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How Far Can This Passive Income Stock Push Pricing?

Unilever (NYSE: UL) has been in the news of late because it is working with shareholder activist Nelson Peltz as it looks to enhance its long-term prospects. However, that story is layered on top of the inflation issues that are impacting the entire consumer staples sector. While both are important to monitor at Unilever, inflation is a short-term headwind that will have the most near-term impact. Here’s what Unilever is doing about inflation, how it is working, and why investors should be worried that the current plan can only take the company so far.

There’s no way to avoid it

Inflation is hitting Unilever just like it is all consumer staples stocks. The maker of Dove, Hellmann’s, and Ben & Jerry’s is seeing costs increase for the ingredients it uses, for the labor it employs, and for the prices it pays to move goods to its retail-chain customers. This isn’t actually unusual, though the inflation being seen today is particularly acute.

Image source: Getty Images.

There’s a well-used playbook in the consumer staples space to deal with inflation. Tactics include directly raising prices, changing the size of packages (charging the same amount but for less product), and cost-cutting (using less expensive ingredients, for example). Like its peers, Unilever is working on all of these so it can maintain its profitability. The problem is the speed with which the company has had to adjust.

Price hikes have increased in each of the past three quarters, with the rate of growth in the recently ended second quarter more than double the rate from the fourth quarter of 2021. The good news is that the company’s efforts have so far led to robust organic sales growth. But all of the news is not good.

Consumers react

The big risk is that customers will change their buying habits when a company increases prices. Essentially, faced with rising costs, some consumers will trade down to lower-priced alternatives. So far the impact of this has been fairly muted for Unilever. But that doesn’t mean investors should ignore the trends.

For example, in the second quarter of 2021, Unilever increased prices and still saw volumes increase. A third-quarter 2021 price increase, however, was welcomed with a drop in volume. More price increases (4.9%, to put a number on it) in the fourth quarter of that year didn’t impact volume at all. But, since that point, the price increases have started to pick up. And so have the volume declines. 

In the first quarter of 2022, Unilever increased prices by a huge 8.3%, leading to a fairly modest volume drop of 1%. However, in the second quarter, management upped prices by a whopping 11.2%, leading to a volume decline of 2.1%. Given the price increase in the quarter, that’s still a fairly modest volume drop, but it shows that the harder Unilever pushes on price today, the more risk there is that consumers will push back. Peer Procter & Gamble recently warned that it was seeing more pushback, too, as consumers adjust their buying habits in the face of rising prices.

The warning about changing consumer behavior from P&G led that stock to pull back, despite still-strong organic sales growth of 7% in the quarter and a volume decline of just 1%. The fear is that future price increases will be harder to push through even as inflation continues to rage. That fear, as the volume trends above highlight, is just as notable for Unilever investors.

Unilever has some distinct business attributes that should help it navigate the current headwinds, most notably that around 60% of its sales come from emerging markets. These markets tend to be more accustomed to inflation than developed markets and, thus, consumers are often more accepting of price increases. Still, investors should keep a close eye on the interplay between price hikes and volume declines. Indeed, Unilever has specifically stated that it is willing to lose global market share in order to protect more profitable markets. Thus, there’s a notable risk it will push too hard on price policies.

Watch the fine print

The headline numbers for Unilever are pretty good right now, but there is a weakness underneath the surface. Management has clearly stated that it is willing to accept some market share loss, so it looks like price hikes will continue despite the negative impact on volume and the warning signals being sent by peers about price increases. This isn’t necessarily a bad approach for Unilever to take, but it is one that long-term investors need to watch closely as they collect the hefty 3.8% dividend yield on offer here. Simply put, that relatively high yield compared to the broader market isn’t risk-free.

Reuben Gregg Brewer has positions in Procter & Gamble and Unilever. The Motley Fool recommends Unilever. The Motley Fool has a disclosure policy.

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