Following 2015 results, Morningstar equity analysts are raising the fair value estimate for Unilever to £31 from £29 to account for the depreciation in sterling against the euro since our last update. Unilever's scale and scope give it competitive advantages, and with 58% of sales generated in emerging markets, the firm offers substantial exposure to growth markets.
Competition in Unilever's core markets is likely to be intense
However, although we view the shift in emphasis to personal care from packaged food as a net positive, Unilever will probably have limited success in expanding its volume and margins simultaneously, given the highly competitive nature of its categories.
Management's stated objective is to achieve organic sales growth, driven by volume, at an above-market rate; we view this as an appropriate strategy that is likely to consolidate the firm's moat over time. As retail is a low-margin, volume-driven business, this should help cement Unilever's place as a primary vendor that is entrenched in its customers' supply chains globally.
The company should benefit from tailwinds from the structural shift to faster-growing personal care from food, the potential disposal of the developed-markets spreads business, geographic white space opportunities and premiumisation in laundry and beauty care; these tailwinds should help Unilever achieve volume-driven organic growth. However, a more-focused Procter & Gamble is also pursuing volume growth, as are others, and competition in Unilever's core markets is likely to continue to be intense.
It is this intense competition that makes us somewhat sceptical on Unilever's margin opportunity. After several years of optimising the cost structure and achieving mid-single-digit emerging-markets volume growth, Unilever's mid-cycle earnings before tax margin has barely improved, rising around 100 basis points to 15%. This is at the low end in the HPC group and well below firms in other staples categories. It is indicative of the categories' competitiveness that cost savings rarely flow through to the bottom line, with neither Unilever nor P&G consistently achieving their volume targets.
For the past two years, Unilever has spent 17% of its revenue on marketing and research and development costs; we suspect this expenditure will act as a cap to margin expansion, since over time, the highly competitive operating environment and commodification of brands may drive these expenditures higher still.
