Why Unilever Can Still Be Put In Every Retirement Portfolio, Close To Double-Digit Returns Ahead

Summary

• I have never invested a penny in Unilever because of the above average valuation of its shares.
• Given the recent surge in share price to a record high price level and a P/E that is north of almost 21, I should hate the shares right now.
• Instead I have had a change of heart on the company shares. I believe Unilever can post close to double-digit returns every year for the rest of this century.
• I substantiate this (bold) claim by using a formula from Columbia Business School professor Bruce Greenwald to calculate expected returns for companies that possess franchise value.
• The averages of 10-year financial data are used as input-variables. I believe this is fairly conservative.

I have always thought of Unilever (NYSE: UN) as one of the best - and actually only - typical Warren Buffett company the Netherlands has to offer (maybe Heineken (OTCQX:HEINY), is the exception).

The reason for my affection can be summarized in one sentence: if over 2 billion people use a product you have produced each day, you must doing something right. Unilever has 14 one billion dollar brands in their portfolio of 400 brands - of which 11 brands belong to the world's top 50 fast moving consumer goods brands in 2014 according to Kantar Worldpanel, think Knorr, Dove and Lux (see full report here), 14 brands together represent 54 percent of total sales (page 11). Still not sharing the same love for the company like I do: how is it possible not to feel affection for the company that invented the Magnum (almond), and is the biggest ice cream maker in the world?

Even though I have always loved this powerhouse of food and personal care brands I have never invested a penny in its shares. The reason for my Unilever-phobia is simple: the share has (almost) always been trading north of a P/E multiple I am comfortable with. As an admirer of Benjamin Graham I have always considered any share trading above a Price Earnings ratio (P/E) of 16 as a speculative investment, as the master articulates in his books Security Analysis and the Intelligent Investor.

As can be seen in the graph below, Unilever rarely trades under 16 times earnings, with the exception of credit crisis year 2008 (10 times earnings!), the euro crisis year 2010 (15 times earnings) and in 2005 and 2006 (very close to 16).

Graph: Unilever trades north of 16 times earnings most of the time

(click to enlarge)

Source: Bloomberg and annual reports

Don't get me wrong. I am still a big fan of Graham's investment philosophy. In 98 out of a 100 investments it is not smart to pay more than 16 times earnings, think for instance of companies that operate in the aviation, automobile or technology sector. But I am starting to believe Unilever is a different animal and could be a great investment at a P/E that is higher than 16. I have to admit that my timing is horrible as Unilever definitely is not a bargain anymore at a close to record high share price of €38 (P/E=21), but I believe an investment in the company's shares could still yield close to double-digit returns each year for the rest of this century. With yields nowhere to be found in this uncertain world, it does make sense to invest in robust companies with a proven track record and a decent dividend yield.

I had a change of heart on investing in Unilever after I read the book Value Investing by professor Bruce Greenwald of the Columbia Business School. In the book, he discusses the return potential of special companies that possess franchise value, and he presents a formula to calculate the expected returns of these kind of companies. I will use the formula in this article to estimate the returns of Unilever in the coming years.

Let me emphasize that this is a theoretical model that gives insight into the three components of the returns one could expect to harvest as a long runinvestor in Unilever: dividends, growth due to reinvestment of earnings and organic growth (more on this later).

Therefore, this article will not touch upon (interesting) risks for Unilever in the short run such as difficulties with the spread activities in Europe or a potential setback in China (both clearly negative). The article does not elaborate on a potential tail wind from lower commodity prices (45% of Unilever's purchases are related to oil including vegetable oil, according to analysts of Nataxis) or the positive effects of the lower euro either.

Where do share returns come from?

Please bear with me, but we have to do a little math in order to see how companies generate returns for their shareholders. Most readers will be familiar with Gordon's dividend growth model, which looks like this:

In this formula, P stands for the share price, D stands for dividend, R is the cost of capital, and G is the growth rate of dividends.

As you probably know, one could rearrange the formula to get the (expected) return as the dependent variable ("R") as opposed to the share price ("P"). This formula looks like this:

This formula essentially tells there are two components of investment returns. The first component of the formula, "D/P," is the cash return an investor gets via dividends. The second part ("G") embodies returns that are the result of an increase in share price due to the fact that earnings/dividends will grow in the future.

