A Growing Trend Takes Root at Unilever and Procter & Gamble

In this episode ofIndustry Focus: Consumer Goods

The latest initiatives at Unilever(NYSE: UL)and Procter & Gamble (NYSE: PG) exemplify the efforts companies are taking in this space.

A full transcript follows the video.

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This podcast was recorded on Oct. 12, 2016.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Wednesday, Oct. 12th, and I am your host, Vincent Shen. Just so you know we are pre-recording this episode and teeing it up to air on Tuesday, the 18th. I am connected with Fool.com senior [contributor] Asit Sharma via Skype. How are you, Asit?

Asit Sharma: I'm doing very well, Vince. Thank you for asking. Doing great this morning!

Shen: Yeah, I had Dan on yesterday. He was in South Florida. I know you're in Raleigh, North Carolina, we were able to speak before the show, and I was glad to hear that everything was OK after the hurricane. But two guests on, or two [contributors] on, and both of you guys did see at least a little bit of impact from the storm.

Sharma: Yeah, we were a little surprised here in Raleigh because most of the models forecast that the storm would hit more fiercely where Dan was. So I thought maybe Dan would be wet, I would be dry. It did come in inland a little bit. I happened to be traveling actually, so missed that, but the good news is the storm is over and we're cleaning up. So we'll move on.

Shen: Yup. So I was really excited to have you on the show today, so we can kind of really pick up from our last discussion and continue breaking down some of the supertrends that we are seeing in the consumer and retail sectors. Last week we talked about mass customization, the growing importance of basically personalizing products and services to appeal to consumers and to build brand loyalty. So we looked at custom sneakers, right? From NIKEiD, how Starbuckscan brew the exact coffee you want with their very expensive Clover brewing system, and then there's Etsy, with the huge marketplace it has built for handmade crafted goods.

So our next supertrend has companies turning their attention, I think, a bit more into their internal operations. That's with SKU rationalization or specifically for our discussion, SKU reduction. So we'll look at this through the lens of two leading consumer products companies: Unileverand Procter & Gamble. But before we get any further than that I mentioned SKU rationalization and I think some of our listeners could probably use just a quick update or refresher on exactly what we're talking about there.

Sharma: Absolutely. What is an SKU? It's shorthand for "stock keeping unit" and Wikipedia has a great definition. I'm going to read this for our listeners. It's a "distinct type of item for sale." So manufacturers identify their products by unique codes that they've built. Those may actually be different than the barcodes that you see in, let's say, a grocery store when you're picking up a package to scan and pay for, but each product a manufacturer builds has this code and every time they vary the product whether it's size, color, anything, that creates a new stock keeping unit, or SKU.

Shen: So, I think that with the SKUs and it kind of comes into conflict a little bit. On the one hand, we're going to talk about in this discussion how companies are working to basically make their operations more efficient, more profitable, and in some cases they are able to even boost their sales by reducing some of the offerings that they give to consumers. But in the last episode, we talked about on the customization side, giving more optionality, more potential to personalize and customize a product for each consumer, but I guess my question is can you give us an idea of how things flow through a company? We can use maybe one of the two companies, Unilever, or Procter & Gamble as an example, but how this decision in terms of what products are offered, the number of SKUs in a company's portfolio kind of flow through and can impact some of the metrics that investors are focused on generally.

Sharma: It's a good question. Companies play a guessing game when they create products for a particular brand portfolio. And that guessing game is: What will the consumer want? What's the consumer's tolerance for product variation? And there are three major factors that drive the expansion of a product portfolio.

First is to keep those product lines fresh and relevant. Most of us have seen the phrase "new and improved," and I guess listeners are are familiar with the concept that this is all in a marketing ploy, but companies also create more products to suit the changing whims of the customer. I have these whims, and you have these whims, we may not know it, a lot of times these are internalized and it's based on what we imbibe from our culture, popular culture. Just also what's practical in our lives. Could be a very small variation on, let's say a handle of a grocery jug. We've seen milk cartons change over time. So, these whims drive product innovation as well.

