raytoei's  Instablog

 

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1. Is this a great business run by great managers?

 

2. How much is the company worth?

 

3. How is the market pricing the company currently?

 

4. What are the catalysts that will unlock the company value? How likely is the most realistic catalyst?

 

5. What is the margin of safety if the catalyst does not occur? How much can we expect the share price to fall? 

 

 

                                                                                                          

(Disclosure: This is an abridged version of my report on Unilever. If you like the full version, you can download it here: retro.ms11.net/unilever-raytoei.pdf

I currently own a very small position in Unilever. Please send your comments to raytoei@gmail.com  4^th August 2009)

 

1. Is this a great business run by great managers?

 

1.   Is success solely dependently upon management's ability to efficiently utilize tangible assets?  Are Patents, Copyrights and Brand name are present, the company product or services are easy to identify.

 

Unilever’s success is due to a strong product brand and relatively affordable fast moving consumer goods. Many of the products are house-hold names,  its top 25 brands account for over 70+% of its revenue.

 

World No.1	World No.2	Local strengths
Savoury	Laundry	Household cleaning
Spreads	Daily hair care	Oral care
Dressings
Tea
Ice cream
Mass skin
Deodorants

 

	Unilever 1bn Euros p.a. Brands
Foods   Blue Band Becel/Flora   Hellmann's   Lipton Knorr Wall's/Algida	Margarine products also sold as Rama, Country Crock and Doriana. Heart healthy spreads containing Omega 3 and 6 and including spreads containing plant sterols marketed as pro.activ. Dressings and sauces including the global No.1 mayonnaise. Has sister brands being Amora, Calve and Wish-Bone. Tea-based drinks. Includes soups, bouillons, sauces and seasonings. Unilever’s largest brand with sales of circa €4bn p.a. 2 of the main ice cream brands that Unilever sells under its international Heart brand.
Home care   Omo	Laundry product that helps to support the 'Dirt is Good' advertising platform (emphasizing how it is perfectly normal and part of the learning process for children to get dirty).
Personal care   Dove   Lux Rexona     Sunsilk	Cleaning and personal care products for skin and hair. Now includes Dove Pro.Age (beauty products for older women). Soap, shower gels, bath additives, shampoos and conditioners. Also sold under the Sure and Degree brands and the first deodorant brand to surpass €1bn p.a. Inclusive of its other brands such as Axe/Lynx, Unilever now sells circa €2bn p.a. of deodorants with Axe/Lynx the world’s No.2 deodorant brand. Meets women's everyday hair needs. Also sold under the Seda/Sedal brands.

(Source: Finncap 2007 report on Unilever)

 

2.  Does the industry have substantial excess production capacity as a result of too many multiple producers?

According to Datamonitor (March 2009, Industry profile of Global Household & Personal Products ), the industry is fragmented despite a tendency towards consolidation. The presence of large players account for less than 40% of the global revenues. The rivalry among players will remain intense, however rivals tend to dilute the rivalry through diversification and many have presence in different segments of the market. Unilever has 400 brands in over 100 countries. The other factor affecting production capacity is the stocking policy of the large retailers like Wal-Mart or Carrefour who are buyers and stockist of these products and are influenced by the preference of the end-users.

3. Do the historical earnings show a strong and upward trend ? Does it suffer from erratic profit or low margins and low inventory turnover?

Operating income is a little lumpy with 2 years of negative growth; including restructuring charges, the EPS shows three years of negative growth, however the trend is clear, there is an upwards growth in earnings.  Margins are healthy and fairly consistent, but a little low compared with its peers.  Inventory turns is slightly better than P&G but not as diligent as Church & Dwight.

(source: morningstar)

4. Is the company conservatively financed. Is there an absence of excessive debt?

 

 

While the 8bn  long term debt may looks scary, the Debt / Equity ratio is only 0.34. With a current annual free cash flow of 3988, it will take slightly over two years to repay its long term debt.

 5. Does the company have to spend a high percentage of its retained earnings to maintain its current operations ? Or is the company free to invest the retained earnings in new businesses or used it to repurchase the company shares?

 

Unilever generates a lot of free cash flow after paying for its capital expenditure. The free cash flow is used for dividend payouts as well as share buy back.  