Columbia professor Bruce Greenwald takes it one step further and divides the "G" into two components: growth as a consequence of investments of retained earnings and growth that is purely organic - the sales that require no/barely additional investments. He presents a formula in his great book Value Investing From Graham to Buffett and Beyond that looks fairly similar to this:

Where b stands for the dividend payout ratio (hence: (1 minus b) is the reinvestment rate), E is earnings, ROIC is the return on invested capital and h stands for the organic growth rate.

The formula looks a little scary at first, but if you look more closely the formula is not that difficult to interpret:

1. The first component, , represents the return that is given to shareholders via dividend payments. It is nothing less than the dividend yield.
2. The second component, , represents the return a shareholder gets because earnings can be reinvested (in a profitable way). Note that ROIC must be bigger than R in order to increase the expected return (to be more specific: to get a return out of the first two formula components that is above the earnings yield, E/P)
3. The last part ("h") represents the organic growth rate, or the percentage return an investor collects because the demand for products of franchise companies increase as economies grow.

Some conservative assumptions

I hope you are still with me. I am afraid, however, the most difficult part is to actually fill in the numbers for Unilever.

Of course this is an arbitrary process. But bear in mind that it is not the intention to calculate an exact return. I want to have a reasonable approximation of the long run returns an investor can get when he buys Unilever shares today. Of course, I want to be conservative in my estimations (I did not throw my Graham books out of the window!). The input-variables are estimated by averaging ten-year financial data. I do this because I not only want to be conservative, but I also want to take into account the full business cycle. The next section of this article elaborates on the input-variables for the three return components - dividends, reinvestment and organic growth.

1. The dividend return component: A reliable dividend yield

A company can do two things with the profits it makes. It can give earnings back or it can reinvest in the business. Unilever has an extremely strong track record of giving back cash to shareholders as the company has been able to increase its dividends for the last three decades.

For the dividend return component I have calculated the average of 10-year earnings per share (EPS), dividend per share (DPS) and the payout ratio. As an input for the formula, I use the average EPS of 1.53 euro and the average payout ratio of 54 percent.

This leads to a dividend return component - or more simply put dividend yield - of 2.2 percent (54% x €1.54/€38).

Table: Unilever - a European dividend aristocrat

Year	Mean	2014	2013	2012	2011	2010	2009	2008	2007	2006	2005
EPS	1.53	1.82	1.71	1.54	1.46	1.51	1.21	1.79	1.35	1.65	1.29
DPS	0.82	1.14	1.05	0.95	0.88	0.82	0.47	0.72	0.50	0.98	0.79
Payout	54%	63%	62%	62%	60%	54%	39%	40%	37%	59%	61%

Source: Bloomberg and annual reports of Unilever. Figures in euros.

2. Reinvestment Returns: ROIC consistently above cost of capital

If CEO Polman used roughly half of Unilever's profits to pay as dividends in the last decade he must have used the other half to reinvest into the business. Is this a sensible thing to do for company like Unilever?

In his book Value Investing Bruce Greenwald makes the convincing case that most companies (i.e. companies that don't have moats, pricing power, franchise value or whatever you want to call it) do not create value for shareholders if they invest in growth. The reason for this is that most companies do not have a competitive edge and competition will result in pressure on profitability and (eventually) a return on invested capital (ROIC) that is equal or even lower than the cost of capital (COC).

As outlined at the beginning of this article, intuitively, Unilever is a different animal. Most brands of the company have huge consumer captivity due to brand equity and high switching costs. It is my experience that most people find it very difficult to change the brand of deodorant, toothpaste or laundry detergent they ordinarily use.

So far for the marketing chit chat. The only way one can really ascertain if a company has franchise is to examine if the ROIC is - consistently - above the COC.

