Following our look at Microsoft (MSFT:NASDAQ), this is the second instalment in the Shares mini-series aimed at arming readers with an easy-to-use five step framework which can be applied to most popular types of company.

Hopefully the structure we’ve provided will allow you to quickly assess if a stock looks right for you, with built-in rest-stops at each stage where you can decide to hop off for a deeper dive or carry on learning.

ANALYSING UNILEVER

In this instalment, we are going to look at Unilever (ULVR), one of the world’s largest consumer goods companies and one whose shares are widely owned, to decide whether it makes a good investment today.

Hopefully, you will come away from this feature with a deeper understanding of what drives the consumer giant’s performance and a fair chance of sizing up whether that will continue in the future.

STEP 1: ANALYSING SALES GROWTH

Let’s start by looking at revenue growth over the last decade. The first thing to note about Unilever is it isn’t a single business, it is a collection of five separate units each serving different consumer markets: home care, personal care, beauty and wellbeing, nutrition and ice cream.

The table overleaf shows how Unilever’s sales have grown over the last decade... 

A second point to make is that the group has changed a lot over the last decade as businesses have been bought and sold, and the rate of inflation – which dictates how much the firm can raise prices – has also changed over the last decade, especially in the last two years.

Pricing power is crucial for a company like Unilever because sales growth factors in the volume of sales for each product line and the average selling price.

As a rule of thumb, the more a company raises its prices the bigger the negative effect on volumes as customers look for alternatives – only firms with strong brands can raise prices without hurting unit sales.

Another important factor for Unilever is the performance of the euro, the firm’s chosen reporting currency, against other major currencies, in particular the dollar as the firm has a large exposure to both the US and emerging markets, where local currencies are often pegged to the greenback.

As the chart shows, in aggregate Unilever’s sales were barely changed from 2013 to 2019, then they dropped due to the pandemic, although it could be argued volume growth held up reasonably well in 2020 and 2021.

The step change came last year when the firm ratcheted prices up by over 11% to cover rising input costs, sending sales up over 14% to more than €60 billion.

Even including this outstanding result, however, we calculate Unilever has only grown its sales at an average annual rate of 2% over the last decade which is disappointing given its portfolio includes 14 ‘billion-euro’ brands.

The company has faced criticism over its sprawling structure from major shareholders including Fundsmith Equity (B41YBW7) and US manager AllianceBernstein, which called for a ‘root and branch’ restructuring, and just over a year ago US activist Nelson Peltz – who has previously targeted Unilever’s rival Procter & Gamble (PG:NYSE) and food group Kraft Heinz (KHC:NASDAQ) – joined the board after taking a stake in order to ‘help drive strategy, operations and shareholder value for the benefit of all stakeholders’.

Jefferies analyst Martin Deboo has suggested ‘the right path to unlock value at Unilever’ is via disposals from its slow-growing foods business or a complete separation of the unit through a sale or spin-off, but for now the company is resisting.

STEP 2: HOW PROFITABLE ARE SALES?

Given how slowly Unilever tends to grow its revenue – and assuming it doesn’t repeat 2022’s double-digit growth rate this year – the next question is how much profit does it make on each euro of sales?

If the company can expand its margins, then maybe a pedestrian top-line performance is acceptable – after all, if profits are rising faster than sales it must be doing something right?

Here, the picture is more encouraging with Unilever becoming increasingly profitable both on an absolute basis and in terms of operating profits as a percentage of sales over the last decade, although the pandemic has clearly taken a toll.

As with sales, margins in both absolute and percentage terms were on a rising path until the pandemic and even then, they held up relatively well.

However, rampant cost inflation in 2022 saw the operating margin drop back below its average despite the firm raising prices by over 11%.

The key questions for this year and next year are as follows:

– Will input costs increase at a slower pace?

– Will Unilever be able to keep its prices where they are without suffering further falls in volume?

If the answer to both is yes then margins could rebound strongly.

STEP 3: HOW MUCH PROFIT CONVERTS INTO CASH?

