Re-lever Unilever?

Hats off to the Unilever Board for rejecting out of hand the recent takeover approach from Kraft-Heinz. Aside from the socio-political obstacles, there are compelling financial and business reasons why Unilever is better off on its own, and it is encouraging to see the Board taking such a strong stance on this.

The private-equity group 3G Capital no doubt saw the potential to increase Unilever’s profitability significantly, as they have done at Kraft-Heinz and Anheuser-Busch before that. The 3G model is one of radical cost cutting. Combining strong brands that are protected by pricing power with a ruthless focus on removing layers of management can result in huge increases in profitability. Slap on a healthy dose of financial leverage and the returns to equity holders can be enormous.

Indeed, both Anheuser-Busch and Kraft Heinz shareholders have been well rewarded in recent years with strong absolute and relative total returns. And, now with the backing of the mighty Warren Buffett, how could anyone argue against the 3G model?

Yet the jury is still out on this approach. A recent McKinsey report showed that market shares for some of Heinz’s key categories had fallen following the 3G takeover1. Of course, financially this was more than offset by the increase in profits from the massive reduction in costs. But is this really a sustainable long-term approach to managing a business so dependent on the strength and health of its brands?

The attachment of consumers to these brands is the main strength of the consumer staple business model. Radically cutting costs risks damaging these customer relationships, or leaving a gap in the market for newer, more innovative entrants. Whilst cost cutting provides an immediate boost to profits, such changes can take several years to become apparent.

There are plenty of companies in which the 3G model would make sense; but Unilever is not one of these. This is a company with a heritage and culture stretching back decades and an investment horizon that looks equally far into the future. Culturally it is hard to think of a worse fit for the 3G approach. Unilever has also delivered impressive shareholder returns over almost any time period, suggesting it is already pretty well managed. Ripping costs out and leveraging its balance sheet might enhance shareholder returns even further but this would also significantly increase the risk profile.

With the deal scrapped, commentators are asking what Unilever should do now. How can it protect itself from future approaches? Some have suggested that Unilever should leverage its “inefficient” balance sheet in order to buy back shares and boost earnings, whilst others have suggested using the money to finance a big deal. This is classic bull market talk, reminiscent of the mid 2000s when every consumer company was supposedly underleveraged and on the verge of being acquired by private equity. We all know how that ended.

Here is some alternative advice for Unilever: Don’t rock the boat. Continue to run the business for the long-term. And as for the balance sheet, low leverage is as much a strength as a weakness. As Mr Buffett himself is fond of saying: “It is only when the tide goes out that you discover who’s been swimming naked.” The current era of cheap money and high valuations is unlikely to last forever. It would be far better to deploy the balance sheet counter-cyclically from a position of strength and when valuations are lower, than be peer-pressured into doing something rash today2.

Matthew Tillett

 

1. Source: Bloomberg news – https://www.bloomberg.com/news/articles/2015-08-20/kraft-warren-buffett-3g-capital-may-push-cost-cutting
2. This is no recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.

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Author - Matthew Tillett

Matthew Tillett

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