6. Will value added by retaining earnings lead to an increase in the stock market value of the company ?

No yet. While the Book value per share has doubled from 2.27 to 4.57, the market-cap is only marginally higher between 2000 and the present. From the peak in 2007, the market gradually lost confidence in Unilever.  However, this is a temporary phenomenon, once Unilever achieves the unit volume growth, the market will respond positively.

7. Does the company consistently earn a High rate of return on shareholder's equity?

Yes. ROE and ROA are high and growing, according to Bear Sterns, Unilever’s Return on invested capital (ROIC) is above its industry peers:

 

 

8. Is there an absence of Organized labour ?

Unilever has been present in many emerging markets for decades, and in many case more than half a century, unions have been organized in many of the Unilever plantations. There have been four complaints which has been brought to the OECD by the Unions against Unilever which relate to site closure, freedom of association, collective bargaining and the use of temporary and contracted labour.

9. Is the company free to adjust prices to inflation?

Yes. Unilever has successfully passed on the higher commodity costs onto its customers. In fact, the 2008 revenue increase is due to higher unit price, to quote from the annual report: “Underlying sales growth of 7.4% was broad-based across categories and in line with our markets overall. Growth was primarily driven by increased prices, with volumes essentially flat. “

2. How much is the company worth?

 

A peek in the past history of EPS earnings of Unilever:

 

Despite its lumpy earnings growth, Unilever has managed to grow at around 11.9% a year for the past 10 years.

 

I will model the following EPS growth scenarios for Unilever using the operating EPS of $1.87.

Scenario	EPS Growth	DCF Valuation
Optimistic	10 years of 9 ~ 12% growth followed by long term growth rate of 5%	$74.23
Realistic	10 years of 6 ~ 8% growth followed by long term growth rate of 5%. I am matching this with P&G’s 2009 forecast of a core earnings growth of 6~8%. (Page 2 , Deutsche Bank Conference handout, http://www.pginvestor.com/phoenix.zhtml?c=104574&p=irol-presentations  )	$55.23
Conservative	Company grows only the rate of the world wide population growth, at roughly 5%	$46.24

My assumptions are a discount rate of 9% and a long term growth rate of 5%. This isn’t rocket science, most analysts have the discount pegged at 8% WACC for Unilever, and a long term rate of 3%, however I am being consistent across my equity valuation for international consumer brands.  

 To comment on the Conservative scenario, if I totally discount management's restructuring efforts (“Path to Growth”, "One Unilever" etc) as well as ignore it's past history of 11.9% annual EPS growth, I would use another metric to measure long term growth: long term GDP growth of the world, approximately at 5% a year.  At EPS growth of 5% less debt, Unilever is worth around $46.24.

Using a range approach, I would put the value of Unilever between  $46.24  - 55.23 per share. With a lower 25% margin of safety for this high quality blue chip company, that would put the buy price of Unilever between $34.68 and $41.42.

Unilever	Low	High	Remarks
Intrinsic Value	$46.24	55.23	Assumes only either 5% (LOW) or 6~8% (High) EPS Growth.
Buy In Price	$34.68	$41.42	Based on 25% Discount to IV
Recent Price		$25	P/E of 13.36 based on adj EPS of 1.87

3. How is the market pricing the company currently?

 At the recent $25., the market is pricing EPS growth at around 2.5% a year. The key issues with the lower valuation are:

 1999 – 2004 “Path to Growth” initiative did not bring in the top line revenue growth that the company was hoping for, instead of 5 ~6 %, the company managed 3 ~ 4% revenue growth. With the changes of Chairman, CEO and CFO in 2007 / 2008, the market does not think the “One Unilever” initiative can recapture the growth albeit the lower growth targets set by management: 3 ~ 5% Revenue growth by 2010 and Operating margin of 15%. 

Other issues include the increase in commodity prices will not help the margins in the short-term, operating margins have been declining for the past three years. In the most recent quarter, the management indicated lower margins due to increased R&D spending. Perhaps the reason for the low valuation of Unilever is due to its competitors, chiefly Procter & Gamble, making inroads into the emerging countries. Having a high market share in India means that its growth will slow at some point. 