A key ratio many analysts use when looking at companies is cash flow conversion, which measures how effectively a business turns sales into cash.

There is an old saying that cash is fact, everything else is a matter of opinion, and there have been numerous cases of companies with seemingly strong profits getting into serious difficulty because they didn’t turn enough of their sales into cash.

By measuring how much cash Unilever generates after working capital outflows for operations and maintenance spending compared to its stated net profits, we can get an idea of the underlying liquidity of the business.

With a couple of exceptions, over the last decade Unilever has managed to generate cash equivalent to around 80% to 90% of its net profits and has topped 100% of net profits on occasion.

The good news for investors is that maintenance capital expenditure at Unilever is quite low compared with an industrial company, for example, which has to continually invest in plant and equipment to stay competitive. Although as a maker of fast-moving consumer-goods, advertising is a major cost for Unilever if its brands are to stay relevant and at least maintain their market share.

If, as seems likely, input cost inflation slows or even turns negative during the course of 2023 and 2024, then free cash flow as a ratio of net profits should rise sharply in line with the operating margin.

STEP 4: ALLOCATION OF CAPITAL

Having looked at how much cash the firm generates, what does it do with it?

Capital allocation is a huge bugbear for Unilever’s critics, who complain the firm frequently invests in businesses which add little to no value and should instead return surplus cash to shareholders.

The acquisition of start-up Dollar Shave Club in 2016 is a case in point – Unilever paid $1 billion for the ‘disruptor’, or five times that year’s expected sales, more on the strength of its connection with millennial male customers than the quality of its product offering or its capital returns.

In its fourth-quarter results last year, Unilever admitted that while it was ‘marginally profitable’, Dollar Shave Club’s sales had ‘continued to decline in a fiercely competitive market’ and the business had not lived up to expectations, resulting in a large write-down.

Another good example – in this case a near-miss – was the company’s failed £50 billion bid in early 2022 for GSK (GSK) and Pfizer’s (PFE:NYSE) jointly-owned consumer health unit now known as Haleon (HLN), a deal described by Fundsmith Equity (B41YBW7) founder and manager Terry Smith as a ‘near-death experience’.

Smith insists the companies he invests in should allocate ‘his’ capital to projects which will generate the highest return, and he measures a management team’s ability to add value by looking at the return on capital employed, also known as ROCE.

On this count, Unilever could do much better – we found the last five years’ worth of return on capital employed on Morningstar’s website, and scanning through earlier annual reports there is not even a mention of return on capital.

The company prefers to look at return on assets which ‘provides additional insight on the performance of the categories and assists in formulating long-term strategies with respect to allocation of capital,’ according to the company.

For our part, we would suggest the firm publishes its ROCE in future as for many investors – actual and potential – it is a crucial benchmark.

STEP 5: VALUATION AND INVESTMENT CASE

Judging by the sideways performance of its shares this year, the jury would seem to be out on whether Unilever is a buy or not.

On a 12-month forward price to earnings metric, the stock trades at 18.4-times which is towards the low end of its range over the last decade, while on a ratio of EV (enterprise value) to EBITDA (earnings before interest, taxes, depreciation and amortisation), which includes debt as well as equity in the calculation, it trades on just over 12-times which again is at the low end of its historic range.

As to the investment case, we can certainly envisage a scenario where, if input costs fall – or at least rise at a much slower pace than they have over the past year – and the firm can make its price rises stick then margins, cash flow and earnings should all rebound even without a big increase in sales volumes.

Unilever said in first-half results on 25 July that it had absorbed most of the increase in input costs. It commented: ‘Our expectation for net material inflation for 2023 is around €2 billion of which €0.4 billion is anticipated in the second half. We continue to expect a modest improvement in underlying operating margin for the full year, reflecting higher gross margin and increased investment behind our brands.’

Meanwhile, the arrival of a renowned activist on the board and the oversight of big institutional investors might at last stop the firm spending its increased cash flow on acquisitions of dubious worth and encourage it to think instead about ways of improving shareholder returns.

When you weigh up the different factors, we rate the shares as a ‘buy’.

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