Unilever Indonesia: Caution Is Still Warranted

Summary

• A year ago, I wrote about how Unilever Indonesia was a leading consumer products name, but trading at a then-P/E of 52.66, it was already fairly valued.
• Since then, the stock has gone nowhere, trading just below the level seen in the same period last year.
• I highlight in this article what are the key balance sheet items I am monitoring.

Revisiting The Range-Bound Trading Thesis Of Unilever Indonesia

A year ago, I wrote about how Unilever Indonesia (OTCPK:UNLRF, OTCPK:UNLRY) was a leading consumer products name in the Southeast Asian country which it was based in, but trading at a then-P/E of 52.66, it was already fairly valued (PRO+ article). Furthermore, there are strong international competitors, such as The Procter & Gamble Company (NYSE:PG), Japan's Kao Corporation (OTCPK:KAOCF, OTCPK:KCRPY), UK's Reckitt Benckiser Group (OTCPK:RBGPF, OTCPK:RBGLY) and established local rivals such as PT Wings Surya, which manufactures soaps, detergents and toiletries. I concluded with the following price expectation:

"Hence, I am of the opinion that the optimism towards the company's prospects has been baked in the share price which would likely trade rangebound between IDR45,000 and IDR50,000."

The stock traded on the Indonesia Stock Exchange and was priced at Rp46,800 per share. Fast forward to today, the share price is almost unchanged at Rp46,150 per share. Nimble traders, however, had opportunities to profit from the volatility, as the stock closed as high as Rp55,900 on the last trading day of 2017. Since a year has elapsed, I shall revisit the company's financials and prospects to see if the thesis for a range-bound trading of the stock remains valid.

Profit/Loss Statement Review

Unilever Indonesia's fiscal year follows that of the calendar year. In 2017, the company increased its revenue by 2.9 percent and its net profit by 9.6 percent over the previous year. This is, of course, a remarkable feat except when the stock trades for a P/E above 50x, but it gets worse. For the first quarter of 2018, its revenue fell 0.9 percent year on year (y/y) to IDR 10.74 trillion (US$773 million), while its net profit declined 6.21 percent (y/y).

Payments To Parent Company Accounting For A Larger Proportion Of G&A

In my initiation article on Unilever Indonesia, I delved into the rising expenses due to the service agreements with its parent company, Unilever PLC. The payable items in three areas - Trademark, Technology, and Service fees - are a result of cost-sharing arrangements with the HQ for the use of its branding and formulation, among other intangibles. In the quarter ending March 31, 2018, while the quantum for such payment was relatively stable year on year (lower by less than 1%), as a percentage of the total general and administrative expenses, the figure has risen to 79.5% from 70.8% in the corresponding period the previous year.

Only 15% of the shares are owned by the public, while the remaining 85% is indirectly held by Unilever PLC. Unilever Indonesia also buys certain raw materials from local subsidiaries controlled by Unilever PLC, including PT Unilever Oleochemical Indonesia, which supplies ingredients used in a wide range of products, from food to detergents. As such, it is only reasonable to expect the parent company to extract more value for itself rather than "taking care" of the minority investors. Investors who had ridden the fantastic growth in the early days of the company would have nothing to complain about this arrangement. However, newcomers should start questioning the directors during the Annual General Meetings if such related party payments keep escalating.

Aging Analysis Of Trade Debtors

One of the important balance sheet items to monitor for any company is the aging profile of its trade receivables. This rings true particularly for Unilever Indonesia, as the market it is serving has been experiencing some slowdown. In 2017, the sum of doubtful debts written off was 7.2 times that of the previous year, though the quantum was still insignificant at Rp112 billion (US$8 million). Thus far in 2018, the doubtful debt amount written off was only Rp2.3 billion, which is certainly a good sign for the rest of the year.

Nevertheless, the trade receivables as a whole have continued to balloon despite flat-lined revenue numbers. As at the end of Q1 2018, trade receivables have risen 14.5% over Q4 2017, while year on year it was an increase of 28% over Q1 2017. The amount overdue more than 30 days has fortunately declined around 7% from Q4 2017. This suggests that the company has given its customers more relaxed payment terms, perhaps less insistence on cash on hand. While such move would cause it to tie up more working capital, it might be necessary to encourage the customers to maintain its restocking plans amid a lackluster consumer environment.

A consumer survey conducted by Bank Indonesia and Citi Research revealed that consumption as a percentage of household income was reduced to 68.3 percent in the first half of 2017, from 71.8 percent the same period a year ago. This meant that consumers are likely to be more cost conscious or reduce their purchase amount, and consumer products companies like Unilever would need to be more promotional to push sales. That would inevitably come at the expense of margins. Already, Unilever is squeezed by retailers who are themselves finding their business environment more challenging due to the rise in e-commerce players.

Conclusion

Over the weekend, I set about to understand the narrowing valuation gap between P&G and Unilever (UL, UN). I concluded that P&G appears undervalued when we consider the relative underperformance of its share price against that of Unilever, in spite of facing the same industry headwinds.

I then turn my attention to the Indonesia subsidiary of Unilever to find out if my original thesis is still valid. As Unilever Indonesia is listed, there is a wealth of information to be gleaned from its published reports which provide a more comprehensive understanding into the prospects of the parent company, Unilever PLC/NV. For instance, in my earlier article, I noted how Unilever had benefited from the steady revenue growth in its overseas subsidiaries as well as a steady increase in the royalty payment obligations in the past years. As seen from the latest set of results from Unilever Indonesia, even as its revenue and net profit declined, the payments to related parties remained relatively unchanged. It remains to be seen which of the two companies would extract greater value from the other going forward, though, in my opinion, the parent company might not be able to demand higher payment from its overseas subsidiaries if the latter's slowdown remains unabated.

The macro environment might help Unilever Indonesia get back on its footing. After its extensive reporting on the weak Indonesian spending in 2017, Bloomberg has noted an improvement in household spending. In February, Bloomberg published an article highlighting two major fund managers which boosted their holdings in the Southeast Asian country following the promise of government stimulus. The optimism premised on the probable stimulus and promises for public spending thanks to regional elections due this year, as well as stable electricity prices. Andrew Swan, head of Asian and Global Emerging Market Equities for BlackRock Inc., also believed that "with commodity prices having stayed at a decent level, the wealth effect could assist the consumption recovery.”

Nevertheless, while Unilever Indonesia might be able to ride on the wave of consumption recovery, some caution is warranted, as its P/E remains high at 51x. In addition, Aashna Dodhia, economist at IHS Markit, cautioned in early April: “Input cost inflation intensified to the sharpest since October 2015, predominantly driven by higher raw material costs stemming from currency weakness relative to the US dollar. Amid monetary policy tightening and heightened global uncertainty, the Indonesia rupiah remains vulnerable to capital outflows. Subsequently, business sentiment was at the lowest level since December 2012."

(1 US Dollar equals 13,901.95 Indonesian Rupiah.)

What's your take? Do you think Unilever Indonesia deserves its high P/E ratio? Please freely share your thoughts, let me know if you found this article useful or provide your feedback in the comments section.

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