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While difficult global economic conditions are still weighing on consumer goods firm Unilever, third-quarter results support our thesis that the firm's expansive scale and strong brand portfolio should enable cash flows to hold up even in challenging times. Our fair value estimates of 1,719p for the PLC shares and EUR 20 for the NV shares remain in place.

Third-quarter sales fell 2% year over year, but increased 3.4% excluding unfavourable foreign currency movements, driven by higher volume (3.6%). It appears to us that Unilever's strategy of actively managing pricing is working. For example, although Western Europe remains weak (as underlying sales grew a mere 0.2%), Unilever reduced aggregate product pricing in the region by more than 2%, driven in part by moderating input costs, to ensure that its products remain competitive with other branded and private-label offerings. As a result, volume increased 2.2%. In our opinion, this is an appropriate strategy in such a weak economic environment.

Efforts to reduce manufacturing complexity, eliminate low-margin stock-keeping units, and reduce the employee base led to increased profitability, as the adjusted operating margin expanded 70 basis points to 16.8%. Further, we were impressed by the firm's cash-flow generation through the first nine months of the year (EUR 4.8 billion, or 16% of sales), which primarily resulted from improvements in working capital. Although we question whether cash generated from lower inventory levels is sustainable, we believe Unilever's investments to simplify its supply chain should lead to lower inventory levels longer term.

Fair value: 1,719p (PLC) / EUR 20 (NV) │ Fair value uncertainty: Medium │ Economic moat: Narrow

Thesis (Last updated 26-08-2009)

In the past, an extremely decentralised and complex structure hindered Unilever's ability to realise the growth and profitability that should emanate from one of the largest players in the packaged food and household and personal product industries. That said, we believe that management's efforts to root out inefficiencies (a strategy that was begun by former CEO Patrick Cescau and that new CEO Paul Polman is continuing to implement) seems to be gaining traction, despite numerous external head winds.

Unilever's status as a giant consumer product firm partly resulted from its foresight to secure a first-mover advantage in international markets, particularly in fast-growing developing and emerging markets. However, because of its use of a local go-to-market strategy, Unilever's efforts failed to generate a clear global strategy, while at the same time producing a bloated organisation in terms of brands, facilities, and employees. In our opinion, Unilever neglected the scale and efficiency advantages that potentially exist for a firm of its size.

Management is not sitting still, but rather is working to jump-start sales growth and operating margin improvement. The latest restructuring plan seeks to aggressively reduce the firm's brand portfolio, manufacturing facilities, and employee base. Although new management is still reluctant to target the level of improvement it anticipates from these efforts, we expect the operating margin will approach 16% by 2013 (versus 14.6% in 2008). We are concerned about whether these efforts will be more successful than past attempts to reduce the complexity of Unilever's business--most notably through the firm's path to growth initiative--that failed to generate the pop to sales and margins that management had expected.

Besides its internal challenges, Unilever also faces external challenges, such as elevated commodity costs. During the recent past, the firm has charged higher prices on its products to offset at least a portion of these increased costs. Even though we had been concerned that the higher prices Unilever was charging could hurt volume as consumers rein in their spending, it now appears that the firm is committed to actively managing the pricing of its products. Although these initiatives seem to be successful now, we will monitor whether the firm's efforts to chase volume gains will ultimately prove to be an unprofitable endeavour.

Despite these issues, Unilever generates substantial free cash flow, and given its scale and the strength of its brand portfolio, cash flows should hold up even in difficult times, in our view.

Valuation

Our fair value estimate for Unilever PLC is 1,719p per share. We do not believe there have been any fundamental changes in Unilever's business since our last update. Although we believe sales will be flat in the current year as volatile foreign currency movements and soft consumer spending restrict the firm's growth, we model average annual revenue growth of 2%-4% during the next five years. We expect elevated commodity costs will continue to pressure gross margins over the near term, but we expect Unilever will realise a portion of the anticipated cost savings from its current restructuring initiatives. As a result, our forecast assumes that reported operating margins approach 16% by 2013, up from 14.6% in 2008.

