Hermann Simon, in his book, Hidden Champions of the 21st Century, states ‘innovation is the only effective long-term means of succeeding in competition’. Indeed, it is a reasonable assertion that companies striving to innovate stand the best chance of flourishing themselves, as well as improving broader society.
In our analysis, we regularly observe that dissatisfaction with the status quo can be a driving force behind positive both investment and societal outcomes. As an example, medical software firm EMIS enjoyed a dominant market position in on-premise GP patient record databases a few years ago. The company could have technologically stopped there, but if it had, we would now not enjoy the benefits delivered by its EMIS Web cloud-based service, benefits of which include: online access to bookings, prescriptions and medical records; and the start of connectivity between different parts of the NHS.
The benefits will continue to be developed in future years. However, there is clearly a business risk factor at play; if EMIS did not innovate, a competitor would probably have come up with a cloud-based solution and threatened the incumbent’s position. An economic moat can be dug, but it must be maintained if the castle is to survive a siege. In this case, business considerations caused agitation which spurred innovation, creating a virtuous circle. However, what happens when a restlessness to innovate potentially poses a greater threat than opportunity?
Restlessness as a risk
One example of restlessness risk lies in merger and acquisition activity, which can create questionable outcomes for the investor. M&A, often funded by debt, is a feature of the current market environment. We had a particularly high profile M&A case recently with Unilever. Since Kraft-Heinz approached the firm about a takeover and was swiftly rebuffed, Unilever has revisited its strategy and pressed ‘fast forward’.
A reassuring element of the announced strategic plan was that long-term growth driven by investment is still front and centre – another instance of the virtuous circle of business agitation at work. Elsewhere, there is a plan to accelerate margin improvements, and to increase leverage from 1x to 2x net debt/EBITDA. These are areas where we must pause to reflect. Increasing margins could mean the intended investments don’t happen, or are not as effective as they might otherwise be in the long term.
Doubling the debt burden increases financial risk to the equity holder, the potential payoff being improved returns if things go right. In other words, investment risk may be enhanced. There are many other considerations to the investment case, but Unilever provides a current case-in-point for exploring where we can analyse activity, and make risk-based judgements on the outcomes.
Unilever strikes the right balance
On the margin/investment front, it is impossible to state precisely what the ‘right’ level is. We can look to competitors for clues – the suitor Kraft-Heinz has operating margins in the mid-20s, and Reckitt Benckiser in the high-20s, already significantly higher than Unilever’s new medium-term target of 20 per cent. It should be noted that these are different businesses with different category and geographical profiles, but, in the round, we think Unilever has struck a good balance between ongoing long-term investment and increased efficiency.
Debt is something that we tend to shy away from, and we are deliberately positioning the Evenlode Income portfolio with low overall gearing, in order to manage risk. That is not to say there is no debt, of course, and some of the higher levels in the portfolio are found in consumer goods companies.
Resisting the urge to over-leverage
The key point is that certain companies, Unilever included, tend to have more stable cash flows than the average firm. The probability of these flows falling to a level that risks firstly the dividend, and secondly, the equity base, is lower. Nonetheless, there is a level of debt for any business that is too high. Again, relative to other firms, we can see that Unilever’s proposed 2x is not out of the ordinary, and, in our view, remains prudent.
Thinking critically about what could happen on the downside helps us build clarity and test potential scenarios. We can imagine that demand for Unilever’s low-ticket goods should be solid, and furthermore, observe historically that it has remained resilient through a wide range of economic conditions. This gives us comfort in the new targeted capital structure
Some commentators and analysts were calling for higher margin and leverage targets than the targets that Unilever had laid down (in some cases significantly higher). We are pleased that Unilever has settled on a measured compromise: a bit more efficiency, and a bit more leverage, without sacrificing a low-risk profile and an ability to continue investing consistently in long-term growth.
Ben Peters is CEO and fund manager at Evenlode Investments