Table: A different animal - Unilever has an impressive ROIC in the last 10 years

Year	Mean	2014	2013	2012	2011	2010	2009	2008	2007	2006	2005
Sales	43.9	48.4	49.8	51.3	46.5	44.3	39.8	40.5	40.2	39.6	38.4
Ebit	6.4	9.3	7.5	7.0	6.4	6.6	5.0	5.8	5.8	5.4	5.1
Taxes	1.5	2.1	1.9	1.7	1.6	1.5	1.3	1.8	1.1	1.1	1.2
Profit aft tax	4.9	7.1	5.7	5.3	4.8	5.1	3.8	3.9	4.7	4.3	3.9
Assets	41.5	48.0	45.5	46.2	47.5	41.2	37.0	36.1	37.3	37.1	39.5
Spont. Liab.	7.2	12.6	11.7	11.7	11.0	6.0	4.0	3.9	3.7	3.8	4.0
Invest. Capital	34.3	35.4	33.8	34.5	36.5	35.2	33.0	32.3	33.6	33.2	35.5
ROIC	14.2%	20.2%	16.8%	15.3%	13.3%	14.5%	11.4%	12.2%	14.0%	12.8%	11.0%

Source: annual reports of Unilever and Bloomberg. Figures in billion euros. I use Bruce Greenwald's definition of invested capital. Greenwald subtracts the so called spontaneous liabilities from total assets to get invested capital. Spontaneous liabilities are defined as current liabilities that bear no interest like accounts payable and accrued expenses. These liabilities are in a sense free capital and can therefore be subtracted from the balance sheet total.

In the past decade, Unilever generated a little over 0.14 euro for every euro of capital that it invested in the company. Last year, the ROIC was with 20.2 percent at its highest level, and in 2005 (ten years ago) the return was with 11 percent at its lowest.

Although I can't put an exact figure on it, it is obvious to me that the average ROIC of Unilever in the last ten years lies above the yield investors' require (COC). The (exact) size of the gap between ROIC and COC, however, is difficult to measure. Let's give it a shot anyway.

Since debt is "cheaper" than equity - especially for Unilever which almost issues debt at zero interest at this moment (see here), and I want to be conservative I assume Unilever is completely financed with equity. In reality, Unilever carries €9.9 billion euro net debt on its balance sheet. The market capitalization is about €116 billion.

The CAPM model - defined as  - has its shortcomings, but let's try to use it to calculate the cost of equity anyway. It seems reasonable to assume that the beta of Unilever is 1 given the defensive character of its businesses (I am conservative, in fact the Beta is 0.79 based on two-year data according to Bloomberg). If we assume the risk free rate can be represented by a 10-year German government bond yielding close to 0.5 percent and the equity risk premium is the historical average of 4.5 percent, one comes up with a required return for suppliers of equity of 5 percent (0.5% +1 x 4.5% = 5%).

Despite the fact that we live in a zero interest rate world it makes sense to me to add 3 percentage point returns to get a COC of 8 percent. Note that I have sympathy for investors who demand a (much) higher hurdle rate (see: 'Sensitivities, assumptions and more food for thought' at the end of the article).

If we fill in the numbers, investors in Unilever get a return out of reinvesting earnings of 3.3 percent (46% x €1.53/€38 x 14.2%/8%).

3. Return related to organic growth

The third and final component simply represents the long-term organic growth rate of sales (and profits). This growth is essentially free as it is the result of increased demand due to economic growth (no extra investment is needed)

This organic growth rate can be added as the last return component for shareholders. In the table below, I have summarized the organic growth rate of Unilever - defined as underlying sales growth, or "the increase in turnover resulting from acquisitions, disposals and changes in currency" (see page 32annual report)

Table: Unilever has a history of strong organic growth

Year	Mean	2014	2013	2012	2011	2010	2009	2008	2007	2006	2005
Org. Growth	4.8%	2.9%	4.3%	6.9%	6.5%	4.1%	3.5%	7.4%	5.5%	3.8%	3.4%

Source: Annual reports of Unilever

In the past 10 years, Unilever realized an average organic growth rate of 4.8 percent. In most years, this growth rate was higher than the aggregate market. It will be no surprise that Unilever realizes the biggest growth in emerging markets, which represent 57 percent of total sales.

During the annual result presentation CEO Polman told that fast growing economies like Indonesia, India, Turkey, the Philippines and (the whole of) Latin America show organic growth rates that are in double digits (page 3).

Europe is more problematic with a negative organic growth of 2.1 percent in 2014. Unilever deals with a "high competitive intensity in many countries and continued price deflation." Especially the spread business, which recently got a separate status to improve focus, has been a drag on the topline performance.

What is a reasonable estimate for the organic growth rate? CEO Polman is not very optimistic in the near term as he stated that he does not "plan on significant improvements in market conditions in 2015." The company statedthat underlying sales growth will be between 2 to 4 percent this year. Given the strong track record of sales growth and the large exposure to developing countries, I believe it is fair to pencil in an organic growth rate in the middle of this range (3 percent) for the long run. This is significantly lower than the 10-year average of 4.8 percent.

