The market currently underappreciates the ability of Unilever (UL) to generate steady cashflows in a time of historically low interest rates. The company’s competitive position should enable it to deliver attractive returns for shareholders for years to come. Judging from current valuations the market seems to either expect margin and ROIC erosion or a substantial increase in interest rates, neither of which I expect to come true with the severity that would justify the current sentiment.
Unilever produces and sells products of about 400 brands in more than 190 different countries. As of 2017 the company owned 13 of the world’s top 50 brands according to Kantar’s brand footprint report. These 13 brands each generate sales in excess of 1 Billion Euros annually and include Dove and Axe in the personal care space as well as Knorr, Lipton and Magnum in the foods and beverages category.
Competitive Position and Profitability
The company aims to make its products stand out from the crowd by focusing on specific purposes such as moisturizing skin care cream or shampoos catering to certain types of hair. Strong brand recognition coupled with functionality allows Unilever to charge a premium on its products which in turn translates into impressive margins and healthy returns on capital.
The numbers support this perspective:
In 2018 Unilever earned 9.808€ billion on a book value of equity of 12.292€ billion which brings its ROE for that year to a whopping 79%. After adjusting for 3,176€ billion of non-underlying items which significantly impacted operating income we are left with a ROE of 59%. While both the current ROE as well as the ROE improvement over the past few years are very impressive, a ROE of that kind is often achieved by high leverage and indeed Unilever has tremendously increased the debt to equity ratio from 0.91 to 2.02 over the span of 4 years. In order to assess whether the company actually managed to employ capital more efficiently we will take a look at the ROIC which measures the return on both debt and equity.
Source: Modeled by me, data taken from filings of the company
ROIC has steadily increased over the recent years and currently sits at 26% unadjusted. Adjusting for non-underlying items we get a adjusted ROIC of close to 20% which is still more than 4 times the company's cost of capital of 4.79%. This means that Unilever earns about 15% in excess returns on its total invested capital which suggests a strong competitive position since returns would come down towards the cost of capital if competitors were able to replicate the business model of the company. The fact that returns on capital have not only been high in the past years but have also been increasing shows that the company is successful in maintaining its competitive status.
To value the equity I used a discounted cash flow (NYSE:DCF) model. I assumed revenue growth to be 3% annually for the coming 5 years and fall of to 1% afterwards. Management expressed their goal for the operating margin to increase to 20% by 2020. Since I believe that target to be reasonable I let the operating margin converge to 20%. The tax rate and the sales to capital ratio as well as the ROIC were left unchanged. Cost of capital converges to 6% in perpetuity to account for increases in interest rates in future years.
These assumptions yield a value of 181 billion euros for the entire business. After subtracting net debt and minority interest and dividing by the total amount of shares outstanding we are left with a per share value of 53.81€ which means that the stock is currently trading at about a 10% discount to its estimated value.
Source: Modeled by me, data taken from filings of the company. Amounts are in € millions except per share data.
I identified 3 main risks to this investment:
- A substantial and quick rise in interest rates
- Deteriorating brand value
- currency risk
Rising rates would make future cashflows much less valuable than modeled. However I do not expect rates to rise in the near term since the ECB recently announced for rates to remain low until at least the end of 2019. Even if they started increasing rates afterwards I highly doubt that it would be done with a quicker pace than assumed in the model.
As a consumer goods company Unilever relies on the brand strength of their products in order to be able to charge a premium. If consumers are no longer satisfied with the products or the company fails to stay on top of changing trends it will negatively impact margins and therefore the bottom line.
Since Unilever generates more than 50% of its sales in emerging markets a devaluation of emerging market currencies can also eat into earnings.
Unilever offers an attractive upside at moderate risk. A diversified brand portfolio will enable the company to stay on top of changing consumer trends. Additionally the premium paid by consumers due to brand loyalty and product quality means that margins will remain high which will result in returns on capital in excess of the cost of capital.
At a current dividend yield of more than 3%, investors will be paid to wait for the market to realize that this is an undervalued company.
Unilever NV (UN) and Unilever PLC (UL) effectively operate as a single entity. Unilever PLC ADRs are listed on the New York Stock Exchange and each represent 1 ordinary share of Unilever PLC. The fair value estimate in this report will refer to the euro demoniation of the Unilever plc share so please keep this in mind when comparing it to the dollar price of the ADR.
I am not a financial advisor and this report is not to be considered financial advice. Please always conduct your own research and consult a financial advisor before making any investment decisions.
Disclosure: I am/we are long UL. 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.