Qualiport

Continued from Part One

Fool Buys Unilever, Part II
Wednesday 15th July 1998

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.

Return on equity (ROE) is an important calculation, but often distorted by goodwill written off on acquisition. It 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 shareholders' 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.

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. Interestingly, and this is probably a better measure of their increased efficiency, Unilever's ROIC for 1996 was 15.0%.

Valuation

Once we've decided a company is a worthy member of the Qualiport, the next step is to assess its value. Valuation is important, as the initial buying price has a big bearing on your total return. The Qualiport's aim is to buy and hold great companies for the long term, ideally for a period of 5 years minimum and preferably for 10 or more. You may be thinking that makes it pretty boring, but if a portfolio of great companies can return 15% compounding growth per annum, we'll take that any day. To put that compounding return in perspective, £20,000 compounding at 15% per annum will be worth £81,000 in 10 years' time, and £327,000 in 20 years' time. And that's without adding any additional fuel to the compounding fire.

The great and yet often confusing thing about stock analysis is that there are so many ways of assessing a company's worth, and each one could be very correct or very wrong. Even the basic earnings per share (EPS) number is open to interpretation. I spent a large part of this morning trying to work out what I perceived as the true EPS number. It is made difficult by the various factors, such as the profit from the sale of the chemicals business and the restructuring costs. The Hemmington Scott site lists Unilever's trailing EPS as 27.0p. I calculate it as 20.4p, a full 32.4% less. The difference basically boils down to my interpretation of their £469m restructuring costs. You may remember that Unilever said they expect to spend between ½% and 1% per annum on on-going restructuring and rationalisation. On turnover of almost £30b, that works out at between £150m and £300m. In getting to my EPS of 20.4p, I have deducted the full £469m from their normalised profits, but Hemmington Scott haven't deducted anything, hence their higher earnings number. You may think that's me being conservative again, and you're probably right. But costs are costs, and this clearly is not a one off charge, although it may be higher in 1997 than it will be in the future.

Anyway, as we intend to hold Unilever for 10 years or more, it is appropriate to look 10 years down the track when trying to assess their value. This is where a few judgement calls come into play. It is difficult enough to predict a company's 1998 earnings, let alone its 2008 profits. However, as Unilever is a huge global company with great brand names and predicable earnings, it does become a little easier and viable to make these long term assumptions. If we were talking about a company that was small, in the early stages of its development and in the technology sector, I would feel far less comfortable with these long-term predictions.

Earnings Per Share

The City usually values companies on their short-term earnings potential, looking out, say, two years. The theory goes that any forecasts after that are pure guesswork. That short-termism, however, also sometimes provides opportunities for the canny investor who is prepared to look further into the future, especially where a company has predictable earnings.

Unilever is a huge company, with many essential day-to-day products. Their profits are relatively predictable, as are their products and markets. Smaller companies, which constantly need to innovate to keep up with the competition, are far less likely to have predictable earnings over a long period of time. Only the very best will turn into the Microsoft of tomorrow.

The following table gives a likely scenario about Unilever's long-term valuation.

   
Year   EPS     P/E  Price  Growth  CAGR   Divs
    
1997   20.4   33.3   680                   8.42
1998   25.0   27.2   680                   9.00
1999   27.0   25     675                   9.90
2000   30.2   25     756                  10.89
2001   33.9   25     847                  11.98
2002   37.9   20     759                  13.18
2003   42.5   20     850    25%    4.6%   14.49
2004   47.6   20     952                  15.94
2005   53.3   18     959                  17.54
2006   59.7   18    1074                  19.29
2007   66.9   18    1203                  21.22
2008   74.9   18    1348    98%    7.1%   23.34
    
2008 Share Price      1,347.72
Total Dividends         166.78
Total 10 Year Return  1,514.50   123%   8.3%

The following assumptions are very important, and can materially affect any valuation:

EPS Growth Rate 2000-2008: 12%
Dividend Growth Rate 1999-2008: 10%
Base Year: 1998

The EPS growth rate and the P/E ratio are the numbers which could both be either pessimistic or optimistic, depending on any number of factors. As I've said previously, Unilever could just be beginning an unprecedented growth, efficiency, and profitability phase of their mature corporate life. Under Niall Fitzgerald, the company appears much more focussed on shareholder value and on return on assets than it has been in the recent past.

