6% of sales in the past decade, compared to the industry average of 4.3%. Yet since 2014 it has spent £15bn on share repurchases.
Revenue has grown at a compound annual rate of 1.1% over the past decade, although that’s still faster than that of P&G and Nestlé.
Management has been forced to rethink the company’s strategy after Unilever’s disastrous attempt to acquire GlaxoSmithKline’s consumer healthcare arm earlier this year. The group is now focusing on growing its presence organically and with smaller deals in key target markets, such as beauty.
A new strategy based around organic growth and investment in e-commerce
Unilever Prestige, the beauty division, is the fastest growing part of the group. Management wants the division to achieve sales of €3bn within a few years, up from €700m in 2020.
All of its sales channels recorded double-digit sales growth last year, eclipsing the wider group’s relatively pedestrian sales growth of 4.5%. High-end beauty brands lend themselves to e-commerce retail where direct-to-consumer sales have been a priority for some time.
More than half of beauty sales are already booked through online channels, but this figure looks set to grow as Unilver invests €7bn across the group over the next couple of years to boost its visibility on and offline.
Unilever’s e-commerce sales grew 44% overall last year and now account for roughly 14% of group turnover.
For all of the company’s issues, it still has some desirable qualities. It remains a leader in a broad range of fast-moving consumer goods (FMCG) categories, which continue to command valuable shelf space in shops. It is divesting slow-growth, lower margin divisions (such as its tea business) and investing more in high-margin product categories such as beauty brands. And the corporation has a vast presence in emerging markets.
Price rises are helping the business deal with inflation
It also seems as if the FTSE 100 company is coping well with the current economic environment.
Unilever’s underlying sales grew 7.3% in the first quarter of 2022. Price increases boosted sales by 8.3%, while declining volumes detracted -1%. The company is raising prices to try and deal with rising input costs in its supply chain, but this is clearly deterring some customers.
However, this trend is not universal. Unilever’s priority markets are the US, India and China. All of these regions saw strong growth from both price and volume in the quarter.
Underlying sales growth in North America was 8.5%, with 6.6% from price and 1.8% from volume. Sales in Africa, the Middle East and Asia jumped 9.1% with 8.5% from price and 0.5% from volume.
Europe was the notable outlier. Sales in the region grew just 0.7% as price rises of 5.4% offset a volume decline of 4.4%. Europe accounted for just under 20% of group sales for the period.
These figures indicate that the strength of Unilever’s brands are helping the business navigate the current economic climate.
But there is no denying Unilever will feel the heat this year. It expects input cost inflation of around €2.1bn in the first half and €2.7bn in the second. This is significantly higher than the €2bn projected at the start of the year. Its operating margin is expected to take a hit as a result, coming in at the lower end of the previously guided 16% to 17%.
Management believes the business will be able to rebuild its margin in 2023 and 2024 to the previously targeted 20%, although that really depends on what the future looks like for the global economy.
A global footprint is Unilever’s real competitive advantage
Unilever has made some strategic errors in the past, but the qualities that have helped it stand out in the past still exist; more than a third of the world’s population uses its products every day in 190 countries around the world.
More importantly, Unilever has a distribution network that can meet this demand, particularly in emerging markets. As its first-quarter figures show, these markets are still growing rapidly and seem to be absorbing the price increases the company is pushing through to deal with increasing commodity prices.
The big question is, how much longer will this continue? Uncertainty is the name of the game here. As CEO Alan Jope said on the first quarter conference call, this is “uncharted territory” for prices and volumes.
So there are two sides to the story here. On the one hand, Unilever has made some errors, but its competitive advantages seem to be helping keep its head above water; on the other hand, it is facing unprecedented margin pressure, which could get worse, only piling the pressure on management.
Investors need to consider how much they are willing to pay for the stock considering these issues. According to FactSet, analysts are projecting earnings per share of 173p for 2022, that puts the shares on a forward price-to-earnings (p/e) multiple of around 20.6, in line with its five-year average. The shares also yield 4%.
Even after weighing up its challenges, as a long-term holder, I’m not willing to give up on Unilever just yet. Yes, it has made some errors, but I think there are few businesses that offer the same mix of valuable brands, distribution and global scale. These qualities make up for the firm’s past errors and may help Unilever return to growth in the long-run.
Disclosure: Rupert Hargreaves owns shares in Unilever.
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