Unilever (NYSE:UN) released a trading update this morning. Unilever is one of my largest positions. Given its recent run-up and my desire to find alpha beyond the S&P500 I am wondering what return I can expect from Unilever over the next few years. I am leaning toward trimming the position since I really don't expect much alpha after its 20% run-up in the last 3 months.
Unilever's recent annual performance
Unilever has generated about 5B EUR of Free Cashflow for each of 2015 and 2016. Unilever Operating Income has bounced around7.5-8.0B EUR per year for the last 4 years. These cash streams are highly diverse and unlikely to collapse. Even if volumes struggle, as they did in Q1 2017, Unilever has the capability to increase prices. Spectacular, organic growth is not likely but steady, slow, uninterrupted growth is very likely.
The Q1 2017 Update - Business As Usual
3% overall growth was met by price increases as volumes struggled. Unilever can flex its market power muscle as required to meet its growth expectations to investors. Very few companies have this discretionary capability to control their own destiny. This is the reason why investors love Unilever.
But if it's just doing what it normally does why has the share price jumped 20% in 3 months?
Is the 20% price jump rational?
The catalyst for the price appreciation was not organic earnings growth but rather a failed takeover approach from Kraft Heinz and a subsequent major strategic response from Unilever's incumbent management. This strategic response seems to have locked in the 20% gain because of the following plans:
- The spreads business it to put up for sale. Analysts seem to value it at about 7B EUR
- Dividends to be increased by 12%. This item is now actioned in today's trading update. The Unilever dividend is now back to 3%.
- A 5B EUR buyback has been approved for the remainder of 2017. Unilever does not traditionally do much of a buy back… about 0.25B EUR per year. It has retired the share count by about 0.65% per year over last 4 years. The 5B EUR buyback will retire about 3-3.5% of shares at current price levels by the end of 2017.
- The operating margin is to be increased to about 20% by 2020. It is about 15% at the moment. 1.5% operating margin will be realized on exiting the spreads business. The balance of 3.5% to be realized over the next 4 years.
- Maintain Underlying Sales Growth of 4% to 2020.
- 3% of Sales will be invested into capex with at a high teen ROIC. This will actually see capex drop substantially with the sale of the spreads business: from about 2B EUR to 1.6B EUR.
What does this all mean for 2017?
Using the 5B EUR of FCF in 2016 to an Enterprise Value (EV) of nearly 170 B EUR then Unilever trades at a very expensive 3% FCF Yield. I believe the market is factoring a forward 4.5% FCF to be achieved by the end of 2017. I believe Free cashflow will increase to about 7B EUR if the spreads business is sold as follows:
Sales (excl Spreads)
The above action increases the FCF yield to 4% at today's Enterprise value, but the 7B EUR in proceeds from the sale in the spreads business alongside the 5B EUR buyback increases the FCF yield to an attractive 4.5% of EV by the end of 2017.
What does this mean in 2020?
Organic growth of 4% from 2018-2020 alongside operating margin expansion from 16.5% to 20% should see Free Cashflow increase to 10.5 - 11B EUR.
I appreciate there is execution risk in the above but is there really? Consider the following:
- Unilever has a very predictable growth trajectory. If volume growth is non-existent, then Unilever just uses its market power to increase prices.
- Kraft Heinz sought to buy Unilever because it believed it could cut costs. As such, Unilever management can too. The opportunity exists.
- The main foundation of the plan is selling the spreads business. I believe this will happen at a very attractive prices because the private equity world is awash with huge sums of money that it needs to invest. It's a perfect time to sell this type of asset which can be collateralized with debt. Private equity will love this type of "leveragable" investment that will juice their returns. There will be numerous potential suitors that will bid the price up of this business. Such suitors will be more aggressive with debt compared to Unilever. In addition, this is a business which has been around for 100 years. The spreads business is the oldest part of Unilever. Banks will be falling over themselves to provide debt to private equity buyers.
Given the above I think Unilever will deliver a capital return of around 11% per year to 2020.
Combine that with a 3% dividend return and you are talking about a 14% return. There's plenty of life in this seemingly over-priced investment. I will stick with Unilever. I believe it has great alpha potential and fantastic risk-reward. Even if things don't go to plan it's very likely Unilever will still deliver a return that is at least in line with the market.
Obectively analyzing a company is really a worthwhile exercise. About 2 hours ago I was 90% sure I'd be selling some of my position in Unilever.
Disclosure: I am/we are long UN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.