Unilever’s Agflation Challenge: To Preserve Margins or Market Share?

Unilever (NYSE:UL) is the second largest consumer goods company in the world after Procter & Gamble (NYSE:PG) and manufactures everything from ice creams to shampoos. Unilever is the global leader with close to a 50% share of the grocery market and sells under well-known billion-dollar brands such as Knorr, Hellmann’s and Ragu. It is the leading manufacturer of tea beverages sold under Lipton, Brooke Bond and PG Tips brands, and comes only after Nestle as one of the leading manufacturers of ice creams sold under the Heart brand, including Cornetto, Magnum, Carte d’Or, Wall’s, Ben & Jerry’s etc.

Given Unilever’s strong presence in foods segment, it comes as little surprise that Unilever buys approximately 12% of world’s supply of tea, 6% of its tomatoes and 3% of its palm oil! What’s more, around 50% of Unilever’s raw materials come from agriculture and forestry. And this is what raises our concerns with regards to the vulnerability of Unilever’s operating margins to fluctuating prices of agricultural produce.

With droughts in Russia, excessive rains in Canada and Pakistan and adverse weather conditions affecting the harvest in the U.S., the U.S. government has cut its forecast for stocks of key crops such as corn, wheat and soybean. The markets are speculating a steep rise in food prices with agriculture commodity futures surging to record high levels. ^[1]

We currently have a $38 Trefis price estimate of Unilever’s stock, which is close to 25% premium to its current market price.

How to deal with rising food prices

Here we explore the impact on Unilever’s stock price, (i) if it were to preserve operating margins at the cost of losing market share, or (ii) if it were to preserve market share at the cost of operating margins of its leading dressings and spreads product segment.

During boom times, Unilever could pass on higher raw materials prices to consumers through price increases and cost controls, thereby preserving margins. However given the current macroeconomic conditions with a slow pace of recovery from the recessionary 2008-09, we do not foresee Unilever being able to pass on price increases to consumers.

Amid historically high unemployment levels exceeding 9.8% as of November 2010 and lower disposable income levels, raising prices could draw volumes away from Unilever to local brands and private labels leading to a loss in market share. Market share losses due to lower priced substitutes typically take longer to regain than the economic recovery as consumers who experience acceptable quality at reduced prices do not revert back to premium brands easily.

Market share forecast

We currently estimate Unilever’s share of global grocery market to rise from 49% in 2010 to over 50% by the end of the forecast period while improving operating margins from 16.4% to17.2% over the same period. If Unilever can preserve operating margins by passing on the rise in the prices of agricultural produce to the consumers, we can expect the market share to decline to 46%  leading to a 6% potential downside to our current $38 Trefis price estimate of its stock.

Profit margin forecast

However, if Unilever were to focus on market share and absorb the rise in the prices of raw materials, we can expect the operating margins to take a hit over the short-term (2011-13) reaching 15.9% by 2013 and recovering thereafter to around 16.3% in a few years, leading to a 2% potential downside to its stock.

You can see a detailed analysis of our $38 Trefis price estimate of Unilever’s stock here.

1. Food Prices set to rise after US cuts crop stock forecasts, The Telegraph, January 19, 2010 [↩]