- Financial statements of Unilever confirm its story of a great company with capable management and strong brands.
- The current price of $40 offers a 10% expected return with a narrow margin of safety.
- Unilever has tremendous exposure to emerging markets and their currencies. Be careful with currency risk.
The aim of this article is to decide whether Unilever (NYSE:UL) is a worthwhile business and judge its attractiveness at the current price.
My analysis is based on the reported accounts from the last six years. Whatever enticing or nightmarish stories are connected with a company, if they are not backed by tangible information, they remain just stories and I will not base my decisions on them.
Note that historical data often get restated. If you take numbers from various annual reports, they are not entirely consistent. However, the restatements are almost always small in the case of Unilever, and so they are of no concern to us when building a general overview of the company.
The most important metrics we will focus on are return on tangible assets which indicates quality of company's intangibles and return on equity which indicates how efficiently retained earnings are reinvested. I will more precisely define these metrics after presenting the historical data relevant to us. (The data in the following table are taken from the annual reports for years 2008 to 2013 available on the company website. Note that IFRS is used.)
The crucial step in my calculations is an estimate of owner earnings (OE), that is, net income plus depreciation and amortization minus maintenance capital expenditures minus an increase in working capital. I am using current assets minus current liabilities as a proxy for working capital. Unilever happens to be operating with slightly negative working capital which has not changed much over the years, and so we can leave this term out of the calculation of OE. (In fact, our working capital proxy has been steadily decreasing since 2009. If it was true also for the true working capital, the calculated owner earnings would be understated. However, it would require a detailed analysis of inventory accounting etc. Therefore, we will err on the side of caution and not include working capital decreases in OE.) Hence, the only problematic part is maintenance CAPEX.
Unfortunately, Unilever's management is not very open in disclosing information about capital expenditures (they confirmed it in a reply to my direct e-mail request). What I have found is that the value of property, plant and equipment is significantly dependent on currency translation effects (see Note 10 in the 2013 annual report); this corresponds well to the fact that emerging markets constituted 57% of Unilever's business in 2013. Currency translation effects are something to really keep in mind when analyzing Unilever; underlying sales growth in emerging markets was 8.7% in 2013, but it was flat after currency translations!
Emerging markets constituted only 47% of the business in 2008. The increased proportion attained in 2013 is due to gradual, but robust growth of emerging markets business, driven by increased capital expenditures (revenues grew at 8% CAGR). Thus, at least some part of the reported CAPEX is related to growth. The following charts (taken from a useful presentation Charts 2012) show the significant increase in capital expenditures, both in absolute terms and as a percentage of sales.
The capital expenditures before 2009 sufficed to not only maintain, but even increase business volume, so I think it is safe to assume that maintenance capital expenditures do not materially exceed depreciation. Consequently, owner earnings are roughly equal to the reported earnings.
Let us return to important derived metrics. First, the net margin looks fairly stable at about 10%, which I am fine with. Second, interest coverage ranged from 10x to 15x and the long-term debt to equity ratio has decreased from 65% to 50%, so debt levels are easily manageable and I have no worries about the balance sheet strength. (The amount of leases and other fixed charges is not dangerous, though it is material; see page 31 of the 2013 AR. The pension fund is in a reasonably good shape too.) Third, the amount of share buybacks after 2008 is immaterial since they were only used to offset dilution. The shareholder yield (dividends plus repurchases divided by OE) is thus sustainable and runs in the range of 50 to 60%.
Next, we turn to return on tangible assets (ROTA). In order to calculate tangible assets, I take current assets stripped of tax assets and add property, plant and equipment, financial assets and "other non-current assets". (I guess I should pay more attention to the reported pension assets and possibly slice the reported balance sheet entries a bit more, but I believe the above-given formula is suitable for the rough calculation I am interested in.) ROTA is operating income divided by tangible assets; it takes into account all the income derived from operating the tangible assets (it does not matter whether the income goes to shareholders, bondholders or the government). Unilever's ROTA of about 30% is fairly stable even in tough consumer environments and demonstrates the quality of the brands the company is managing.
The return on equity (OE divided by equity) of 30 to 36% also pleases the eye of a shareholder. We can conclude that Unilever indeed is a worthwhile business.
The crucial part of the valuation is determining future growth rates. Unilever has an appealing track record: dividends have grown each year from 1979 to 2013 at CAGR of 8% (in EUR, according to the company's 2014 presentation). Since the payout ratio is fairly stable below 60%, we can take future dividend growth as equal to the estimated earnings growth and then discount the future dividends to their present value. The company engages in small acquisitions time and again, but I am confident of the management's capabilities and so I believe they are getting at least a dollar's worth for each dollar they retain.
The earnings growth potential is limited by the return on equity and the amount of retained earnings. For Unilever, retention of about 40% of earnings, reinvested at 30% ROE, gives earnings growth of 12% (which can be possibly enhanced by price increases on the existing volume). It is obvious from the data that the actual growth was smaller; it warrants further investigation.
(Such an investigation leads to questions exceeding the scope of this analysis: for instance, while the company retained about 2 billions of earnings in 2013, the equity has decreased by about 1 billion --- why? It is caused by "other movements in equity", which include "the impact of acquisition of non-controlling interest"; see page 91 of the 2013 AR. Most of it is explained in Note 15B: Unilever has acquired an additional interest in Hindustan Unilever Limited.)
Let us assume that the dividend growth rate will range between 8% and 12% (where 8% is the historical growth rate and 12% is the theoretical limitation derived from ROE). Assume further that this growth will slow to only 3% (inflationary growth) after 12 years, but the payout ratio will increase to 100% at that time. My preferable discount rate (desired rate of return) is 10%. The dividend estimate for 2014 is about $1.50 per share. The present value of the assumed dividend stream is thus between $44 and $62.
The current price of less than $40 for a UL share thus offers a narrow margin of safety (assuming no withholding tax on dividends). I have to admit this came as a bit of a surprise to me: at the first glance, I considered Unilever mildly overvalued at the P/E ratio of 17. An investment in Unilever looks attractive to me because I believe Unilever will be able to reinvest some portion of the earnings at the attractive 30% ROE also after twelve years. And the 3.6% dividend yield is also nothing to scoff at.