Unilever PLC is one of those defensive income stocks that investors love to love.
In fact, investors love Unilever shares so much they’ve pushed the price up from £25 in 2015 to a recent high of £45.
Does this mean it’s too late to buy Unilever shares? Or if you already hold them, should you keep holding or does the price increase make this a good time to sell?
Unilever: A defensive growth stock in a world of frightening volatility
Investors love Unilever because it’s pretty much the closest thing you’ll find to a sure thing in the stock market.
It sells everyday branded consumer products like Domestos detergent, Dove soap and Magnum ice cream to millions of people around the world.
These items are priced at a premium relative to unbranded alternatives, and that premium ends up as profits on Unilever’s income statement and dividends in shareholders’ pockets.
Because these products are bought every day by millions of people, Unilever’s revenues, earnings and dividends have been very steady over many, many decades.
The company’s recent performance looks like this:
As you can see, the general trend is upwards, and while earnings declined for several years following the financial crisis, the normal state of affairs (i.e. earnings growth) has been resumed.
Cautious, defensive dividend investors just cannot get enough of this stuff, especially when the Unilever Fact Sheet says that Unilever’s dividend has increased by 8% per year since 1979!
And the latest annual report has this to say:
Over the last 5 years our dividends have increased 7% per annum and our share price is up by around 50%
The company also has other attractive features, including:
- High profitability: High margin branded products have given Unilever an average return on capital employed (ROCE) over the last decade of 15%, well above the market average of 10%.
- Reasonable capex requirements: With no need to build retail stores or relatively little need to invest in factories and other equipment, Unilever’s capex-to-profit ratio has averaged an undemanding 44% over the last decade.
- No excessively large acquisitions: Acquisitions can destabilise an otherwise stable business, but Unilever has not been overly aggressive with its acquisitions. Over the last ten years, total acquisitions came to just 23% of total profits.
In summary then, Unilever appears to be a genuinely great company and up to this point, I’ve been unrelentingly positive about it.
However, it is possible to view Unilever through glasses which are decidedly less rose-tinted.
Unilever’s days as a growth stock could be over
You may have noticed in the chart above that Unilever’s revenues have more or less been static over the last few years.
And as I’ve already mentioned, earnings declined between 2010 and 2014, so Unilever is not quite the relentless growth machine that its almost mythical status might suggest.
In fact, when averaged across revenues, earnings and dividends, the company’s growth rate over the last decade has been just 3.5% per year.
But didn’t the annual report mention dividend growth at 7% per year?
Yes, it did. And over the period in the chart, Unilever’s dividend growth rate was a reasonably impressive 6% per year.
But earnings growth was a far less impressive 2.1% per year while revenue growth was hardly any better at 2.3% per year. And yet inflation over that period has averaged 3% per year.
So the unpalatable truth is that when inflation is taken into account, Unilever has not grown its revenues or earnings at all over the last decade.
This is not what I’d expect to see from an almost universally admired stock.
But the truth is that Unilever’s results may be even worse than that.
Without Brexit, Unilever has already gone ex-growth
In the chart above, Unilever’s revenues, earnings and dividends all made a healthy jump upwards between 2015 and 2016.
Is this a sign that the company is returning to its long (and distant) history of impressive growth?
No. It is mostly down to Brexit and the related fall in the value of the pound.
The value of the pound matters because Unilever generates most of its revenues overseas in currencies other than GBP.
As a result, when the value of the pound falls, Unilever’s revenues, earnings and dividends, in GBP-terms, become higher than they would otherwise have been.
So what would Unilever’s results look like in a Brexit-free world? One in which the value of the pound hadn’t collapsed in 2016 by around 15% relative to the Euro and other international currencies?
With the Brexit boost removed (note the lack of a jump upwards in 2016), Unilever’s results over the last few years looks even more anticlimactic than they did before.
Revenues have gone almost nowhere since 2010 and have in fact been falling since 2013.
The story for earnings is about the same, with a recovery since 2014 only just offsetting declines since 2010.
Only the dividend has continued to go up, with growth over the period of 5% per year. That’s not bad, but I don’t think it’s anything worth paying a premium for.
Another worrying trend is that the dividend has been growing faster than earnings or revenues. This is simply unsustainable.
In this Brexit-free world, revenues have grown by just 2% per year (on average) and earnings just 1.5%.
Since dividends must be covered by earnings in the long-run, the dividend cannot keep going up at 5% per year (or 6% if we reinstate Brexit) if earnings are going up by 1% or 2%.
While this is going on, Unilever’s dividend cover is gradually being eroded. For example:
At the end of the previous decade, Unilever’s dividend cover was around 1.8. But over the last three years it has averaged a measly 1.4.