 

  In my opinion, the short-term nature of the capital markets has resulted in a low valuation of Unilever, and a buying opportunity for the patient.

4.   What are catalysts and how likely are the scenarios?

 

a. Management Changes

The chairman, CEO and CFO are relatively new, having being in Unilever only in the last three years. This is a catalyst since Unilever has historically hired from within.

 

Chairman Treschow, Michael	Turnaround Chairman at Electrolux and Ericsson	Since 2007
CEO Polman, Paul	Previously  Group President Europe, P&G 2001-2006. CFO  Nestlé S.A, EVP for the Americas 2008.	Since Jan 2009 (announced in 2008)
CFO Lawrence, James	Vice Chairman at CFO of General Mills. Various positions in PEPSICO	Since2007

 b. “One Unilever” and other company initiatives

Since 2001, Unilever has cut various product lines from 1600 down to 400. And reduced the number of operating units from 200 down to 30 at the end of 2008 and a final target between 20 ~ 25 units.  Since 2005, it has started to move away from localized programs in favor of centrally managed global brands, where global roll-outs marketing plan is coordinated and executed in various countries at the same time.

It will spend more on R&D and product development, and funnel customers to spend more on higher margin items like Personal care where it is growing fast, products like deodorants (eg, Rexona) and Mass skin (eg. Dove) are number 1 while Daily Hair care (eg. Sunsilk) is no.2. Oral care (eg,. “Close Up”) enjoy local strengths. The keyword is “Vitality” this is a combination of well-being that meets basic nutrition, hygiene and personal care. For example, the Lipton “Lipton Linea” slimming tea is a good example of a Vitality product.

 

c. Lastly, Unilever wants to replicate its success in India and Indonesia into other D & E (developing and emerging) countries. Hindustan Unilever is no.1 in all categories except Ice Cream while in Indonesia, it is no.1 in all categories except Fabric Cleaning and Savory where it is no.2.  The growth rates in D & E countries has averaged 9% a year despite some country specific issues. In China, it’s grow has averaged 20+ % a year, effectively doubling in three years.

Unilever sees the addressable market to expand by 1bn by 2018 in the D&E market, this is due to overall increase in the standard of living in emerging countries as well as the population with the greatest growth. Unilever wants to increase its 50% of unit volume currently derived from the D&E countries.

d. Other Catalysts

While I have not read any company announcements on this, a possible catalyst could be the abandonment of its Dual Listing Company structure (DLC). The company shares are traded in Netherlands as well as in London. There is a consistent arbitrage situation, where the share price of each twin trades a discount to each other, and a discount to its peers. Add in the additional costs of managing a dual listing, unlocking the share price from change of structure is a real catalyst. According the following article, 10 of the top 12 companies have abandoned the DLC structure.

 ( http://paguntaka.org/2007/02/12/bhp-set-to-ditch-its-dual-listing/ )

 

Of the above catalysts, I would rank (C) as the most credible. Catalysts (A) and (B) are interrelated and it is dependent on the management’s ability to execute its strategy. Catalyst (C) is a bet that the emerging countries will grow in population demographics and GDP per capita will increase; that brand loyalties are not easily displaced and lastly, low ticket items such as shampoo and personal care products will not suffer cut-backs during recession or price increases during commodity inflation.

5. What is the margin of safety if the catalysts do not occur? How much can we expect the share price to fall?

 

If none of the above catalysts materialize, then the earning power of Unilever would be calculated as EPV / ( Discount rate), assuming no growth at all. This works out around $20 a share.  In other words, if Unilever experiences no growth forever, then it is valued at $20 a share.  At the recent price of $25.00, this would be a negative 20%  swoon to $20.00.

 

 

However, a -20% drop is cushioned by two shareholder friendly actions that the company has done consistently:  a 3.6% dividend yield and a 2% share buyback. This brings the negative returns for a worst case scenario to -20% + 5.6% = 14.4% share loss if the catalyst does not occur.

 

Note that there is a difference between valuation price and trading price. Ie. A security may trade higher or lower than the valuation, whether at a reasonable EPS growth rate or zero growth rate.  A good example would be the 2009 March sell-off, where Unilever traded at slightly above $17.

 

 Appendix: DCF calculations
 

 

Appendix II.

