Patrick Kirts co-wrote this article.
Part of constructing Portfolio Asset Management’s core retirement portfolio includes looking at companies that are going through some type of corporate change that will act as a catalyst for future growth in profitability. We started searching for a staple that could sustain itself though a deep recession and still make a profit. This year has been hard on the staple sector due to the high input prices of oil and food. If a firm can make money in this environment, can it also profit if volumes and input prices decline? We don’t know. So, we have to look at how the company is set up.
We will go through Unilever (UN) in enough detail to understand its management changes, product restructuring, and financial strength. This will lead to clues that can help us decide if there is a high probability of the firm maintaining its market share and profitability. Buying a staple is not just about a flight to safety, it is about consistent generation of cash flow by selling a diversified product line of everyday products. Quality counts, and top tier products with strong brands are worth paying for. Looking for the cheapest company is not the only factor, as the valuations on many top staples are pricy. If we can identify the lowest valuation in the top tier group, we can have a margin of safety on valuation and quality.
Unilever, through its subsidiaries, manufactures and distributes brand-name food, home, and personal health products worldwide to most income levels. Going into (as if we are not in it already) an economic downturn, it stands to maintain its market share due to its line up of top quality, trusted brands. Dove soap, Axe deodorant, Lipton tea, Vaseline and food giant Knorr, all have the necessary large name recognition. When we add in the benefit from structural changes in the company, we see a company leaner and more responsive to market changes.
Let’s start with management. In 2007, Unilever brought in James Lawrence as CFO. Lawrence was formerly with General (GM), a top US staple. This September, Paul Poleman took over as CEO after being passed up as head of Nestle. Prior to this, more importantly, Poleman spent 26 years at archrival Procter & Gamble (PG). Add in three new board members all with international expertise and you have a fresh team to get the company moving. A new Chief R&D Officer, Genevieve Burger, suggests the firm sees delivering innovative products a top priority. Unless you are Coke (KO), you will have brands that get stale. A larger diversified firm with new management has the opportunity to cut out tired brands.
Unilever has maintained sales growth and underlying operating margin improvement despite two major headwinds: First, the incredible increase of input prices from commodity cost increases and second, the softening of consumer volume, particularly in Europe and North America.
Commodity costs increased almost 20% in the first two quarters of 2008, mainly from mineral oil and edible oils. Mineral oil, whose cost is double that of second quarter 2007, is used in plastics and petrochemicals, which go into products and their containers and are used for transport. Edible oils, which are a main component in many food products, seem to have stabilized but at a high absolute level. Unilever is innovating to deal with these costs with new products using less oil or packaging material.
Two examples are brilliant in our opinion. Hellmann’s Light Mayonnaise has less oil, thus higher profit margins. Think about it. You sell a product that is marketed as better for your health, but is really just a way for the corporation to fatten up margins. The same idea is seen in Small and Mighty concentrated detergents. Smaller, less wasteful packaging has the allure of more ‘eco-friendly’ thinking. The real thinking is less transport cost, which includes everything from the boxes the products are shipped in to the weight on the truck or ship. Everything counts in large amounts.
Now down to the numbers. Remember that without volume, no amount of profit will help a consumer staple company. Unilever’s underlying sales growth is around 7%. However, while volume increased 0.8% in the first half of the year, it decreased 0.5% for the second quarter. The continuing causes of this growth illuminate both the effect of decreasing consumer volume, and Unilever’s remedy for it and commodity price increases. Prices were increased 6.1% during the first half of 2008 and 7.4% in the past quarter. We will be interested to see if this increase continues relative to volume in Q3. The company believes that the price increases are sticking, which could cause some earnings tailwind as input prices drop. When oil is down 50% from the peak this year, we expect to see some of that go directly into increased volume and top line profit.
Sales growth is not merely attributed to decisive price action, but restructuring of the business. Strong growth in developing and emerging markets (D&E) has balanced North America and Western Europe. Sales growth and volume for Asia Africa division were up 14.7% and 5.7% respectively. China, Indonesia, Turkey, and South Africa performed well and Latin America grew at 11% this year. Even Russia and Central Europe were all in the double digits. Compare that with Western European growth at 1.3% and a decline in volume by 2.5%. US grew at 4%, but it was entirely driven by price action. While we should be concerned that the declines will spread to D&E countries, Unilever is better positioned to do business in those markets than competitors. Let us get a big picture overview of why this could be.
The recent restructuring of the business, or ‘transformation’ as management likes to call it, has made Unilever more responsive to changing economic circumstances. Total employees have been cut over the past five years, most significantly in Asia Africa, from 234,000 in 2003 to 174,000 in 2007. This corresponds with divestiture of companies with limited growth potential, notably Bourse and Lawry’s, and the olive-oil business of Bertolli (the company kept the food part of Bertolli, a big winner in North America). Twenty-three factory closures have been announced or completed, and 28 more streamlined.
Management claims that over 75% of the disposal program has been completed. Structural changes means that now, only one central management oversees and co-ordinates operations in each country. This allows for regional scale, increased communication, and cost savings for HR, IT, and finance. Keep in mind this ‘transformation’ started prior to the recent rise in commodity prices. Our take is that Unilever got lucky with its timing on restructuring. It is always better to be lucky than smart on Wall Street.
With a strong dividend of over 5% and a decent balance sheet, we don’t fret about excessive leverage or dicey credit lines. What would cause us to reevaluate would be the inability of the firm to pass on input increases or seeing dramatic volume decline, which are essentially different sides of the same coin. The bottom line is we are long Unilever. While we may trade around our core position, we want a claim of earnings going forward into a difficult market.
Lastly, Unilever bores Wall Street: the Q2 webcast showed analysts practically falling asleep. This large, diversified firm with fresh management sells staples around the world and has double the dividend of Procter & Gamble with a cheaper valuation. It’s a better idea than hiding your money in treasuries with paltry yields.
*For those who didn’t get the title, Cherry Garcia is a popular ice cream flavor by Ben & Jerry’s, a subsidiary of Unilever.
Full disclosure: Portfolio, LLC is long UN at the time of this writing.