Sunday, September 26, 2021

    Unilever: Nearly 30% Upside, 3.3% Yield And Improving Fundamentals

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    Unilever appears to be one of the most under-owned large-cap consumer staples companies.

    The new single parent legal structure will have important consequences for the company that owns many of the world’s strongest brands.

    While business fundamentals are improving, Unilever still trades below its fair value while offering 3.3% dividend yield.

    Almost a year since I first covered Unilever (UL) and took a long position in the company, the company’s share price is still one of the cheapest in the large-cap Personal & Home Care and Packaged Food sectors.

    During the period UL underperformed the Consumer Staples sector as measured by the Consumer Staples Select Sector SPDR ETF (XLP).

    Data by YCharts
    The disappointing performance came largely as a result of the company’s somewhat disappointing H2 2020 results. This resulted in a sharp drop in February this year when results missed both topline and operating profit estimates.

    However, monthly performance rarely matters for long-term investors, unless it is a sign of a turning trend or an indication of deeper problems with the company.

    If this is not the case and the company’s share price falls due to short-term headwinds, then this is an excellent opportunity to increase positions.

    In the case of Unilever, I have a reason to believe that it is the latter.

    Where Unilever currently stands
    As I have covered in detail a few months back, Unilever is unique in a number of ways.

    Apart from its dual-headed legal structure that is currently undergoing unification, Unilever is also the only major consumer staple company that has significant operations in Personal & Home Care and Packaged Food sectors.

    At the same time Unilever is far more segmented as far as its geographical exposure is concerned, which adds yet another layer of complexity.

    Not working as a single economic entity while having such a wide product and geographic reach has been a significant obstacle in becoming leaner and more profitable organization.

    That is why, in spite of Unilever’s iconic and high price premium brands, the company’s margins are still lower than most of its major peers in the Personal & Home Care and Packaged Foods industries.

    Consequently, this results in Unilever also trading at much lower multiples.

    Nevertheless, Unilever is changing rapidly and as a conservatively valued company with many of the world’s strongest brands and best-in-class distribution network, it looks very attractive for long-term shareholders.

    Not only that, but it also has one of the highest dividend yields in the space.

    Transformation of the business

    From a predominantly Foods & Refreshments business back in 2007, today Unilever’s Beauty and Personal Care division is by far the largest in terms of revenue.

    On one hand, the Personal Care & Beauty space offers much higher price premium as we saw above in the graph comparing EBITDA margins of companies in the sector with those of the Packaged Foods industry.

    On the other, Unilever’s personal care brands, such as Lifebuoy, Dove and Sunsilk, are among the top 10 global FMCG brands by footprint.

    Therefore, not only does Unilever’s Personal Care and Beauty segment generates significantly higher margins, but also holds significant growth opportunity.

    This process of portfolio change is still undergoing and this year, Unilever is expected to generate significant proceeds through the divestment of its tea business.

    This way Unilever will free significant amount of capital to pivot towards more the profitable areas where it also has built some of the strongest and most widely known brands.

    As part of its restructuring efforts, Unilever is also pivoting towards the United States, where it is leading in many of its key product categories.

    During the recent presentation on US Deep Dive, Unilever’s management described its unique strategy to succeed in one of the most competitive markets.

    The strategy in the country will rely heavily on purposeful brands, such as Seventh Generation which UL acquired back in 2016 and is already among the leading Home Care brands in the country.

    Valuing Unilever
    Using a beta of 0.5 based on the data below, risk-free rate of 2.5% and equity risk premium of 5.5% (based on Duff & Phelps estimates), Unilever’s cost of equity comes at 5.25%.

    Historically, Unilever’s dividend per share has been growing at around 6.3% on an annual basis.

    The growth rate accelerated to 6.9% over the past 5 years, even though Unilever was one of the few large-cap consumer staple companies that did not engage in share buybacks in 2019 and 2020.

    Thus if we assume that dividend per share will grow at 6.0% per annum for the next 5 years as well and will then revert back to a 2.0% growth to be consistent with inflation, Unilever’s implied share price based on a Dividend Discount Model (DDM) in Euros comes at 61.2 which is 29% higher than what it currently trades at in Amsterdam.

    To sense check this valuation, we could plot the implied P/S ratio of Unilever based on the calculated share price above and revenue per share in 2020, also assuming constant EBIT margin.

    Based on the nearly 30% higher share price, Unilever would actually trade right on the trend line below, which brings it closer to its fair value.

    A 29% higher share price will also result in a Dividend Yield of 2.7%, which is close, although yet below, to that of Procter & Gamble (PG).

    This will once again close the gap between the two.

    Having said all that, investors should also bear in mind the inherent currency risk for Unilever.

    The company is one of the most geographically diverse businesses with a strong focus on Emerging Markets.

    Its debt profile, however, is predominantly issued in U.S. dollars and Euros, with the British Pound making 9% of the debt.

    Therefore, if we plot the revenue exposure by region (currency) on the left hand side and total debt on the right hand side, we could see to what extent is Unilever exposed to currency movements.

    This has been a major headwind for Unilever for a number of years now, as many major Emerging Markets currencies depreciated against the Euro and the US dollar.

    While this could continue to be the case for the next decade as well, a trend reversal could have a significant positive impact on top of everything we covered above.

    Unilever owns many of the world’s strongest brands in the Personal & Home Care space as well as Packaged Food sector.

    It is one of the world’s largest consumer staples companies with a broad reach to almost all Emerging and Developed Markets around the globe. And yet, the company trades at a significant discount to its major U.S. peers.

    One of the key reasons for that appears to have been its dual legal structure and historically lower margins.

    However, as both of these factors are changing, Unilever is on course to improve profitability while pivoting towards the higher margin Personal Care & Beauty space.

    At the same time, Unilever offers 3.3% dividend yield and appears to be trading around 30% below its fair value.

    Disclosure: I am/we are long UL, HKHHF, ASBFY. 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.

    Additional disclosure: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity.

    The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis.

    The author recommends that potential and existing investors conduct thorough investment research of their own, including a detailed review of the companies’ SEC filings.

    Any opinions or estimates constitute the author’s best judgment as of the date of publication and are subject to change without notice.

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