Earnings Per Share	Euros	USD  (1E= 1.44)	Remarks
Reported EPS	1.79	2.57
ING Adj EPS	1.44	2.07
Jeff Co Adj EPS	1.32	1.90
Credit Suisse Adj EPS	1.30	1.87	We will use this since this is most conservative.

 

At the end of 2008, debt per share is calculated as 8,012.00 debt divided by 2,810 number of shares  = $2.85.

Assumption: EPS of $1.87 is a proxy to Free Cash Flow.

Ticker	UL			%
			Growth (Y1 to 5)	12.00
Free Cash Flow	1.87		Growth (Year 6 to 10)	9.00
SharesOut	1		Discount Rate	9.00
Long Term Debt	2.85		Long Term Growth Rate	5.00
			Long Term Discount Rate	9.00
DCF-IV	74.23

 

Ticker	UL			%
			Growth (Y1 to 5)	8.00
Free Cash Flow	1.87		Growth (Year 6 to 10)	6.00
SharesOut	1		Discount Rate	9.00
Long Term Debt	2.85		Long Term Growth Rate	5.00
			Long Term Discount Rate	9.00
DCF-IV	55.23

 

Ticker	UL			%
			Growth (Y1 to 5)	5.00
Free Cash Flow	1.87		Growth (Year 6 to 10)	5.00
SharesOut	1		Discount Rate	9.00
Long Term Debt	2.85		Long Term Growth Rate	5.00
			Long Term Discount Rate	9.00
DCF-IV	46.24

 

 

Disclosure: I bought Unilever at $25.00 last week. Unilever has dual listing, one in London and the other in Netherlands, both tickers are traded as an ADS on NYSE as UN and UL. Both should be identical, but  UL, which I bought a small position,  is about 4% cheaper than UN.


Q. How much should I be thinking about Unilever ?

A: Europe isn't growing, the Americas are slow growth, Asia and Africa are smaller in total revenue but growing at double digits. Unilever grew revenue in 2008 by price increases, increases in unit volume was very small.

The company has a stated aim of growing 4% sales and operating margins of 15%. It is undergoing a restructuring of the units and streamlining its product lines.

A peek in the past history of EPS earnings of Unilever

Year1999	2000	2001	2002	2003	2004	2005	2006	2007	200
EPS0.92	0.33	0.53	0.67	1.03	0.77	1.56	2.00	1.79	2.53
Growth	-64.13%	60.61%	26.42%	53.73%	-25.24%	102.60%	28.21%	-10.50%	41.34%

1999 to 2008CAGR11.90%1999 to 2008CAGR11.90%





Despite its lumpy earnings growth, it has managed to grow at around 11.9% a year for the past 10 years. If I were to be conservative and i. totally discount management's restructuring efforts ("One Unilever" etc) as well as ignore it's ii. past history of 11.9% annual EPS growth , I would use another metric to measure long term growth: GDP growth of the world at an estimate of 5% a year.

At EPS growth of 5%, Unilever is worth around $43 (1.73/ 0.09 - 0.05)

Q. How much is Unilever worth if it doesn't grow ?

A: The EPS for 2008 is around $2.5, but the core earnings is around $1.73. So with a WACC of around 9%(well, actually it is 8%, but I use 9% for all blue chip companies), the earnings power EPV is 1.73 / 0.09 or $19+

So if Unilever doesn't grow ever, I would expect the current price to drop to a price of around $19+, a drop of around 20%

At no growth, I would still expect the company to continue to pay the dividend of 4% and a share buy back of 2%. Bring the total tally of -14% if the Unilever doesn't grow at all, forever.


Q. How much growth is the market pricing Unilever ?

A: Currently the market thinks the CEO cannot make it, that increasing commodity prices is going to crimp its margins and P&G is eating Unilever's lunch, despite Unilever being no.1 in a number of catergories (especially in bath and shower products). The market only expects a 2.5% growth from Unilever.

In conclusion: Unilever is Cheap, and the market has low expectations of this 70+ year old company. So while the company figures out how to get its Unit Volume mojo back, I will wait for patiently for the 4+2% dividend and share buy back returns. There is of course the possibility that UL may go downhill and never recover from its restructuring efforts, that is a business risks but I will rate this occurrence as remote.

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