Unilever: Value Idea?

Unilever (UN) (Source: Google Finance):

... is a supplier of consumer goods across foods, and home and personal product categories. Group operations are organized into two divisions: Foods and Home and Personal Care. Unilever serves as a food company that meets everyday needs of people, through branded products. In Personal Care, six global brands are the core of its business in the deodorants, skin cleansing, daily hair care and mass-market skin care categories.

UN has a three broad product categories littered with well known brand names:

• Foods:Lipton, knorr, Becel, Flora, Hellmann's, Slim-Fast, and others
  
• House Care: Cif, Sunlight, Surf, Omo, and others
  
• Personal Care: Axe, Dove, Lux, Pond's, Sunsilk, Vaseline, and others
  

Business Economics Quality

The company is lagging peers in margins. Unilever have a 13.7% operating margin compared with the likes of Heinz 16.4%, General Mills 15.9% and a sector average of 17%. The consumer category has better margins but still lags its peers like P&G; UN gets 17% operating margin while P&G earns 20%.

I like to examine the cash to cash cycle, length of time to convert idle purchased inventory to cash in the bank, as another indicator of a business efficient economics. UN had a cash cycle of 35 days in 2006 down from 41 days in previous years, which is good improvement and should have additional room to bring it down further. They are yielding 40 days plus for account collection while it should be under 30 days. The company inventory days, length of days inventory is idle, is one of the lowest in the industry. However, on TTM basis there is a unfavorable trend developing, both AP and AR days have shot up. It seems that the company is not as efficient collecting from customers and as a result not paying its suppliers, it takes almost 90 days to pay suppliers which is very uncommon. The measure gives another dimension to the inefficient economics evident by the low margins noted above.

Unilever's management stated that its number one priority is growth -- competitive, profitable and consistent. The company plans to reinforce this with steps to accelerate performance; these are raising the bar for innovation, more aggressive shaping of the portfolio and cost and asset reduction to further enhance margins. The cost reduction programs include (1) "One Unilever", which management thinks can generate around $1.3 billion in yearly savings during 2008, (2) Shared services, which covers finance, information technology and human resources and should be completed in 2007 to 2009, (3) Global buying, which management expects to save, on average, over $500 million per year from 2005 to 2007, and (4) Strengthened Marketing & Customer Management, which is rolling out 2006 to 2008. Management says that these programs are apart from its "normal" restructuring.

Recent quarterly figures have not produced any significant improvement for UN margins over its historical record. Therefore the jury is still out on the competitive cost structure and the success of its restructuring efforts. A review of UN history reveals that the company has taken previous restructuring projects and its margins were flat over the years, which leads me to wonder if this plan will be any different. I think it will due to management commitment to the program and it is evident by the recent disposition of sub-par margin products.

In addition to the administrative restructuring and to further improve its margins, the company has set to dispose of non strategic products. Indeed, the company over the past few years has been disposing of mainly the low margin business of food products and North American products. UN in 2004 disposed of frozen Pizza, olive oil, in 2006 sold frozen food products, and in 2007 it sold off more food divisions mainly US cheeses and cooking products. I generally do not like packaged foods producing businesses, as I think they have no advantage over generics, have a lot of competition, and plenty of raw materials cost pressures. So the general direction and strategy of disposing of food is a positive one.

The positive aspect of UN operations is its strong geographic diversity: Americas constitute 37% of revenue, Europe 32% and Asia 27%, and, the most important growth segment, the emerging markets have more than 1/3 of its sales. Emerging markets constitute a great opportunity to grow and UN have already an established strong position in these markets that they can capitalize on. The emerging market represent a good opportunity due to: 1. emerging consumer class with spending power, and 2. positive demographics of young consumers.

UN spending on Research and Development (R&D) lags competitors like P&G. UN spends 2.27% of revenue of R&D, while P&G spends 2.76%. Even with additional spending, UN may be ineffective as it has more than 400 brands. Spending the R&D budget over this wide selection of products will not yield meaningful results. However, in their latest financial results the company is reshaping its R&D efforts "...we are focusing resources on world class R&D capabilities, working with clear innovation targets and concentrating on fewer – but bigger – projects", which combined with focused mission of "vitality" will help yield better results from their future R&D efforts.