The third thing is product innovation. Now, when I think of product innovation, I think of a brand-new product. Because, well, innovate; you must be creating something new. But corporations look at slight variations in product packaging or say they change a formulation, add a flavor to a juice. If you are a beverage manufacturer that is a third reason. And innovation to a manufacturer can be very slight tweak.

So these three factors drive that expansion of a portfolio and what we see is that in the consumer marketplace, companies will first expand their portfolios and then start to draw them back because it's an art, it's not a science. If a company had a handle on exactly how many variations of a product per each geographical region was necessary, then they would find this miraculous optimization of profit. And that's just not something that comes easily.

Shen: Yeah, I think it's important to point out that with every item that a company offers essentially, that has costs and investments associated with it. Think the storage of your completed product and the materials needed to create it, packaging, your supplier relationships, the marketing of your offerings, and also disposal in some cases for some products or SKUs that have gone obsolete.

So every dollar a company spends toward one SKU that would have been better spent on another, will potentially result in a reduction in the top or bottom line. Or both. So, I think for publicly traded companies, it's fair to say that investors and shareholders place a high value on also the predictability and accurate guidance from management. I think you had mentioned earlier a little bit about forecasts; if you have an overabundance of offerings and SKUs, I think it becomes increasingly difficult to essentially forecast out your expected sales and that can reduce profitability if discounting, for example, is needed to reduce stock or you have to send additional stocks to suppliers because items sold out unexpectedly.

And let's jump directly into one of our two companies. Let's start with Unilever. No. 3 consumer goods product company by revenue behind Procter & Gamble, and Nestle. Can you tell us a little bit about their efforts and how they've approached SKU rationalization?

Sharma: Sure. So, our supertrend for today is this idea of shrinking SKUs or SKU rationalization and why it's a supertrend and why Unilever is such a great example. We, in our last episode, separated the idea of just a trend from the idea of supertrend by saying if many corporations are out there jumping on this trend and they're both big and small, that is a great indication we're seeing a supertrend.

Unilever fits right in because they're one of the biggest, baddest consumer goods companies on the planet. They have hundreds of brands and literally thousands and thousands of SKUs and they practice what Vince has mentioned a couple times: SKU rationalization. Let's quickly define that term if you're not familiar with it. It's a really simple concept. SKU rationalization is when you use data and analytics to pair down those underperforming SKUs and then you transfer your resources into the SKUs which are getting market share.

So we're going to use this term a lot and it's a great way to sound really smart if you're talking to other investors; you can talk about SKU rationalization and your favorite companies. Unilever's multiyear goal is to reduce their SKU by 20%. When you visualize a company which is in hundreds of countries around the globe dealing with local markets, you can image the complexity of their operation. So for a company like this to decide to reduce SKUs ... Well, let me stop here. Last week we talked about Nike, which I also call Nike, SKUs are often pronounced as "skews," so if you hear me start saying "skews," same thing.

But this multiyear goal sprung from management's realization that if we undertake this investment, we may reduce revenue somewhat but we're going to have more profitable products. I'd like to talk about one case study. This is something that happened several years ago when Unilever's U.K. and Irish units combined into one group. When they got together, this was around 2008 to 2009, and they performed an analysis of their SKUs and they found that 60% of product variance contributed just 5% of their sales, but that made up 20% of inventory. And Vince, I know you had also seen that case study. What are your thoughts about that? That really opened my eyes to why a company should jump in and perform SKU rationalization.

Shen: Yeah, those numbers -- notably the 5% of sales and the 20% of inventory -- is unbelievable. This case that you mentioned, I think it was from 2008 to 2009, but even as recently as 2014 Unilever still had about 50,000 SKUs in its portfolio. So it's a monumental task. You know, keeping track of that, managing that, and the fact that, as we'll get into more detail, about how the company and specifically the U.K. and Irish units kind of approached this issue. Really, the results you'll see have had a very direct impact on their financial performance.

