Weakness in Emerging Markets and Europe May Depress Unilever’s Q4 Results

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Unilever (NYSE: UL) is scheduled to release fourth quarter earnings on Tuesday, January 20th. During the first 9 months of 2014, the consumer products major registered revenues of €36 billion, which is a year-on-year decline of 4.3%. The decline was primarily because of strong currency headwinds which depressed revenues by 6.6%. Underlying sales growth, which excludes the impact of currency movements and acquisitions/disposals, was 3.2% year-on-year during the first nine months. Non-GAAP operating margin stood at 14% in H1 2014, which was stable compared to the same period in 2013 (Unilever does not report quarterly operating margins).

Unilever does not provide earnings guidance, but consensus revenue estimates for the full year stand at approximately €45 billion, [1] which is a 9% decline from 2013 revenues of €50 billion. Further, the company stated in its first quarter earnings report that it expects non-GAAP operating margin to improve in the second half of 2014, after declining in the first half. [2]

Unilever’s shares fell by 2% in 2014, although they have since recovered after gaining 4% in the week ended January 16 on pre-earnings anticipation.

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We have a price estimate of $47 for Unilever, which is about 13% higher than its current market price.

See our complete analysis of Unilever here

Slowdown in Emerging Markets

Unilever derives more than half of its revenue from emerging markets, which witnessed decelerating growth in 2014. Specifically, a severe slowdown in China and recessionary conditions in Brazil pulled down the company’s overall performance in the emerging markets. Unilever’s CFO, Raoul Jean-Marc Sidney Huët, stated in the third quarter earnings call that worldwide market value growth rate in the company’s product categories slowed down from 7% – 8% in 2013 to less than 2% in the third quarter. [3]

In China, a steep drop in demand forced Unilever to undertake destocking measures, resulting in a 20% fall in Unilever’s sales in China in the third quarter. The destocking is expected to continue in the fourth quarter and the company expects a similar level of decline in fourth quarter sales. Although China accounts for accounts for only 4% of Unilever’s total sales, the plunge in China will be compounded by slowing volume growth in other emerging markets like Brazil, Russia, India and South Africa.

Deflationary Environment in Europe

Faltering consumer spending in Europe has heavily impacted Unilever’s European business. The company was able to maintain a stable performance in Europe in the first quarter, but plummeting prices drove down revenues in the following quarters. The price deflation was driven by benign commodity cost environment in key markets like France, Germany and the United Kingdom.

Volume declines in Unilever’s ice creams and spreads businesses in Europe further exacerbated the effect of declining prices. The only silver lining was good performance in the Home Care segment, which partially offset the fall in foods and refreshments. However, the overall European volume growth of 1.1% during the first 9 months was not sufficient to offset the price decline of 1.5%, resulting in a fall in European revenues.

Further weakening of the Euro during the fourth quarter and the fallout effect of economic conditions in Greece have delayed recovery in consumer spending even more. Therefore, we believe that Unilever’s European business will continue to suffer in the short term.

Currency Headwinds Remain a Matter of Concern

Given that Unilever derives a majority of its revenues from outside North America, the company is heavily susceptible to adverse movements in foreign currency. This fact was underscored by the negative 6.6% impact of currency movements on revenues during the first nine month.

In the fourth quarter, the dollar strengthened even further against most major currencies, including the Euro, Brazilian Real and Russian Ruble to name a few. The weakening emerging market currencies not only depress Unilever’s revenues but also suppress its margins due to commodity cost inflation. Given that Europe, Brazil and Asia are all major markets for the company, we believe that currency headwinds will have a substantial negative impact on the fourth quarter performance.

However, Unilever’s ongoing cost-saving programs, especially in the supply-chain, are expected to provide some relief. Its strategies like ‘Maxing the Mix’ are aimed at optimizing the product mix for realizing margin accretion. Separately, it is accelerating low cost business models in the emerging markets, which may provide additional breathing room for its margins. [3]

Unilever was able to keep its non-GAAP operating margin stable in the first half of the year due to these measures. We believe that continued successful implementation of the same during the rest of the year may provide a slight improvement in the full year non-GAAP operating margin.

Growth in Home Care and Personal Care May Offset Disappointing Foods Business

Excluding the impact of currency headwinds, Unilever achieved strong growth in its Home Care and Personal Care segments during the year. Year-on-year underlying sales growth during the first nine months was 6.4% in the Home Care segment and 4% in the Personal Care segment, driven in equal measure by volume and pricing growth.

The company’s Refreshments segment was also able to register underlying sales growth of 3.5%, despite poor performance of ice creams in Europe due to poor weather conditions. On the other hand, the Foods business was bogged down by poor performance of the spreads business due to decline in demand for margarines. For the first nine months of 2014, the Foods segment registered a year-on-year decline of 0.5% in underlying sales growth despite a pricing growth of 0.4%.

It is pertinent to note that despite the poor macroeconomic conditions, Unilever has performed better than the market for the most part. The company has stated that it is still gaining market share in about 60% of its businesses, which is encouraging news for the its long-term prospects. [3] Market share gains have allowed it to maintain volume growth, while across-the-board pricing growth has allowed it to battle commodity cost inflation, thus preserving margins. Lastly, with the exception of the Foods business, the company achieved positive underlying sales growth in all its segments. Therefore, we believe that while the company’s prospects in the fourth quarter are not encouraging, it has strong long term potential.

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Notes:
  1. Based on 2014 average rate of Euro per USD of €0.75 []
  2. Unilever Investor Relations, April 24, 2014 []
  3. Unilever Q3 Earnings Call Transcript, Seeking Alpha, October 23, 2014 [] [] []