For a long time, there have been question marks about Unilever\u2019s (ULVR) ability to grow margins. The consumer staples conglomerate has strong brands in personal health and food products, but in recent years that moat has looked to be draining as supermarkets, discounters and online retailers improve the quality and perception of own label products.<\/p>\n
In our dividend portfolio, the role of Unilever is rather like Saturday night television: not too exciting, you could be doing something better but it\u2019s never worrying or controversial. When we launched the portfolio, I included the company for its steady cash flows which supported estimates for annualised yield of 3.5 per cent.<\/p>\n
Ironically, given the stock was picked for being \u201clow vol\u201d, its corporate activity has been frantic and had analysts poring over fresh projections.<\/p>\n
That\u2019s because in pursuit of growth, the business has made some big strategic decisions. The first was already known to us when we added Unilever: the profitable but volatile Magnum ice cream business was being spun-out, to be listed in the Netherlands. The new business\u2019 valuation was at the more modest end of expectations, which wasn\u2019t great for Unilever which still owns 19.9 per cent of its equity.<\/p>\n
That level is just below the threshold for reporting \u201csignificant influence\u201d under IFRS accounting standards, which would require Unilever\u2019s share of Magnum to be consolidated in its financial statements if it was 20 per cent. That would have defeated the point of spinning it out as Unilever\u2019s goal was to achieve less volatile earnings per share and run a tighter ship in terms of its working capital requirements.<\/p>\n
As it stands, Unilever is instead keen to sell down its stake as the Magnum business becomes more profitable, with it being likely that the investment will be reported at fair value through other comprehensive income in future reporting. That would enable it to record just future dividends from Magnum on the income statement. Unrealised price gains or losses on the shareholding would go straight to other comprehensive income, removing a source of volatility in Unilever\u2019s own earnings per share.<\/p>\n
Unilever\u2019s food fight<\/p>\n
While Unilever may yet sell down its Magnum stake at a higher price, giving cash flow statements a few nice boosts and the balance sheet a sleeker feel, its most recent moves to lessen focus on food have riled the market<\/a>. The deal announced with McCormick (US:MKC) would combine Unilever\u2019s food business (which the deal values at $45bn) with the American sauce maker\u2019s portfolio to create a $66bn entity.<\/p>\n It\u2019s a complex deal structure known as a Reverse Morris Trust (RMT), whereby there is a \u201cUnilever side\u201d which splits the 65 per cent contribution of Unilever Foods to the new entity\u2019s value between Unilever plc and Unilever shareholders, rather than treating them as one. In effect, Unilever is becoming smaller with a chunk of its investors\u2019 equity in the erstwhile Unilever Foods business being transferred to the new McCormick managed entity.<\/p>\n Under the proposals, 55.1 per cent of the new company\u2019s equity would be issued direct to Unilever\u2019s shareholders. Importantly, Unilever plc will only own 9.9 per cent, a stake size which keeps it well below having \u2018significant influence\u2019 for IFRS purposes. It is also designed to stay below tax thresholds in Europe and prevent the company in effect being double taxed on dividends it receives from the new business.<\/p>\n In addition to its 9.9 per cent, Unilever plc will get $15.7bn in cash, which should give it some firepower to pursue a growth strategy based on premiumisation in the personal care goods market. That sounds good, so why has the market feedback been somewhat unenthusiastic?<\/p>\n For starters, there is no getting around the fact Unilever will be diminished in terms of size and furthermore, it is giving up control of the division with the highest operating profit margin. Analysts told<\/a> Investors\u2019 Chronicle\u2019s Erin Withey that the premium for the spin-off still looked a little thin, which makes the deal seem less attractive.<\/p>\n Unilever chief executive Fernando Fernandez can counter that the company will still earn dividends from the new expanded food entity, which will benefit from cost synergies (Unilever predicts these will be c.$600mn a year) to help drive earnings growth. That does, however, rely on McCormick\u2019s management delivering.<\/p>\n Perhaps more importantly, there is a key exclusion from the deal in that Unilever is keeping hold of its India foods business. This region has seen the strongest food revenue growth and keeps the contribution from popular brands owned by Unilever Hindustan firmly in the mix for Unilever plc profits.<\/p>\n Will a leaner Unilever still deliver for an income portfolio?<\/p>\n No-one can accuse Fernandez of not being bold enough. The foods spin-off will allow for a sharper focus on the faster growing home care, personal care and beauty divisions. Although the company anticipates \u20ac400-500mn of stranded costs as a result of separating the developed markets foods business, it is hoped greater efficiency in group working capital will help underlying organic profitability.<\/p>\n What\u2019s more, the plc will use its cash proceeds from the McCormick deal to off-set costs, pay down debt and maintain leverage to its current level of net debt – roughly twice Ebitda (earnings before interest, tax, depreciation and amortisation).\u00a0 The board is still confident enough to propose spending \u20ac6bn on buying back shares over the next three years.<\/p>\n Capital plans going forward involve earmarking around \u20ac1.5bn per year for bolt-on acquisitions. For our portfolio\u2019s income mandate, the target to payout 60 per cent of earnings is a key detail.<\/p>\n When deciding if we should keep Unilever in the portfolio that\u2019s a good start, although the growth strategy is not without risk. In no small part it depends on identifying good acquisitions, not over-paying for them and then managing all the challenges of integration. When Phil Oakley took a look at Unilever for Alpha (before the big McCormick news), he highlighted some very encouraging success<\/a> in the 2020s so far, in hydration and hair loss markets.\u00a0\u00a0<\/p>\n With a riskier growth model, the low volatility reason we had for picking Unilever to balance our portfolio isn\u2019t the same. Although, consumer staples is still a nice sector to have represented. Growth was always the nagging doubt where Unilever was concerned so the intent is welcome, albeit the analysts\u2019 points about adequate risk premiums are always valid.<\/p>\n To that end, as I like the thinking underpinning Unilever\u2019s push for growth, I\u2019ll take some time to reserve judgement. In part Unilever\u2019s share price fall is a simple fact of a proposal which shifts billions of dollars of the value of ordinary shareholders\u2019 equity to a new entity. Whether the earnings power going forward warrant Unilever\u2019s continued inclusion ahead of a different stock will depend on how well personal care brands can hold demand amid a recessionary shock or an economic contraction.<\/p>\n That sort of uncertainty demands a wider risk premium, but the market has already given the stock a steep ratings downgrade (it now trades on 15 times next twelve months\u2019 earnings compared to almost 20 times before the announcement). Of course, we can\u2019t forget the world is on fire, too, but the rationale to Unilever\u2019s strategy is sound: although we\u2019re experiencing short-term volatility for now, there are grounds to keep backing it in our income portfolio.<\/p>\n","protected":false},"excerpt":{"rendered":"For a long time, there have been question marks about Unilever\u2019s (ULVR) ability to grow margins. 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