Sharma: Sure. One of the ways that Unilever and other companies benefit once they trim those SKUs is that their manufacturing setups become more profitable. So again, some learning today -- companies have what are called manufacturing lines. That is, when you go into a plant you can imagine that not every product has its own manufacturing line, else we would have factories taking up most of the square footage on Earth. But similar products lines and manufacturing setup is a process of preparing several products to run through lines either individually or ganged up together. So if you can take, to use an example, package of cereal and reduce the sizes of those boxes or the numbers of sizes that you offer, that is, then you can make that one manufacturing setup, which is there to produce those boxes, more profitable.

And those of you who are familiar with manufacturing will understand that the company itself may have part of the manufacturing process, but every multinational conglomerate has to work with a series of smaller suppliers and they have their own manufacturing setups to produce one product. So, you can see this trimming of SKUs reducing the complexity of the operation and this is a big thing that industry people talk about. It's not just shrinking or reduction, it's the reduction of complexity and Unilever is really bent on doing that.

Shen: Yeah, I think ... Let me just jump in there really quick. The thing that really surprised me is when they talk about this project, the fact that the amount of work that they had to do with their partners. It wasn't just this internal process that the right managers in departments could implement unilaterally. They had to work with their marketing teams that had previously invested resources and time into certain projects, excuse me, and products and SKUs. And then also their retailers, for example, you know the companies that they distribute their products to are concerned about making sure their shelf space is the way they want it to be. And that the products that Unilever is providing them -- you know a huge supplier, I'm sure, for a lot of these retailers -- that basically they can still optimize their shelf space, what they keep in stock, in their stores based on these changes. And some of them very radical that Unilever was making.

Sharma: That's an excellent point. We're going to talk about our second company, Procter & Gamble, in a moment, but P&G's CEO recently made that point on an analyst call and he said that when they talk with their retail partners, that's one of the major things that CEOs of their retail partners are telling them is, "Hey, reduce this complexity."

And you know, we're in a political season. Elections are coming up next month and one of the things we can extrapolate from what you just said, Vince, is that this can be a really political process. You can imagine if a marketing team has worked two years on an innovation and another management part of the company looks at this product that marketing team has pushed forth and realizes that logistically it's very hard to produce, and you have teams tussling over whether a product stays or goes. And the companies which are successful at SKU rationalization understand that they, at the end of the line, are responsible to shareholders, to earnings per share.So they have to make some tough decisions, and this often means reducing suppliers.

I'm going to give you another eye-opening statistic. We talked about Unilever reducing SKU count by as much as 20% as a multiyear goal. The company also wants to reduce the number of its suppliers by 35%. And these two goals are related; it may be a little scary to have a revenue concentration with a huge corporation like Unilever or a smaller sub-manufacturer and understand they are looking, not just to trim the SKUs, but to trim the number of people they work with. But again, this serves shareholders' interests, it reduces complexity, and reducing complexity reduces costs, which boosts net income at the end of the day.

Shen: Yup. So in our last few minutes here, I wanted to make sure we got to Procter & Gamble because they have been taking, I think, this whole process and reducing and optimizing their offerings to a whole other level with the amount of brands they have dropped recently and how they're trying to refocus their resources, their money, into basically what they see as the most profitable brand portfolio that they can possibly target.

Sharma: Absolutely. If you take the concept of SKU rationalization and blow it up, there's a term for it. It's called brand rationalization. And that's what Procter & Gamble is up to. They also have been talking up their effort to reduce SKU count over the past several years. But a couple of years ago they woke up one day and realized: We have way too many brands in our portfolio. So, over the last 18 months, Procter & Gamble has exited, or consolidated, 61 of their brands and it's in the process of exiting 44 more by the end of this year. Again, going back to what we found in Unilever's case study, the brands that Procter & Gamble is getting rid of represented only 6% of profit during those 18 months. And when this whole process is completed, Procter & Gamble is going to be left with only 65 brands across 10 major categories.

Shen: So let me hop in there really quick. One thing I wanted to make sure we touched on for listeners was also just previously, over the summer, we'd done a show that's somewhat related to this, was around inventory turnover, inventory management, and there's a point here, a metric here, for Procter & Gamble that really stands out to kind of show how this brand rationalization that you mentioned has benefited them. So let's touch on that, and then also I'd love if there are any other metrics. I know there's nothing that is one-to-one necessarily with SKU management and with reduction that investors can look at, but what other metrics can investors use when trying to evaluate a company's effort in this space?

