Fair Value Estimate: 1921p | Uncertainty Rating: Medium | Economic Moat: Narrow
Thesis (Last Updated 21/12/10)
In the past, an extremely decentralised and complex structure hindered Unilever's (ULVR) ability to realise the growth and profitability that should emanate from one of the largest players in the consumer goods industry. But we believe management's efforts to root out inefficiencies--a strategy begun by former CEO Patrick Cescau and which new CEO Paul Polman is continuing to implement--seems to be gaining traction, despite numerous external headwinds.
Unilever's status as a giant consumer product firm partly resulted from its foresight to secure a first-mover advantage in international markets, particularly in fast-growing developing and emerging markets. However, because of its use of a local go-to-market strategy, Unilever's efforts failed to generate a clear global strategy, while producing a bloated organisation in terms of brands, facilities, and employees. In our opinion, Unilever neglected the scale and efficiency advantages that potentially exist for a firm of its size.
Management is working to jump-start sales growth and operating margin improvement. The latest restructuring plan seeks to aggressively reduce the firm's brand portfolio, manufacturing facilities, and employee base. Although management is still reluctant to target the level of improvement it anticipates from these efforts, we expect the operating margin to approach 16% by 2014 (versus an adjusted operating margin of 14.8% in 2009). We are sceptical whether these efforts will be more successful than past attempts to reduce the complexity of Unilever's business--most notably through the firm's path to growth initiative--that failed to generate the pop to sales and margins that management had expected.
Unilever also faces external challenges, such as elevated commodity costs and weak consumer spending. Commodity cost pressures (for inputs such as petrochemicals, edible oils, and tea) will not abate over the near term, given supply constraints and increased demand in emerging markets. Unlike the past, Unilever's ability to charge higher prices to offset these increased costs could be challenged. Until unemployment levels retreat further, consumers will maintain a guarded stance regarding their purchase decisions, in our view. While Unilever has increased its spending on promotions over the past several quarters to drive volume higher and maintain market share, we expect the firm will selectively seek to raise prices in order to offset these cost pressures. We intend to monitor the impact of these actions on the firm's sales growth and profitability.
Valuation
We're increasing our fair value estimate to 1,921p per share from 1,917p, which implies forward fiscal 2011 price/earnings of 16 times, enterprise value/EBITDA of 11 times, and a free cash flow yield of 6.1%. Our valuation is based on the 12-month rolling average exchange rate of £0.86 per euro as of Dec. 16. Because of Unilever's global business, our fair value estimate will continue to fluctuate with this exchange rate. Left unhedged, depreciation in the euro will lower the British-denominated investment in the firm's shares.
While we believe Unilever is overpaying to acquire Alberto Culver, the deal makes sense from a strategic perspective. We contend that Alberto's hair-care brands will complement Unilever's portfolio, filling the gap between Unilever's existing value brand Suave and premium-priced brand Dove, and Unilever should be able to expand the distribution of Alberto's offerings into faster-growing emerging markets. However, the addition of Alberto will make only a modest dent in tilting Unilever's portfolio toward higher-growth personal-care categories and will not affect our fair value estimate.
In our view, consumer spending will remain fragile, given that unemployment levels remain elevated, but we expect the global consumer product firm to benefit from new product launches. We believe annual sales growth will approximate 4% over the next five years. Elevated commodity costs, as well as investments to support its core brands in this highly competitive operating environment, will limit margin expansion, but we expect Unilever to realise a portion of the anticipated cost savings from its current restructuring initiatives. As a result, our forecast assumes that operating margins approach 16% by 2014, up from an adjusted operating margin of 14.8% in 2009. Through 2014, we expect returns on invested capital to average 18% compared with our 8.9% cost of capital, supporting our thinking that Unilever possesses a narrow economic moat.
Risk
Elevated commodity costs can weigh on Unilever's profitability, and because consumer spending remains weak, the firm may be unable to offset these cost pressures with higher prices. In addition, with about 50% of its total sales resulting from developing and emerging markets, Unilever is subject to changes in foreign exchange rates. This international presence also exposes the firm to political and economic risks. Finally, Unilever is undergoing a major restructuring initiative, the results of which are far from certain and could lead to instability in its operations.
Management & Stewardship
Paul Polman, 53, has held the top spot at Unilever since January 2009, after most recently serving as executive vice president and zone director for the Americas at Nestle NSRGY. In our opinion, Polman--the first outsider to run the large consumer goods organisation--could be the right person to shake things up, after gaining valuable experience during his nearly 30 years at Procter & Gamble PG and Nestle. Overall, corporate governance at Unilever is fair. We are impressed by the level of detail this firm provides to the market, particularly in its quarterly earnings releases. We also like that Unilever operates with different individuals holding the positions of chairman and CEO. However, that is where the favourable aspects of the firm's corporate governance end. First, we take issue with Unilever's compensation structure. More than 50% of the CEO's total annual compensation is composed of base pay. Also, directors are paid hefty sums for serving on Unilever's board, again mostly in cash. We believe management's and directors' interests could be better aligned with shareholders' if equity represented a larger portion of total compensation. Finally, in our opinion, the firm's multiple-class structure, with varying voting rights, is not in the best interests of minority shareholders.
Overview
Financial Health: Unilever is in solid financial health and should be able to service its debt without any financial strain on its business. At the end of 2009, Unilever's long-term debt amounted to EUR 7.7 billion (debt/capital of 0.45) and operating earnings covered interest expense 10 times. We forecast debt/capital of 0.4 by 2014 and earnings before interest and taxes to cover interest expense 10 times. We give Unilever an issuer credit rating of A+.
Profile: Netherlands-based Unilever NV and UK-based Unilever PLC operate Unilever Group, a diversified packaged food (about 50% of total sales), and household and personal product (about 50% of total sales) company. The firm's brands include Knorr soups and sauces, Hellmann's mayonnaise, Lipton teas, and TRESemme hair-care products. With roots that trace back nearly 140 years, Unilever now operates as a leading player in consumer goods, selling products in more than 170 countries.
Bulls Say
-- Unilever is the third-largest packaged food firm in the world, producing more than EUR 21 billion in annual sales from a stable of brands including Knorr, Hellmann's, Lipton, Breyers, and Ben & Jerry's.
-- As one of the largest global household and personal product firms, Unilever generates nearly 50% of its annual sales from well-known brands such as Dove, Ponds, Suave, TRESemme, and Noxzema.
-- By focusing on opportunities in developing and emerging markets years earlier than its peers, Unilever has realised some of the benefits of being a first-mover and now generates around 50% of its sales from these markets.
-- Cash flow generation in fiscal 2009 was impressive (at EUR 3.7 billion, or 14% of sales), primarily because of lower inventory levels as Unilever appears to be realising the benefits of its efforts to reduce the complexity of its supply chain.
Bears Say
-- Operating margins have suffered during the past several years as Unilever failed to present a clear global strategy, while also inefficiently ramping up its product base and overhead.
-- Despite spending heavily on marketing and promotions and reducing price points, sales continue to suffer in Western Europe, which makes up about one third of Unilever's total revenue.
-- Even after culling its product portfolio from 1,600 items to less than 400 during the past five years, Unilever still had trouble generating consistent sales growth.
-- Unilever paid a full price for Alberto Culver, and wringing out the cost savings needed to make the deal worthwhile will not be easy
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