Unilever (UL 0.63%) is one of the largest consumer staples companies on Earth, with an incredibly diverse portfolio. As with all its peers, inflation has been a major headwind for Unilever in the last couple of years, putting material pressure on margins. It did what needed to be done, increasing prices, and now it has to wait to see if things play out like they normally do. Here's what investors should be watching for.
The normal margin squeeze
When you walk into a grocery store and buy a bottle of Unilever's Hellmann's mayonnaise, you are participating in the very end of the chain for that product. The beginning of that chain starts when Unilever buys ingredients and packaging. The middle of the chain is the selling and shipping of inventory to grocery stores. Consumer staples companies face a lot of costs in that mix.
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When inflation is running hot, as it has been of late, Unilever's costs go up. That puts pressure on its margins, which reduces profitability. To put a figure on that, the company lost 300 basis points (or three percentage points) of gross margin between the first half of 2019 and first half of 2022. That's a huge decline, largely driven by rising costs for ingredients, packaging, and transportation. Employee salary expenses are also a notable headwind.
Inflation itself isn't unusual in the consumer staples space, but the rapid increase in costs this time around was a bit odd. That forced companies to act quickly and repeatedly to counteract the hit. There are three primary ways that companies like Unilever combat inflation: Cost cutting, package size changes, and increasing prices. The last item, price increases, is the big one and the one that customers see most directly.
What to watch for next
There's a trade-off when it comes to price hikes. Basically, when faced with higher costs, people reduce their spending or switch to cheaper items. So, as prices increase, volumes tend to decline. If a company is lucky, and Unilever has been, price hikes more than offset the effects of volume declines. That helps to protect margins. In this case, margins have started to expand again, up 30 basis points in the first half of 2023 compared to the first half of 2022.
Unilever's efforts to increase prices are now slowing down. That will mean less benefit from price hikes as time goes by. However, customers are getting used to the price increases, and price-led volume declines in previous periods are being lapped. So there's a new dynamic to monitor. The big question is: Will customers come back to the brands they love? Historically, the answer is usually yes.
That's why volume is increasingly the key number for investors to watch. For Unilever, volume declines were particularly bad in 2022, when it started to ramp up its price increases. In the first and second quarters of 2023, however, volume declines have dropped materially. In Q2, volume was off just 0.3 percentage points, which was just a touch worse than Q1. That is a good sign, as it suggests that customers have accepted the price increases and are getting back to normal spending habits.
The big risk
So, at this point, it looks like Unilever has navigated the recent bout of inflation fairly well. But the company doesn't operate in a vacuum. If the company's peers don't see the same success, they may resort to running sales to gain back volume. And that could create an industry spiral that again puts pressure on margins. If you own Unilever, you should be happy with the results it is producing. But you still need to watch the company and industry closely, because the next stage of the margin recovery playbook is only just beginning.