If you assume that Unilever will hit their forecast EPS of 25p for calendar year 1998, then according to Hemmington Scott Company REFS figures, normalised EPS will have grown from 20.6p in 1993 to 25p in 1998, for a CAGR of 3.9%. This is a far cry from my 12% earnings growth from 2000. On the other hand, Unilever's 1998 first quarter EPS at current exchange rates was up 44%, a truly astonishing growth number for such a huge and mature company. I believe the 12% average growth rate for most of the next 10 years is a fair mid-point for investors to realistically expect.

The other big assumption with this particular model is the company's P/E ratio. Over the past five years, Unilever have traded at an average P/E of between 13 and 22, with the higher number only occurring relatively recently. The EPS model expects the P/E to come back from the 1998 estimate of 27 towards 20 and then 18. This again could be either too high or too low, and may very be at the mercy of things completely out of the company's control, such as the overall level of the stock market and, more importantly, the prevailing interest rates. We make no attempt to judge either of these unknowns -- the economists are divided about which way interest rates are headed right now, let alone 5 or 10 years down the track.

I am basing all numbers based on Unilever's forecast EPS for the year ended 31/12/1998. That is a full 6 months ahead of now, and all returns are therefore assuming today's date is in fact 31/12/98. The fact that it isn't means we are effectively foregoing any returns from any investment for the next 6 months if we bought shares in the company right now.

Taking all those assumptions at face value, the above model shows that on 31/12/2008 we expect that our total return including dividends from 31/12/1998 could be 123%, for a CAGR of 8.3%. As a comparison, the current risk free 10 year bond return is about 5.84%, and the base interest rate is 7.5%.

Other Valuation Methods

As I said, there are other valuation methods which can be used to help determine a company's fair value. I will not go into the methodology too much in this report, suffice to say that we will do so in the very near future.

Return on equity is a vital number in the armoury of the equity analyst, notwithstanding the many different interpretations and calculations you can have on what should be a rather simple concept. You will have seen that I calculated Unilever's trailing ROE at 10.4%, yet I have decided on the following assumptions:

Return On Equity: 14% for 3 years, then 16% for the next 3 years, and 18% for the next 4 years.

A model I have used gives a CAGR of 5.0% after 5 years, and CAGR of 8.0% after 10 years, dividends included.

The final valuation method I have used when assessing Unilever's prospects is discounted cash flow (DCF). Again, I won't go into detail apart from saying that I've assumed a discount factor (risk free) of 9%. The model, which it must be remembered can be relatively flattering, values Unilever at a discount to its current intrinsic value of 31.2%.

Valuation Summary

We have various valuation models amid some wide ranging assumptions. A company like Unilever is open to such valuation techniques because of its size and quality of earnings.

I always like to have some sort of high and low point expectations regarding a company's valuation. Using the 10-year earnings per share model, we can plug in a couple of high and low assumptions to look at potential 10 year annualised returns.

If EPS growth = 8% per annum and 2008 P/E = 14 and dividend growth = 8%, the 2008 CAGR = 2.9%.

If EPS growth = 12% per annum and 2008 P/E = 18 and dividend growth = 10%, the 2008 CAGR = 8.3%. These are the assumptions used in the above model, and I believe are the most likely.

If EPS growth = 15% per annum and 2008 P/E = 25 and dividend growth = 15%, the 2008 CAGR = 15.0%.

That gives a big range of potential returns, from a low point of 2.9% per annum to a high point of 15.0% per annum, with a mid point of 8.3% per annum. The other most likely valuations techniques using the ROE and DCF methods give a CAGR of 8.0% after 10 years, and a discount to intrinsic value of 31.2%. These need to be compared with the risk free rate of return which is 5.75%. The Unilever returns, whilst not risk free, are relatively stable and predictable.

