It took an approach from Kraft Heinz to spark management into life, but the results of Unilever’s (ULVR) strategic review suggest that the company has finally grasped the competitive challenges it faces. We welcome the overdue measures to leverage its wide economic moat and extract more cash from the business, and we think the new financial targets are, for the most part, achievable.
It will initiate a €5 billion share-repurchase programme and raise the annual dividend by 12% this year
When Unilever announced that it was to undergo a strategic review in response to the acquisition attempt by Kraft Heinz, we said in a note on February 22 that we would like to see three outcomes: 1) an acceleration in cost-reduction initiatives; 2) asset sales, particularly of the spreads business; and 3) increased shareholder returns. Unilever has delivered all three.
The most significant aspect of the review, in our opinion, is the new 2020 operating margin target of 20%, up from 15% in 2016. If achieved, this would go a long way to closing the profitability gap to Unilever’s best-in-class peers such as Reckitt Benckiser and Kraft Heinz, whose margins are in the mid-20% range. Management has also committed to achieving 100% cash conversion over the same time frame.
The second significant development is the intended disposal of the spreads business. This was the minimum course of action management could take, in our opinion, to satisfy investors’ expectations for portfolio optimisation. The business is strongly cash-generative, but has been declining at a mid-single-digit rate. We value the assets at around €6 billion, and think Kraft Heinz and private equity players will likely show interest. Although this asset sale falls well short of a broader exit from food, we think more of Unilever’s food assets may ultimately be sold, particularly if the acquirer is a strategic one.
In aggregate, the commitments undertaken in Unilever’s strategic review will generate a war chest with which management can face up to the challenge of growing competition. We anticipate several uses of this incremental capital. In the near term, management has stated that it will initiate a €5 billion share-repurchase programme and raise the annual dividend by 12% this year. We regard this as a sweetener to shareholders for the rebuttal of the Kraft Heinz offer, which valued Unilever at a 26% premium to the then-market price. In the longer term, however, a significant portion of the additional cash will likely be used to generate growth.
Difficult Times Ahead
It is an uncomfortable fact, even for the largest consumer staples manufacturers with wide economic moats, that a fragmenting global consumer base and the emergence of the hard-discounter and e-commerce channels are increasing competition. Pricing, which has already faded significantly from its low- to mid-single-digit rate a decade ago, is likely to remain weak as loyalty to the big brands fades. At the same time, customer acquisition costs, primarily through new product development and advertising, seem likely to rise over time, as new business-to-consumer models allow barriers to entry fall and niche competitors to emerge.
In this perfect storm of unfavourable changes in both the consumer and retail landscape, growth is likely to come at the expense of margins, unless manufacturers adopt a similar approach to that upon which Unilever is now embarking, and focus on lowering their cost structure in order to meet the rising ongoing customer acquisition costs.
By taking this course of action, Unilever is leveraging its wide economic moat. The key source of Unilever’s economic moat is its entrenchment in the supply chain, which comes from its scale and its position as leader or number two in many of its categories. It is this scale that allows a large-cap manufacturer such as Unilever to find economies and compete on price, a strategic option not usually open to smaller players. Management guided that two thirds of the annual cost savings, which are likely to amount to a cumulative amount of €6 billion by 2019, will be reallocated to fuel growth, and we think this is a reasonable assumption.
Could M&A Be on the Agenda?
Another long-term use of the savings is likely to be for acquisitions. The recent acquisitions of Seventh Generation and Dollar Shave Club highlight the ongoing fragmentation in both consumer tastes and selling channels that Unilever is facing. We expect future acquisition strategies to be focused on building out the company’s premium portfolio – we approve of the move into prestige beauty, for example, because we believe pricing power is stronger in prestige than it is in mainstream cosmetics – and on expanding the direct-to-consumer platform that Dollar Shave Club provides.
On the whole, we regard Unilever’s announcement as being positive to shareholders because the measures taken are likely to improve returns and set the company on the right path to grow in an increasingly competitive environment. However, the strategy was forced onto management by an acquisition approach that brought into focus the higher expectations around financial performance that now prevail in the consumer staples industry. We think the ripple effect of the impact of 3G will be felt far beyond Unilever. Across the food and home and personal care space, the large-cap multinationals all have work to do to trim costs in order to stimulate growth.
