Unilever Is An Inflation Beneficiary

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The Q1 results and associated updates and guidance from Unilever PLC’s (OTCPK:UNLYF) management have been reassuring. Investors responded rationally by lifting the stock price by 5% in the two weeks after the results were published on the 28th of April. Unilever has ticked all the right boxes, and the saga about the botched acquisition attempt for GlaxoSmithKline’s consumer healthcare division seems now to be distant memory. Sales were lifted by almost 12%, mainly due to price increases, while the good news is that volumes were not adversely affected and decreased by a meagre 1%. (Results, presentations and webcasts)

In the Q1 updates, Unilever noted that input cost inflation is expected to be worse in the second half of the year than in the first half – a total of EUR 3.8 billion in the full year is expected. The provision of this estimate provides assurance to investors that a reputable group such as Unilever should be rightly on top of things. Management have been clear that cost will be passed on to consumers. Volumes would be affected, but given that much of Unilever’s portfolio could be considered less discretionary, cheap products, the negative impact on volume is not likely to be 1-1. Consumers can eat less ice cream but they are unlikely to use less toothpaste, deodorants and soap.

The re-opening following the COVID-19 lockdowns came timely; people are unlikely to lock themselves up just because of inflation. Rationing of consumption is more likely to hit higher price tag items such as electronic equipment, furniture and cars than to hit detergents, hygiene and food items. This was clear in Q1 results. As a result, the company’s expectation of underlying sales growth close to 6.5% seems realistic, so is the expectation that underlying operating margin should be in the previously estimated 16-17% range for the first half as well as for the full financial year.

A look at Unilever’s main inputs

Unilever has done a good job highlighting the inflation in its input costs in the Q1 analysis. Out of EUR 17 billion of input costs in 2021, 15% was spent on palm products – used in anything from cosmetics to detergents to ice cream. Although palm oil jumped by a third and palm kernel by a tenth since the Ukraine war started, the removal of the ban on exports of Indonesian palm oil on the 18th of May should help cap the rising prices. Palm oil prices are already off by 13% from their highs three weeks ago.

Other agricultural products represented 26% of input costs – the price of this basket did not jump as significantly, with the exception of soybean oil which jumped, similarly to palm oil, by more than a third, and wheat, which almost doubled in price. Prices of sugar, cocoa, and other “less essential” and non-Ukraine correlated agricultural commodities remained subdued. Crude oil increased by a third, natural gas doubled in Europe, while other hard commodities increased by lower percentages.

While it is likely that staple agricultural commodities affected by the Ukraine war will remain elevated in price this year (and maybe beyond), it is unlikely that prices of hard commodity will. A squeeze on consumer and government budgets caused by inflation and higher interest rates will definitely lead to a slowdown in economic activity which will have to slowdown demand on hard commodities. As such, Unilever’s forecast for inflated input costs throughout this year might be well-estimated and should be controllable and manageable.

Valuation is compelling

Unilever’s share price has not been this low since January 2017, and is a third off the record high of GBP 52.5 per share, set in August 2019. Net income and operating cashflows, in the meanwhile, have grown by a third since 2017 – so the share price and financial results have been going in opposite directions. This resulted in a compelling valuation of 17 times P/E and 10 times market cap to operating cashflow. Compare this to a P/E of 25 times and market to operating cash flow of 19x for Procter & Gamble (PG), and it is clear that Unilever is trading at a steep discount.

There are good reasons for the discount, since Procter & Gamble’s product portfolio is stronger and more monopolistic in some categories. In addition, P&G’s exposure to the U.S. market is much larger than Unilever’s, and P&G’s exposure to emerging markets is much smaller. Nevertheless, a discount that large in Unilever’s valuation is compelling and provides an attractive entry.

Risks manageable

As noted in the previous paragraph; Unilever has a large exposure to emerging markets. Approximately 60% of revenues are generated from emerging markets. While this gives a push to faster growth in sales volumes, the underlying risks of more economic and political volatility, coupled with the general weakness of emerging markets currencies, all represent risks to Unilever’s outlook.

Also, as mentioned, Unilever’s product portfolio generally lacks the monopolistic or market dominance features that products of Procter & Gamble have. This subjects Unilever to lower customer loyalty, and the risk that consumers can switch products to lower cost alternatives, especially in the current inflationary environment.

The inflation in input costs is another key point that has been addressed. And, although Unilever was clear about passing on costs to consumers, the extent this will have on volumes is still a big unknown.

Is inflation categorically bad for business?

Inflation is not all bad for business – for many businesses, it is actually great. In addition to helping lift sales revenues faster, companies can clinch on additional profit margins in the process of raising prices, especially if they can manage cost efficiently. And one of the great benefits is that businesses that can inflate their balance sheet do deflate their leverage in parallel. A billion dollars in debt remains a billion dollars, while inflated operating cashflows can be used as a great opportunity to reduce leverage.

Unilever is in this position. Unilever already enjoys a stellar A+ credit rating from Standard and Poor’s, and luckily the attempted acquisition of the healthcare business of GlaxoSmithKline (GSK) fell through at the right time, otherwise Unilever would have increased leverage significantly at a less than optimal economic turning point. The credit standing, and in turn free cash flow to shareholders, can only improve with inflated revenues and cash flows.

Aside from regulated utilities that link their pricing to inflation, Unilever can be one of the best investments in inflationary times. Dividends currently yield more than 4%, and dividends per share have been increasing every year in recent history. In total, the company paid more than GBP 21 billion in dividends in the past 5 years and spent more than GBP 15 billion to purchase treasury shares during the same period. Add to that: Unilever’s main listing is in London, so for UK-based investors, the company can be a good hedge also against the fall of the British Pound, given that most revenues are non-GBP denominated. With all these factors in place, it is safe to conclude that Unilever is a safe investment in the current inflationary world.

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