Risk

Elevated commodity costs continue to weigh on Unilever's profitability, a situation that shows few signs of abating. In addition, with about 50% of its total sales resulting from developing and emerging markets, Unilever is subject to changes in foreign exchange rates. This international presence also exposes the firm to political and economic risks. Finally, Unilever is undergoing a major restructuring initiative, the results of which are far from certain and could lead to instability in its operations.

Strategy

Strategically, Unilever is focused on driving sustainable revenue growth, while at the same time improving margins. During the last two years, Unilever has steered away from less profitable businesses and geographic segments. Management is emphasising on segments where the firm possesses a higher potential for growth over the long term, such as personal-care products and geographies with favourable consumption trends.

Management & Stewardship

After 35 years at the firm and four years at the helm, Patrick Cescau has stepped down as CEO. To fill his shoes, the board tapped Paul Polman, who was most recently executive vice president and zone director for the Americas at Nestle. In our opinion, Polman (the first outsider to run the large consumer goods organisation) could be the right person to shake things up, after gaining valuable experience during his years at Procter & Gamble and most recently Nestle. Overall, corporate governance at Unilever is fair. We are impressed by the level of detail this firm provides to the market, particularly in its quarterly earnings releases. We also like that Unilever operates with two different individuals holding the positions of chairman and CEO. However, that is where the favourable aspects of the firm's corporate governance end. First, we take issue with Unilever's compensation structure. More than 50% of the CEO's total annual compensation is composed of base pay. In addition, annual incentives paid to executives are primarily cash, which is not ideal, in our eyes. Also, directors are paid hefty sums for serving on Unilever's board, again mostly in cash. We believe management's and directors' interests could be better aligned with shareholders' if equity represented a larger portion of total compensation. Finally, in our opinion, the firm's multiple-class structure, with varying voting rights, is not in the best interests of minority shareholders.

Profile

Netherlands-based Unilever NV and UK-based Unilever PLC operate Unilever Group, which is a diversified packaged food (about 55% of total sales), and household and personal product (about 45% of total sales) company. Unilever derives 31% of its sales from Western Europe, 32% from the Americas, and 37% from Asia, Africa, and Central and Eastern Europe. The firm's brands include Knorr soups and sauces, Hellmann's mayonnaise, Dove soaps, and Lipton teas, among others.

Growth

Acquisitions and divestitures clouded Unilever's top-line results during the last five years. Given the positioning of the firm's brands and the maturity of its core markets, we expect Unilever to post 3%-4% annual sales growth over the long term.

Profitability

We believe operating margins have some room to improve. In 2008, Unilever reported an underlying operating margin of 14.6%. In our opinion, current restructuring initiatives should positively affect profits to the tune of more than 100 basis points during the next five years.

Financial Health

With only EUR 8.8 billion of long-term debt on its balance sheet and interest coverage of almost 9 times earnings, Unilever should be able to service its debt without any financial strain on its business.

Bulls Say

1. Unilever is the third-largest packaged food firm in the world, producing more than EUR 22 billion in annual sales from a stable of brands including Knorr, Hellmann's, Lipton, Breyers, and Ben & Jerry's.

2. As one of the largest global household and personal product firms, Unilever generates nearly EUR 19 billion in annual sales through its portfolio of well-known brands, such as Dove, Ponds, and Suave.

3. By focusing on opportunities in developing and emerging markets years earlier than its peers, Unilever has realised some of the benefits of being a first-mover and now generates around 50% of its sales from these markets.

4. Cash-flow generation through the first six months of the year was impressive (at EUR 2.0 billion, or 10% of sales), primarily because of lower inventory levels as Unilever appears to be realizing the benefits of its efforts to reduce the complexity of its supply chain.

Bears Say

1. Operating margins have suffered during the last several years as Unilever failed to present a clear global strategy, while also inefficiently ramping up its product base and overhead.

2. Despite spending heavily on marketing and promotions and reducing price points, sales continue to suffer in Western Europe, which makes up about one third of Unilever's total revenue.

3. Even after culling its product portfolio from 1,600 items to less than 400 during the last five years, Unilever still had trouble generating consistent sales growth.

Erin Swanson, CFA is a Morningstar stock analyst. Morningstar's editorial policies prohibit analysts from owning stocks they cover.

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