Unilever (NYSE:UL) 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. But such brand strength must eventually be captured in estimates of a future free cash flow stream as Valuentum President Brian Nelson describes here. How else can investors decide whether shares represent a bargain or not? In this piece, let's take a look at Unilever's intrinsic value and assess its timeliness via the Valuentum rating system.
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Unilever PLC posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. The Valuentum Buying Index is a system that estimates the likelihood of a firm being purchased (i.e. the likelihood of its stock price being driven higher) on the basis of its valuation and technical/momentum considerations. A score of 6 is not bad, but it is not as good as other firms that register higher ratings and are included in the Best Ideas portfolio. Generally speaking, a score of a 9 or 10 is equivalent to a "we'd consider buying" rating.
Unilever's Investment Considerations
• 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 doesn't make the cut for inclusion into the Dividend Growth portfolio, but the firm still registers a strong Dividend Cushion score, especially for the size of its annual yield. Its dividend has increased from €0.78 ($1.00) in 2009 to €1.05 ($1.40) in 2013.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Unilever PLC's 3-year historical return on invested capital (without goodwill) is 56.1%, which is above the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Unilever PLC's free cash flow margin has averaged about 20% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Unilever PLC, cash flow from operations increased about 135% from levels registered two years ago, while capital expenditures expanded about 3% over the same time period.
Our discounted cash flow model indicates that Unilever PLC's shares are worth between $31-$47 each. Shares are trading at roughly $44 each at the time of this writing. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $39 per share (the midpoint of the range) represents a price-to-earnings (P/E) ratio of about 7.6 times last year's earnings and an implied EV/EBITDA multiple of about 6.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.7% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 5%. Our model reflects a 5-year projected average operating margin of 14.4%, which is below Unilever PLC's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. For Unilever PLC, we use a 10.2% weighted average cost of capital to discount future free cash flows.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Unilever PLC to peers General Mills (NYSE:GIS) and Kellogg (NYSE:K).
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $39 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Unilever PLC. We think the firm is attractive below $31 per share (the green line), but quite expensive above $47 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Unilever PLC's fair value at this point in time to be about $39 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Unilever PLC's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $48 per share in Year 3 represents our existing fair value per share of $39 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
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.