A lesson from the fallout of misaligned acquisitions

A friend with a stressful job recently bemoaned the shrink-flation that has affected his Friday night Ben & Jerry’s - ‘Bridget Jones-ing’ a pint of ice cream isn’t the same when tubs aren’t pint-sized anymore.

Hein Schumacher (the relatively new chief executive at Unilever, which currently owns the Ben & Jerry’s brand) has blamed this on rising ingredient and energy costs. That’s a slightly disingenuous statement. While there is no denying that inflation is hurting business profits, the cost of sales at Unilever actually declined slightly in 2023 after a spike the previous year. Gross margins were 42% compared to 40% in 2022.

It’s also hard to sympathise with Schumacher’s insistence that “savvy customers” are aware that their goods are getting smaller. If this was simply a case of rising input costs, the company could increase the price of their pints of ice cream and 50g tubs of mayonnaise in good faith. Charging more for less is a tactic that has long been employed by the consumer goods industry to hide rising prices.

And these rising prices is what Unilever’s growth relies on. In 2023, the volume of goods sold rose just 0.2% year-on-year, with the remainder of the 7% underlying sales growth all being provided by price inflation. You have to go back to 2018 to find the last time meaningful annual sales growth at Unilever was driven by rising demand rather than rising prices.

The trouble with price-fuelled growth is that it is far harder for the business to control than demand-fuelled growth. Unilever should be able to spark higher demand by investing in marketing or product innovation, instead it is reliant on consumers’ ability and willingness to pay more. This also makes price-fuelled growth less reliable. When consumers’ pockets are being burned by rising prices, stagnant pay and economic uncertainty, they tend to stop spending on brands.

A company built of acquisition

Unreliable growth is not the only blot on Unilever’s copy book.

This is a company that has long justified a high price to earnings ratio with excellent profitability metrics and cash generation which, in-turn have helped fund acquisitions to drive growth. Since its IPO in 1989, Unilever’s share price has risen at a compound annual rate of 7% (not including dividends), ahead of the MSCI World Index which has risen at a compound annual rate of 6.2% in the same time period, and well ahead of British peers in the fast moving consumer goods market. And this performance has been fuelled by the company’s impressive ability to squeeze returns out of its investment, especially acquisitions.

But recently, investors (including long-time shareholder Terry Smith) have raised questions about the company’s ability to squeeze profits from its acquisitions. Between 2015 and 2027, the company made 27 acquisitions in its beauty business alone, but only disclosed the price paid for three of those companies. More worrying is the fact that, after being purchased, most of these acquisitions haven’t been mentioned again in subsequent annual reports. As Terry Smith noted in 2022, “I doubt that mention was omitted because they were all performing embarrassingly well.” Indeed, hunting outside of the company accounts for evidence of performance of some of the brands bought in doesn’t instil much confidence. According to Statista, sales at Carver Korea (the Korean cosmetics business bought in 2019 for €2.3bn) have declined since it joined the Unilever fold.

There is evidence of the fallout of this poor capital allocation to be found in the cash flow statement.

Between 2018 and 2022, business capital expenditure (cash payments made upfront for investing in assets) was lower than depreciation (the process of deducting the cost of the asset over the value of its useful life). That means that previous acquisitions were costing Unilever more than it was willing to spend on new opportunities. Capital expenditures which average less than depreciation costs over the long run can be a sign that the company is shrinking.

Getting the house in order

But now, finally, with a new chief executive at the helm, Unilever seems to be taking responsibility for the hodge podge of acquisitions that have been shoved together in the last few decades.

The first chunk to be carved out of the conglomerate will be the ice cream business, which looks set for a demerger. Schumacher can window-dress the decision all he likes with phrases like ‘not a good strategic fit’ and ‘allow greater scope for investment in marketing’, but it’s not a great sign that the company looks unlikely to be able to find a buyer. Instead, it’s likely to be floated on the FTSE as a separate entity and Unilever shareholders will be given a stake in this new business. There’s no word yet on valuation, but don’t expect anything special - investors being offered these new shares might want to consider ditching them as quickly as possible.

But how about the outlook for the original company without its ice cream business (which last year contributed 12% of revenues)?

Ice cream has very few synergies with the remainder of the business, including a frozen goods supply chain. Operating margins are also lower, so stripping out this part of the business should support a rise in margins in the remaining company. Ice cream has also been the lowest growth division and its removal should help Unilever reach its target of mid-single digit sales growth.

There also should be more capital available for investment in marketing, which has already seen an uptick since Schumacher took the helm. More focus on brand and marketing efforts may be able to support that much sought demand growth.

Unilever investors’ hopes have been raised this week that the demerger might spark the start of a turnaround - the share price rose on the news. But if hiving off the ice cream business provides a much needed change in fortunes, investors might soon be clamouring for more demergers. And then, what will be left?