Risks and Opportunities

Over the years, the share market has returned around 12% per annum. Using the possible scenario above, that would imply that the share price needs to fall to 488p before buying shares in Unilever could mean seeing them match the long term returns of the market. As of writing, that level seems unlikely, although at beginning of 1997 (only 18 months ago) the share price was as low as 338p.

My investing style is to be very much aware of the buy point, as that very much determines the long term returns of an investment. There are many other styles of investing, including the "buy quality companies and hold them regardless of the entry point." The theory goes that you can't predict the future P/E of any company, or its long term growth rate. If, however, you make sure you buy obviously great companies, you can at least be guaranteed of market beating returns. If and when the market tanks, you want to have your money invested in great companies, and this should help cut your losses.

We could currently be in the midst of a global re-rating of share prices and the multiples they trade on. Technology has continually allowed many quality companies to become more efficient, and hence more profitable. Return on capital is at historically high levels and could even go higher. Interest rates are relatively low, and one could argue that high inflation is dead for good. There is no doubting that Unilever, or any company for that matter, could trade at a P/E of 30, 40 or 50 in ten years' time. That would make a mockery of my potential forward valuation of the company. History says otherwise, but records are made to be broken. Investors were probably thinking the same thing in the 1970's, when shares like Avon, Xerox and Polaroid were bid up to enormous multiples, in an era now known as the nifty fifty. Where are those companies now? OK, Unilever is not one of those, but it makes the point that in the past we have always seen share prices edge back to average P/E's. What makes now any different? Look at what has happened in Japan for the past 10 years.

I don't want to sound like a bear, because I'm not. The examples I'm giving are purely illustrative, and not indicative of my current thinking. I'm not going to count out completely the purchasing of Unilever at 680p. For me, it is a borderline decision anyway, and I'm all too aware of my conservatism when it comes to valuation. If I really pushed the boat out, I could imagine that Unilever could grow their earnings and dividends at 15% per annum for 10 years. They could trade on a P/E of 25 in 2008, giving them a CAGR of 15.0%. My personal target is to achieve sustainable growth of 15% per annum, so that is bang on target.

No-one ever forces you to buy a part ownership in a company. I can choose to put in the bank for 6 months, earning a risk free 7% per annum, hoping to pick up shares in the company at a much cheaper price at a later date. Or, I can search for a company that I think will be able to achieve better returns than Unilever over the next 10 years. Or I can choose to invest in Unilever and hope that they live up to my most optimistic expectations. That, Fools, is the choice.

Conclusion

I've been learning more and more about Unilever as I've looked closer into their numbers and business. 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.

Unilever could just be 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% v 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.

We're taking the plunge, knowing the potential rewards and the risks. The great thing about Unilever is that you don't have to look at their share price every day. In fact, that's usually a good sign of a great company, or a company with long-term prospects in which you feel confident. Unilever are not going to suddenly announce a profit warning just because they haven't sold many ice-creams in the UK this "summer." They are a core, stable investment, and we believe an ideal selection for the Quality Portfolio. Here's to the next 10 or more years. Oh, and do us a favour when you're next in the supermarket. Make sure you choose Persil ahead of Ariel, Walls ahead of Mars, and PG ahead of Tetley. We will be.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers            Date    15/07/98


          Change     Bid
          pence       £

RTO        0.04      4.36
EMAP      -0.10     12.35
MKS       -0.03      5.41         


Rec'd      #    Stock      Buy      Now   % Change  £ Change

19/12/97 1565  Rentokil   2.55     4.36    71.0%     1.81
17/04/98  337  EMAP      11.85    12.35     4.2%     0.50
11/05/98  722  M & S      5.535    5.41    -2.3%    -0.13


19/12/97 1565  Rentokil  4,040.63  6,823.40  68.9%  2,782.77
17/04/98  337  EMAP      4,043.37  4,161.95   2.9%    118.58
11/05/98  722  M & S     4,052.24  3,906.02  -3.6%   -146.22

Cash                                    33.96

Total                               14,925.33


                Day    Month    Year    History

Qualiport       0.0%    1.4%    53.4%    56.9%
FTSE 100        0.8%    5.5%    19.8%    22.5%
FTSE All Share  0.8%    4.7%    19.2%    21.7%