Sharma: Sure. Well, you've touched on a really great one. This is a metric that you can find on many financial websites, but if you look at days of inventory outstanding. When you hear that big company is trying to become more efficient with its product lines, there's a way you can see if they're being effective or not. Procter & Gamble before this effort, the other day, had a days inventory outstanding of 78 days. What that means is that it takes Procter & Gamble about 78 days to cycle its inventory on average and it replaces its inventory about 78 days, if you average everything out. Through this process, P&G now has a days inventory outstanding of 58 days, and that's a very solid boost to cash flow because inventory is cash tied up. You have to build a product, you have to move it, you have to store it, to get into a store, and then you get paid and collect the cash. So, this is an excellent metric to see if a company is walking the walk. And we can tell in this case that P&G is certainly walking the walk.

Some other metrics you can look at include the cash conversion cycle which again, is maybe effective to look at but might be more difficult to find. But if you want one which is easy enough to locate, look at a company's operating cash flow. Procter & Gamble again is sacrificing some top-line sales in order to trim its brands. That means some brands will disappear, it won't be selling those on the marketplace. But if you look every quarter going forward at the amount of operating cash flow Procter & Gamble generates, if it's being successful, that number is going to grow every quarter here on out. I love to look at that when I know companies are trying to become more efficient with their resources. And these two concepts are tied together. The company cycles its inventory more quickly, it should produce more operating cash flow.

And so far what we're seeing is it's a good thing that Procter & Gamble has undertaken this initiative so long-suffering investors have seen that stock for many years just remain stagnant. It's finally, I think, getting a little bit of lift from these operational efforts.

Shen: Yeah, absolutely. We are about to wrap up here, so thank you Asit for your thoughts. But I really wanted to hammer the point home in terms of how important these efforts can be for companies by stepping back a little bit and giving a little bit of a big-picture context and calling out some numbers that I think can put things into perspective. For example, in 2008 research from the Food Marketing Institute at the typical U.S. grocery store, or supermarket, stocking about 47,000 different products. That is up 50% from the previous decade and about five-fold since 1975. Keep in mind that a Wal-Mart Supercenter, for example, their SKU numbers for a store that size is well over 100,000. And then if you go a step further, researching the case at any one time in the United States, there are at least one million products on the market for consumers to purchase. So that research might be a few years old now, so with some of the other trends that we've seen you can imagine that number is likely much larger than one million at this point with customization, for example.

So the sobering reality I think for a lot of retailers, be it Unilever or Procter & Gamble, is that consumers only use about 340 unique items in a year out of that one million-plus. And making sure that you are maximizing your profitability, maximizing your product mix and what is on store shelves, to boost your revenue and make sure that that small subset of items that each consumer uses includes products from your portfolio, is just really important. Is there any other thoughts that you wanted to leave our listeners with, Asit?

Sharma: Just one last thought. And by the way, those are some mind-boggling statistics and I think that really visually gives us an idea of how much supply there is out there of product and why it's a great idea to reduce as much as you can if you're a manufacturer.

My last point is that we see the Pareto Principle in life a lot, which is, 80% of outputs are due to 20% of inputs.See that in so many different spheres of life and manufacturers have found this to be very true ... SKU and brand rationalization, that a lot of times it's just a few products that are really driving your sales and your profits, so why wouldn't you put in the effort to pare those down and optimize your profit and optimize your cash flow? As investors, we should be looking for the companies which are actively trying to perform this exercise. And the two companies we've mentioned today are really into this. Their management talks about these concepts almost every conference call, we see it in the numbers, and it's a great way to evaluate a consumer goods company. Are they paying attention to the proliferation of products that they've got, and are they trying to make themselves more efficient as time goes on?

Shen: All right. Thank you very much, Asit! That's all the time we have for today, but listeners can continue the conversation with us and the rest of the IF crew via Twitter @MFIndustryFocus or send us any questions or comments via email to industryfocus@fool.com

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