Unilever has the foundation to have good economics and a tremendous upside once management successfully deliver on its restructuring and cost cutting plans. :

• operations are inefficient but the company has ample room to improve and yield better margins,
• disposition of low margin and non strategic assets,
• better R&D focus, and
• strong presence in high growth markets
  

Competitive Advantage Quality

Although Unilever is large but it is half the size, in revenues, of P&G and Nestle, the big gorillas in the industry. However size in consumer products, not foods, is not a competitive disadvantage; smaller players can compete effectively. What is critical is the quality of the product and an effective marketing effort. UN management possess good consumer marketing capabilities. The successful launch of their deodorant AXE is a testament to their capability. AXE campaign is one of the most successful product launches in the industry. UN neutralizes size disadvantage, if any, by possessing good marketing acumen.

UN has an advantage in their consumer brands only. Consumer are more personal than food. Users develop an attachment and a habit of using what they know and works for them best. UN has a host of strong and leading consumer and personal care products that give the company a competitive advantage over others.

UN has an established oversees market for a long time, its Asia and Africa markets was developed in the 90s, and this presence will yield two advantages:

1. experience and established distribution network and efficient and effective logistics infrastructure that will keep competitors squeezed out from store shelves, and
2. mind share of local users and better consumer research then rivals that will enable it to customize products to fit local environments.

The competitive advantage of UN is limited to its consumer products rather than foods. Actually UN is at a competitive disadvantage in foods as its operating margins is lower than rivals, probably due to size issues. However as we discussed above the company is paring down its food products, which will leave the company with the better protected and higher margins brands.

Valuation

Valuation assumptions:

1. increased cost pressures on foods going forward due to raw material inflation.
2. growth rate of 3% for the next 7 years although the company is targeting a growth rate of 4-5%. and a perpetual growth rate of 1.5% in revenues thereafter.

The company discounted free cash flow is $48 per share, adjusting for 50% ownership and exchange rate, compared with market price of $36 per share. The market price represents a 26% discount to intrinsic value. Although a discount exists, is not sufficient to give me a margin of safety that will limit our downside risk. The company would have been a terrific buy 9 months ago at less than $30 per share. You can view valuation figures here.

The company has two separate and distinct operations: food and consumer products. The food valuation is distinct than the consumer product, as the consumer product is more akin to P&G operation and multiples and the food is more like Kraft and Cadbury. In fact the company's multiple is higher than the pure food company but lower than a consumer product company like P&G as displayed in figure below. Therefore a sum of the parts valuation is needed in addition to a typical discounted cash flow approach to ascertain to the derived valuation.

I use Enterprise value to EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) multiple to value the parts of Unilever, as it neutralizes leverage and tax situation between different companies. Using this method I arrive to an intrinsic value of $61 per share close to the discounted free cash flow range, therefore confirming my assumptions about the intrinsic value of the company.

All figures in US $ Billions		Food	Consumer	Sum of the parts
2007 EBITDA (TTM)		$ 5,282.72	$ 4,500.09
EV/ EBITDA Multiple		10.87	13.87
Enterprise Value		$57,423.14	$62,398.28	$ 119,821.42
LTD Debt				$ 14,100.00
Equity Value				$ 105,721.42
Fully diluted number of shares				1,714,000,000.00
Implied Value				$ 61.68

The $48-$61 range represents a good upside, but I still do not view the range as enough margin of safety to make a purchase. Unilever along with all consumer staples have gone up in price so much during the last 4 months due to the credit crises. Investor have shifted their capital to these names due to the relative safety of their earnings and their low volatility. I expect once the crises have been stabilized these names along with Unilever will come down in price making a terrific buying opportunity.

In conclusion, Unilever has a host of good brands, some competitive advantages in the consumer products, a management that is improving operations costs and represent a discount to the current market price, however not enough discount to warrant a purchase at this time. So I will wait to see management future actions in selling lower margin products and monitor its price if the market gives me an opportunity to make a good purchase.

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Sources: Unilever, PG, KFT, and COL annual reports, google finance, Reuters, S&P research

Notes:

Organization structure of UN:
Unilever operates as a single business entity. However, there are two owners: Unilever (NV) and Unilever (PLC) are the two parent companies of the Unilever Group, having separate legal identities and separate stock exchange listings for their shares. You can find Unilever shares trading on NYSE as UN or UL representing NV and PLC respectively.

Please note that most financial sites like Yahoo and Google have UN dividend yield overstated. It still calculates the yield based on UN's old dividend policy. Since the restructure, UN declared two dividends through 2006 an interim and one-off. Their 2006 total dividend was $.625 making the dividend yield 1.7% much lower than Google Finance's 4% yield few weeks ago.