If dividend growth keeps outstripping earnings growth then at some point the dividend will be uncovered.
This will starve the company of cash which it needs to invest for growth, putting further pressure on the company’s already lacklustre growth prospects.
The CEO may decide to ramp up debt levels as an easy way to pay an unsustainable dividend and invest for growth, but that is a very risky strategy.
Unless Unilever starts to turn things around then either a) the dividend growth rate will have to come down towards 1% or b) the risk of an unsustainable debt binge becomes a real possibility.
And that turnaround may never come.
Yes, people love brands, but an increasing number of people don’t care about branded goods, as long as they’re buying “own brand” products from a retailer they trust, e.g. the big supermarkets or Amazon.
Amazon (the destroyer of other people’s profits) is coming
Amazon, otherwise known as “The Everything Store”, is perhaps the biggest threat to companies like Unilever that rely on popular branded goods to deliver high profit margins.
Amazon’s relentless expansion has taken it into the world of recurring deliveries, where you can buy Amazon Basics products (yes, “own brand” products from Amazon) that get delivered to your door every month.
Just imagine, you’ll soon be able to order soap, detergent and toothpaste (all things that Unilever profits mightily from) from Amazon and have it automatically delivered at a frequency of your choosing, all at incredibly competitive prices.
How can Unilever, or any of the other defensive consumer goods companies compete with that? I have no idea.
If you want to ponder this issue further, here are a few brief overviews from 1010DATA:
- Market Insights Series: Amazon’s Advance – The Battle of Batteries
- Market Insights Series: Amazon’s Advance – The Siege of Speakers
- Market Insights Series: Amazon’s Advance – The War of the Wipes
- Amazon’s Brands are Growing 80% YOY
However, this doesn’t mean I think Unilever is about to declare bankruptcy.
What it does mean is that I think investors should be very wary of easy assumptions about Unilever’s ability to keep growing at all, let alone as quickly as it did several decades ago.
So given that I don’t expect Unilever to deliver double digit or even high single digit growth rates in the future, what do I think about its current share price?
Unilever has “expensive defensive” written all over it
It should not come as a surprise that I think Unilever is overvalued at its current price of £42.
The dividend yield is just 2.6% compared to a yield of 3.2% from a FTSE All-Share tracker.
And if you think that’s an unfair comparison because the market index grows its dividend more slowly than Unilever (therefore negating the benefits of a higher yield), you’d be wrong.
The All-Share has grown its dividend by 5.7% per year over the last decade while Unilever grew its dividend by 6% per year (not adjusting for Brexit).
So if we optimistically assume the same dividend growth rate going forwards then Unilever could return 2.6% from its yield and 6% from growth, giving a yield-plus-growth potential return of 8.6%.
But the FTSE All-share has a yield-plus-growth potential return of 8.9%, some 0.3% higher than Unilever’s.
Of course, investors won’t actually get exactly 8.6% or 8.9% per year from either investment, but the point is that Unilever at its current price is not obviously more attractive than a simple index tracker.
In fact, I think the tracker is probably more attractive because the no matter how low risk Unilever might be, it isn’t as low risk as the diverse collection of 600 or so companies that make up the All-Share.
By now it should be clear that I wouldn’t buy Unilever at its current price. Instead, this is what I think:
- I would definitely sell Unilever today because I think it’s just too expensive
Unilever’s share price needs to fall a long way for it to be attractive
I’ll finish with a target buy price, i.e. the price I would be willing to pay for Unilever. And yes, I would be willing to buy it at the right price, despite some of the negative things I’ve said.
Unilever currently has a rank of 165 on my stock screen of dividend-paying companies, out of a total of 220. Number 1 is the top rank, so Unilever is below average and pretty close to the bottom.
However, at a lower price it would move up the screen and at some point it would enter the top 50, which is where I select new investments from.
So if everything stayed the same, i.e. revenues, earnings and dividends unchanged, but the share price fell far enough (and the yield rose high enough), then I would buy.
And here is that price:
- TARGET PRICE: I would be willing to buy Unilever at anything below £23
At £23 Unilever would have a dividend yield of 4.7%, which I think is far more appropriate given its pedestrian 3.5% overall growth rate.
The PE ratio would be 14 and more importantly, the PE10 and PD10 ratios would be 18 and 28 respectively, which are both pretty close to the market average.
I think that valuation looks sensible given Unilever’s mature, ex-growth profile. It’s certainly far more sensible than the company’s current high growth valuation, at least in my opinion.
Of course, £23 is a long way below the current share price £42, so I don’t expect Unilever to reach £23 until there are some problems.
Or failing that, until investors decides that companies selling consumer branded goods are not necessarily worth their current elevated prices.