Conclusion: Adding it all up

Now we have all the variables we need to put into the formula, please see the table below. In the base case scenario, the input-variables are based on 10-year averages, and COC is set at 8 percent. I also present a "2014"-scenario where the input variables are based on last year's financial results.

Table: Overview of the input variables

Based on	10-year averages	2014 results
Dividend pay out	54%	63%
Earnings per share	1.53	1.82
Share price	38	38
ROIC	14.2%	20.2%
WACC	8.0%	8.0%
H organic	3.0%	3.0%

It is time to fill in the numbers. What kind of returns should investors hope for in the long run?

Based on:	10-year averages	2014 results
Dividend returns	2.2%	3.0%
retained earnings returns	3.3%	4.5%
Organic growth returns	3.0%	3.0%
Total expected return	8.5%	10.5%

In the base case scenario, I calculate a respectable expected return of 8.5 percent per annum. If we take the 2014 scenario, the expected return rises to 10.5 percent, due to a higher earnings per share and a (much) higher ROIC.

I would like to emphasize that there were in the past and almost certainly will be in the future better opportunities to buy Unilever at lower share prices and more attractive valuations (lower PEs). But even at a record high share price, I believe Unilever can deliver attractive returns for patient investors with a long run horizon. Even with the high current valuation, Unilever could post close to double-digit returns because it is very likely the company will be able to grow in a way that creates shareholder value.

Sensitivities, assumptions and more food for thought

I am fully aware that it is gibberish to present an exact return figure like 8.5 percent. It is unnecessary to mention that the outcome of the formula will vary with the input variables, although not as heavy as with a DCF model (!). I will briefly discuss some of the assumptions I have made, and have a look at to which degree changes in assumptions impact expected returns.

- The share price of Unilever increased with 10 percent after ECB president Mario Draghi announced to start with quantitative easing about a month ago. This impressive return can for a large part be explained by the fact that investors lowered the yield they require for an investment in Unilever shares (significantly). As in every valuation model, the COC has a huge impact on the outcome. If we lower the COC to 5 percent (CAPM assumptions) the expected return in the base case scenario moves up to 10.6 percent (from 8.6 percent). An investor who believes Europe will be trapped in a low interest rate environment for a very long time, might consider Unilever as the perfect investment. If investors require a yield of 10 percent, the expected return falls to 7.9 percent, which by definition entails Unilever is not an attractive investment at all.

- With respect to the ROIC, I think the 10-year average of 14.2 percent is pretty conservative. If you take for instance the average of the last 6 years - years we dealt with the credit and euro crises - the ROIC increases to 15.2 percent. The improvement in ROIC over the last years are the result of major efforts to reduce costs, the increasing focus on emerging markets and the transformation from a food to a personal care company (higher margins). The impact of an increase in ROIC from 14.2 to 15.2 percent is limited due to the high P/E and the reinvestment rate of the company: the expected return rises only with 0.2 percentage points to 8.8 percent.

- If I use this model to find attractive investments, I have the most difficulties with the organic growth rate that just appears out of thin air. I do believe, however, a 3 percent growth rate for Unilever is not farfetched owing to the fact that Unilever targets the middle income group in rapidly expanding developing countries (58 percent of sales).

- One point I like to make is that the risk of using a model is that an investor forgets to look at risks in the balance sheet (although this should be the first thing a value investor does). If I look at the balance sheet of Unilever I don't shiver, but with a net debt level of €9.9 billion, I am not fully comfortable either (EBITDA 2014: €8,14). The balance sheet does not wake me up at night but a rise in interest rate could become a small hurdle.

- Unilever is the operating arm of Netherlands based Unilever N.V. (HQ in Rotterdam) and UK-based Unilever PLC. Both entities function as a single corporation. The Dutch ADR is traded under UN and the British ADR is traded under UL.

Source:http://seekingalpha.com/article/2964706-why-unilever-can-still-be-put-in-every-retirement-portfolio-close-to-double-digit-returns-ahead

By Smart Owl Research

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in UN over the next 72 hours. (More...)

You don't agree with my assumptions? Please click here to see the model in Excel to fill in your own assumptions and see how this impacts the expected return.