Unilever: Even With Transformation, Weaknesses Still Exist in Product, Pricing and Earnings Arenas

Includes: GPDNF, NSRGY, PG, UL
by: Véronique Adam

Stock price: €21.3 ($26.99 USD)
Conclusion: Notwithstanting the transformation taking place, we feel that Unilever (NYSE:UL) might continue to trade at a discount vs peers, owing to some weaknesses in its product portfolio, lack of pricing power and lower earnings visibility than peers.

H1 Results: Sales up 9.7% (+3.8% organic) to €21.9bn. EBIT margin up 30bp-Net earnings +36%- EPS up 36%. Guidance 2010: volume growth, strong cash flow along with steady improvement in operating margin.

Unilever’s top line (+3.8%) lags behind peers
Sales grew at a much slower pace than Nestle (OTCPK:NSRGY) ( up 5.7%) or Danone (OTCQX:GPDNF) (up 7%) despite outstanding expansion in the personal care division, up 7.9% in H1, combined with a higher innovation rate.

  • Unilever suffers from a structurally weak portfolio in food. Ice cream and tea are doing well but the bulk of the business , savoury, dressing and spreads remained flat in H1. Savoury (Knorr) performed well but spreads continue to decline and Unilever struggles to convince butter users to switch to margarine. Mayonnaise keeps suffering from negative health perceptions.
  • Home care sales (+2.4% in H1) where impacted by strong competition in liquid laundry where P&G (NYSE:PG) is buying volumes.
  • Personal care, once again had a stellar performance (+8%), driven by Unilever’s leadership in deodorants and good momentum in skin cleansing. However, the division accounts for only 30% of sales today and Unilever is still underrepresented in certain categories, like hair care and skin care.

Lack of Earnings visibility
Management reconfirmed 2010 outlook, notably steady improvement in operating margin. Nevertheless, this will be hard to achieve given low pricing power coupled with higher input costs and weak sales in Western Europe.

  • Low pricing power at a time when input costs are rising. Pricing was down 2.6% in H1 and 2% in Q2 with all regions posting a decline. Unfortunatly, Unilever does not disclose pricing and volume by categories which would be really useful to understand the business. Management looks for a return to positive pricing by the end of the year, which should be a challenge in markets, such as Western Europe, where both pricing and volume were negative in Q2.
  • Less savings in H2. Management forecasts €300-400m savings in H2 vs €700m in H1 (180-200bp difference).
  • Restructuring will, again, alter earnings quality. Restructuring charges should account for a similar proportion of sales in H2, around 120bp (€530-550m for the full year). Management warned that the integration of Sara Lee business will require further spending and prevent the group from returning to a more normal level of charges next year.
  • Therefore, advertising and promotions is the only variable likely to move. Unilever indicated that expenditure will be flat in absolute terms in H2, implying a sharp decrease as a percentage to sales. We understand that this should help to meet guidance but wonder about the timing when markets become increasingly competitive.

Unilever trades at 13.5xP/E and 8.5xEV/EBITDA based on our F11 estimates, which implies a slight discount to peers. Our DCF points to a higher value of around €23-€24 per share. Nevertheless, a re-rating seems unlikely in the short term.