Unilever's Dividend Is Levered For Growth

Jul.15.14 | About: Unilever Plc (UL)

Summary

Do your best to avoid backward-looking dividend analysis.

The most important time horizon for investors of all types is the future. Therefore, focus on metrics that measure future dividend growth potential.

Let's take a look at Unilever's dividend growth prospects in this article.

History has revealed that the best-performing stocks during the previous decades have been those that shelled out ever-increasing cash to shareholders in the form of dividends. This makes a lot of sense, as the strongest dividend growers are often the strongest generators of increasing cash flow. Unilever (NYSE:UL) is one such gem. Let's evaluate its dividend growth prospects in this article.

But first, let's start with framing this analysis for readers. Most dividend assessments tend to be backward-looking--meaning the evaluation rests more on what the company has done in the past: how long it has raised its dividend, for example. Don't misunderstand. We think analyzing historical trends is important, but investors should understand that for a cash-rich, growing company to raise its dividend by a reasonable amount in each of the past 20, 30 or more years isn't much to write home about.

Imagine, for example, giving your grandson $1 for his age on each consecutive birthday. Though you'll effectively be raising his "dividend" each year, the payout isn't necessarily tied to your income stream, nor is it very taxing on your lifestyle (even if he lives to 100 years or older). In a similar manner, a dividend payment is not explicitly tied to a firm's earnings stream nor is it very taxing on a firm to raise its dividend each year. For one, firms with substantial earnings don't have to pay a dividend, and companies can report declining earnings and still raise their dividend in the same earnings release.

Over the long haul, earnings growth will have to support dividend growth, but in instances where the payout ratio is low, earnings don't necessarily have to expand for the company to raise its dividend for years and years. A company can double its payout ratio by raising its dividend for 50 consecutive years, for example, but the payout ratio at the end of the period could still only be 50% of earnings at the beginning of the 50-year period. Fascinating, no?

With all of this said, it becomes obvious that assessing the future capacity of growth of the dividend is really what matters most for dividend growth investors. After all, dividend growth investors are investing for the next 5, 10, 20 years, not the past 5, 10, 20. And they want their dividends to increase by a material amount. This forward-looking perspective that assesses the potential magnitude of future dividend growth is all the difference in the world. That is why we created a forward-looking assessment of dividend growth through the innovative Valuentum Dividend Cushion methodology.

For those that may not be familiar with our boutique research firm, we generate a discounted cash-flow analysis for all firms in our coverage. We use these future forecasts of free cash flow (cash flow from operations less capital expenditures) and expected cash dividend payments and consider the company's net cash position to evaluate just how much capacity a firm has to keep raising its dividends long into the future.

The Dividend Cushion is a forward-looking ratio (with a numerator and a denominator). It tells investors how many times future free cash flow (cash from operations less capital spending) will cover future dividend payments after considering the net cash on the balance sheet, which is also a key source of dividend strength. It is purely fundamentally-based and driven from items taken directly off the financial statements.

Let's take a look at Unilever's investment highlights and then its dividend report to see how all of the analysis comes together.

Unilever's Investment Highlights

• Unilever PLC's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

• Unilever owns some of the world's best-known brands, including Dove, Knorr, and Lipton. The company has a strong heritage; Hellman's mayonnaise, for instance, just celebrated its 100th anniversary. Unilever's products are sold in over 190 countries, and billions of consumers worldwide use them.

• Unilever PLC has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 10.9% in coming years. Total debt-to-EBITDA was 0.8 last year, while debt-to-book capitalization stood at 44.5%.

• Unilever has a strong track record of innovation. The firm's focus on gaining consumer insight, enhancing designs and marketing, and supporting its brands have made it one of the most powerful consumer goods companies. The firm can drive margin expansion, but foreign currency exchange can pose headwinds. Emerging markets account for ~60% of its business.

Unilever's Dividend Report

Unilever's dividend yield is nice, offering a ~3.4% annual payout at current price levels. The bottom right of the table below reveals our expectations for Unilever's future pace of dividend growth (~8%-10% per annum). Please have a look (information in the table is expressed in USD).

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Image Source: Valuentum

Note: Unilever's dividend has increased from €0.78 in 2009 to €1.05 in 2013.

Let's now dig into Unilever's qualitative ratings for dividend safety, dividend growth potential and risk of capital loss. The Dividend Cushion ratio not only informs our opinion of the safety of the dividend but also its capacity for future growth.

Dividend Safety / Cushion -- GOOD / 1.3

We assess the safety of a firm's dividend by adding the company's balance sheet net cash (cash less debt) to our forecast of its free cash flows (cash from operations less capital expenditures) over the next five years. We then divide that sum by the total expected cash dividends over the next five years. This process results in our Dividend Cushion™ ratio. A Dividend Cushion™ above 1 indicates a firm can cover its future dividends with net cash on hand and future free cash flow, while a score below 1 signals trouble may be on the horizon. And by extension, the greater the score, the safer the dividend, as excess cash can be used to offset any unexpected earnings shortfall. Unilever PLC scores a 1.3 on our Dividend Cushion™, which is GOOD.

Dividend Growth Potential - EXCELLENT

We judge the future potential growth of the dividend by evaluating the capacity for future increases, as measured by the Dividend Cushion™, and management's willingness to consistently raise the dividend, as measured by the firm's dividend track
record. Firms with GOOD or EXCELLENT Dividend Cushion ratios and strong dividend growth track records register a rating of EXCELLENT as it relates to our assessment of their dividend growth potential. This is the case for Unilever PLC, and we think the firm's annual dividend will be $2.22 per share within the next several years. (by the end of fiscal 2018).

We assign the quantitative dividend growth rates to firms on the basis of their qualitative Dividend Growth rating. The scale we use as guidance to assign future dividend growth rates is shown below.

Dividend Growth Potential Scale

Excellent: 8% or higher
Good: 4%-8%
Poor: 2%-4%
Very Poor: 0%-2%

Because Unilever has EXCELLENT dividend growth potential, we think its dividend will grow at a rate of 8%-10% per year. In addition to assessing the Dividend Cushion ratio and the firm's track record, we also evaluate recent growth rates in the dividend and/or the dividend payout ratio to fine-tune the trajectory of the future dividend forecasts. For those interested in dividend growth forecasts for other companies, we have dividend growth forecasts for every company in our 1,000+ firm coverage universe that pays a meaningful dividend.

Risk of Capital Loss - MEDIUM

Though the dividend certainly can impact a company's share price, we assess the risk of capital loss within the valuation context. If the stock is undervalued (based on our discounted cash-flow process), we think the risk of failing to recoup one's original capital investment (excluding dividends) is relatively LOW. If the stock is fairly valued (it falls within our fair value estimate range), we think the likelihood of losing capital (excluding dividends) is MEDIUM. If the stock is trading above our estimate of its intrinsic value, we think the likelihood of losing at least a portion of one's original investment (excluding dividends) is HIGH. Unilever registers a score of MEDIUM on our scale. Though we generally prefer firms that are underpriced, or have a LOW risk of capital loss, in this market environment, very few dividend growth firms are in this situation.

Wrapping It Up

We like Unilever's dividend growth potential. Though Unilever's dividend doesn't make the cut for inclusion into the Dividend Growth portfolio (we can't hold every great dividend growth idea; only the best of the best), the firm still registers a strong Dividend Cushion score, especially for the size of its annual yield. We think the company's dividend growth potential is as strong as ever.

The following provides the definitions of the terms you may have read in the dividend report (image) above. Thank you for reading!

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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.