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Do they make the Qualiport grade?
After Friday's elimination from Qualiport contention of Cadbury Schweppes and Reckitt & Colman, I would like to spend today's report having a closer look at Unilever. To recap, they are a global company employing nearly 270,000 people in 88 countries. Their corporate purpose is "to meet the everyday needs of people everywhere... with branded products and services which raise the quality of life." To remind yourselves about the structure of the group and their brands, click here and here.
Remembering back to the original reconnaissance reports on Unilever, I found their structure a little confusing. This initially put me off the company, as I like to be able to understand how a company operates. However, as Unilever is such a huge and diverse company, I'm prepared to give it some leeway -- I personally wouldn't like the job of managing such a company, but the current top men are Unilever veterans and probably know the business inside out. Another confusing factor running through their accounts is the job of stripping out the continuing businesses of Foods and Home & Personal Care from the discontinued Speciality Chemicals division.
Remembering back to the ten criteria of a quality company, the first hurdle is whether we think Unilever are well managed. As a measure of this, I like to look at a company's past record, in particular their operating margins. According to Hemmington Scott Company Refs, the operating margin has increased every year for the past five years, going from 8.71% in 1993 to 9.91% in 1997. So far, so good.
The operating margin percentages are certainly nothing to write home about. The average for FTSE 100 companies is 14.3%, so Unilever are certainly lagging in that department. However, they are moving in the right direction, and in their first quarter summary results released on May 1st, the operating margin jumped to 10% versus a comparable 7.7% in the previous year. This is a truly stunning improvement, and confirms that margins are on the still on the up. Unilever's archrival, US based Procter & Gamble (PG), achieved fiscal 1997 operating margins of 15.3%, and on a trailing 12 months basis they are up to 16.2%. You can look at this either as Unilever being far behind the game and struggling or as a target for them to aim at.
If Unilever were not showing this margin improvement, I wouldn't be happy considering them for the Qualiport. Low margins usually means high competition and little competitive advantage. There is no doubt that Unilever operate in competitive environments, witnessed by the ongoing washing powder wars with PG and the ice-cream battles with Mars. Brands play an important part of these wars, and Unilever have some of the strongest in the business. That, however, is not enough to guarantee success, and brands require ongoing investment in the form of marketing and advertising. If you turn you back for a moment, chances are the opposition will be in there in a flash. Low operating margins mean a company has to work that much harder for its profits.
The predictability of Unilever's earnings is an advantage. Their global reach and strong brands mean that Unilever are relatively unaffected if one market in which they operate (e.g. Asia) is gripped by a economic downturn, because the chances are that other regions are still contributing to their profits. The other great advantage is that many of the products that Unilever sell are essentials. Regardless of your personal economic situation, you still have wash clothes, eat, clean the home and yourself, brush your teeth. You will undoubtedly cut back on ice-creams and perfume, but not on most of Unilever's other products and brands. All this adds up to a high degree of predictability surrounding Unilever's profits.
On the face of it, Unilever's sales and earnings growth record over the past 5 years is nothing special. As we found out in earlier reports about them, they are in a constant state of change, so much so that they fully expect to spend ½% to 1% of sales per annum on restructuring. So, before looking at the raw growth numbers, it is worth remembering that in July 1997 they sold their speciality chemicals business to ICI for about £4.6 billion. In 1996, this business had sales of £2.7 billion and returned operating profits of £383 million. As a consequence of this transaction, at the year end Unilever had net cash balances of a whopping £3.2 billion. At any time they so desire, they can therefore go out and spend that money and more on an acquisition, instantly increasing their sales and profits.
Since 1993, turnover has increased by a total of 6.8%, or a compounding annual growth rate (CAGR) of 1.7%. Normal earnings per share (EPS) have grown every year since 1993 and by a total of 31.1% for a CAGR of 7.0%. Hardly inspiring stuff, particularly when you realise the company is trading at a trailing price to earnings (P/E) of about 25.
Cash & Other Numbers
When evaluating a company, the following key numbers are vitally important. They make up the cornerstone of points 6 to 8 of the ideal Qualiport company.
As we have seen above, we don't have to worry about Unilever's debt levels -- because they haven't got any! The £3.2 billion cash does not appear to be burning a hole in management's pockets, since they've had the money for over a year now. This restraint is admirable -- it would be so easy for them to go out and blow it on a big acquisition that may not necessarily fit into their long-term business plan. As well as being positive, it also potentially highlights the lack of opportunities for Unilever.
Unilever has strong free cash flow levels. Depreciation of £688m was less than capital expenditure of £876m, but not by a huge amount. Because sales are reasonably static, this indicates that the company are not having to spend a lot of money on replacing worn out equipment, which is essential just to keep the business ticking over at current levels. Ideally you want to see growing companies spending money in order to keep growing, but not so much for mature companies. For example, a new car for an existing salesperson is not going to increase the company's sales, but if a new car was bought for an additional salesperson, this would hopefully increase the company's overall sales and profitability. As a sideline, the absolutely perfect company would have zero cash-sucking fixed assets and be able to generate huge amounts of sales and profits. This company of course doesn't exist, but a company such as a recruitment agency is a good example of one with a relatively low fixed asset count.
Return on equity (ROE) is an important calculation but often distorted by goodwill written off on acquisition. The goodwill written off refers to the difference between the net assets of an acquired business and its purchase price. For example, if you were buying a machine that prints one £5 note per year, you might be willing to pay £50 to purchase that machine. However, the actual physical printing machine may only be worth £10, so your goodwill on acquisition would be £40. How you account for that £40 in your balance sheet determines the calculated ROE, although it is plain to see in this example that your year one ROE would be 10%.
ROE is calculated as:
Normal Net Profit Attributable to Shareholders
---------------------------------------------------------
Shareholder's Equity + Goodwill Written Off on Acquisition
£1,426m
-------------------------
£7,416m + £6,339m
= 10.4%
ROE gives you an idea of what kind of profit is being generated for every pound that is employed in the business. Unilever's ROE as calculated is very much on the low side and gives the impression that the company is not getting a very good return on shareholder's funds.
We are trying to establish whether Unilever are generating above average returns on their capital. Another way to try to assess this is by looking at return on invested capital (ROIC). This measures the amount of profit generated for every pound of capital invested in the business. Note the subtle but important difference in the definition. The denominator (the bottom part of a fraction -- I remember it because "d" as in denominator is for "down") used in calculating ROIC is quite different.
Normal Net Profit Attributable to Shareholders
---------------------------------------------------------
Total Assets - Non Interest Bearing Current Liabilities - Cash
£1,426m
------------------------------------
£19,247m - £5,555m - £5,853
= 18.2%
The two numbers are poles apart. However, it should be remembered that there is no single measure that will inform you exactly about the quality of a business and its value. The P/E is often used, as is the PEG, PSR, ROE, ROCE, ROIC, yield... the list goes on. (Where's the jargon buster?) Much about stock analysis is knowing and getting a feel for the business in which you are possibly going to buy a part-ownership. This doesn't come overnight. We'll be covering the different ways to value shares in a series beginning shortly.
Interestingly, and this is probably a better measure of their increased efficiency, the ROIC for 1996 was 15.0%.
Next Step
I've been learning more and more about Unilever as I've looked closer into their numbers and business. As you are no doubt aware, they are essentially a huge company with interests in many different countries spread across all continents of the globe. In the past few years, they have gradually and then spectacularly increased their operating margins, often the sign of good management and a quality company. The first quarter results, where in constant terms turnover increased by 8% and operating profit by 41%, were stunning. The profit growth number is almost unheard of for a diverse, mature company the size of Unilever.
The big question now is to determine whether Unilever are in fact a quality company. It could be that they are currently in the process of re-engineering themselves and turning into a lean, high return business such as Coca-Cola. The signs are there -- the sale of their non-core speciality chemical business, the increasing margins (with the scope to stretch them a lot further; remember PG achieves 16.2% vs. Unilever's 9.9%), and the increasing ROIC. And don't forget that they've got over £3 billion in net cash available for reinvestment in the business or to return to shareholders through a share buyback or a special dividend.
I'm personally torn on Unilever. Part of me thinks they are a Qualiport company, but I'm just not sure. I'd like to run through some valuation numbers regardless, just to see whether they offer value at this time. Then, depending on how the valuation pans out, I'll make a final decision about Unilever's immediate Qualiport prospects. This will happen on Friday.
As ever, your input is encouraged and greatly appreciated. Please post all thoughts about Unilever to the Qualiport message board. Are they a quality company?
Bruce Jackson (TMF Googly)
Qualiport Numbers
Today's Numbers Date 24/06/98
Change Bid
pence £
RTO 0.00 4.26
EMAP 0.20 12.50
MKS -0.14 5.42
Rec'd # Stock Buy Now % Change £ Change
19/12/97 1565 Rentokil 2.55 4.26 67.1% 1.71
17/04/98 337 EMAP 11.85 12.50 5.5% 0.65
11/05/98 722 M & S 5.535 5.42 -2.1% -0.115
19/12/97 1565 Rentokil 4,040.63 6,666.90 65.0% 2,626.27
17/04/98 337 EMAP 4,043.37 4,212.50 4.2% 169.13
11/05/98 722 M & S 4,052.24 3,913.24 -3.4% -139.00
Cash 33.96
Total 14,826.60
Day Month Year History
Qualiport -0.2% -0.7% 52.4% 55.8%
FTSE 100 0.6% -1.1% 13.0% 15.6%
FTSE All Share 0.4% -2.4% 13.4% 15.8%