Description

Introduction

Associated British Foods (ABF) is a food producer and retailer with 128,000 employees across the UK and the rest of Europe. It owns a number of famous food & beverage brand names including Twinings, Ovaltine and Jordan's cereal. It also runs British discount retailer Primark, which competes with H&M and Shein at the lower end of the fast-fashion category. 

I found the stock through the Emerging Value Substack, which wrote about the stock a few months ago here (paywall). 

Company history

Associated British Foods was founded in 1935 as “Allied Bakeries” by Canadian W. Garfield Weston. In the following 20 years, the company acquired ten bakeries throughout the UK. By the early 1960s, the company had adopted the current name “Associated British Foods” and controlled almost 20% of UK’s bread market.

It later diversified into other segments. The acquisition of the Twinings tea business came in 1964. The first Primark store opened in Dublin in 1969 and then expanded to the UK in the early 1970s.

Following the death of Garfield Weston, his son Garry took over the business in 1978.

Other important transactions for ABF include British Sugar in 1991 and a majority stake in African sugar company Illovo in 2006 (remaining stake acquired in 2016). ABF expanded into bakery ingredients in the 1980s and into the agri business in the 1990s. In the food product segments, it acquired Ovaltine in 2002 plus a number of brands such as Mazola corn oil, Argo and Kingsford's cornstarch from Unilever in 2004. Finally, the Jordan and Dorset cereal brands were acquired in 2008.

In short, it's been a highly acquisitive business but the focus over the past decade has shifted to growing key retail asset Primark.

Management

Today, ABF remains controlled by the Weston family through the Weston foundation, which holds 51% of the shares.

Current CEO George G Weston is the son of Garry Weston and the grand-son of original founder Garfield Weston. Prior to his current position, George was a managing director of Westmill Foods from 1992-98, and then Allied Bakeries from 1999-2003. He then became CEO of the Australian business in 2003-05 before taking over as CEO of the entire company from 2005 onwards.

He studied PPE at Oxford and has an MBA from Harvard Business School.  

Business overview

The company now has five main segments: 

• Retail (40% of revenues): Low-priced British fashion retailer Primark

• Grocery (26% of revenues): A number of food product brands such as Ovaltine cocoa drink, Twinings tea

• Sugar (12% of revenues): The second-largest sugar producer in the world through British Sugar and Illovo

• Agriculture (11% of revenues): Animal feed, nutrition tand technology based-products through AB Agri

• Ingredients (11% of revenues): The world’s second-largest producer of baker’s yeast, as well as other bakery ingredients supplying the food, nutrition and pharma industries.

Groceries

ABF’s grocery segment includes a number of food product brands sold primarily in the UK, Australia and Europe.

The key brand names include:

• Twinings tea: One of the world’s most popular tea brands, selling across 100 countries

• Ovaltine: milk flavoring product for children

• Patak’s: Indian style spices and related products such as cooking sauces, curry pastes, chutneys, etc.

• Kingsmill: white bread, pancakes, crumpets

• Jordans: Cereal bars as well as breakfast cereal

• Tip Top: Australian bread brand, selling sliced bread, English muffins, hot dog rolls, etc

• Yumi’s: Australian brand offering hummous and other dips

• Mazola: corn-based cooking oil

Margins in the grocery segment have been on an upwards trajectory over the past decade thanks to stringent cost control, though hurt by food price inflation from 2021 onwards.

Sugar

The sugar business is divided into two separate businesses:

• AB Sugar: a beet processor and sugar producer, selling into the food and beverage, pharma, industrial, agricultural, power and energy industries. The company produces around 4.5 million tonnes of sugar annually.

• Illovo Sugar Africa: the biggest sugar processor in Africa. It also owns a beet sugar business in Northeast China.

• Azucarera: The leading sugar producer across Spain and Portugal

ABF’s sugar businesses are price takers and profits are dependent on the global sugar price environment. And profits were hurt by EU’s new sugar regime from 2017, which ended sugar quotas.

Agriculture

The agriculture segment manufactures animal feed, as well as other products and services to the agriculture sector. These products are produced through the following subsidiaries:

• AB Agri: Produces animal feed, feed enzymes, specialised feed ingredients and technology based products to the agri-food industry.

• AB Agri China: An animal feed business operating exclusively in China

• AB Neo: Nutrition for young-farmed animals, including milk replacers, starter feeds, specialist raw materials, starter feed concentrates and feed additives.

• ABN: The leading British manufacturer of pig and poultry compound feed.

It's a slow-growth business with volatile margins.

Ingredients

The ingredients business is split into two separate subsidiaries:

• AB Mauri: Producing bakers’ yeast and other bakery ingredients across the America, Europe and Asia.

• ABF Ingredients: Specialty ingredients for food, nutrition, pharma, animal feed and industrial sectors. These include enzymes, lipids, yeast extracts and culinary powders, specialty flours and drug delivery systems.

Retail (Primark)

ABF’s retail segment is focused on apparel and home furniture retailer Primark. The group holds a 7% share of the UK apparel market (2018 number).

Primark currently has 403 stores across the United Kingdom (most stores), but also Germany, Ireland, Netherlands, Spain and the United States.

Price-sensitive customers seem to love Primark:

• “I love it! Very good price-quality ratio and you can find pretty much anything: clothing, home stuff, beauty products...The prices are really the most attractive part: when I go there I usually buy other things than the ones I was coming here in the first place. There is a lot of choice as well!” – Primark Sheffield (4.2/5.0)

• “As always great bargains to be had. Despite being busy, busy, busy staff at the tills were amazing and kept the queue flowing. Staff were pleasant and approachable.” – Primark Bolton (4.1/5.0) “Good choice of merchandise. The staff in primark are usually very helpful and friendly but the girl on floor two on the tills was very very slow and rude. Such a shame as the staff are usually really good. Wish I had got her name as its a shame she is letting the team down.” – Primark Harrogate (4.3/5.0)

• “I have been to many Primark's, mostly because my daughter is weirdly into them. I have distilled her obsession down to the fast fashion pocket money prices. No great shakes there, BUT, we went to Newcastle and after several years living in a monochrome world of outfits Primark Newcastle suddenly motivated her to buy COLOUR. This was in no way a hyperbolic big deal in our small pointless existences. Well done to this shop.” – Primark Newcastle (4.3/5.0)

• “Very stylish and minimalist home decorating tools with a very reasonable price. But you know they must not be durable for a year long or so because most of them are Made in China (MIC) goods No offence just spilling out the facts” – Primark Oxford Street, London (4.3/5.0)

• “Nice and clean. Very well laid out too. Get in nice and early to avoid the rush !! Plenty of tills anyway on the ground and 1st floor. Fitting rooms too. Oh and not to forget the greggs clothing range lol see pictures" – Primark Glasgow (4.3/5.0)

There seems to be some growth potential in smaller cities across the UK, with many sub-100k population cities not having access to any local Primark store.

There could also be expansion potential overseas. For example, when Primark first expanded to the US in 2015, Morgan Stanley commented that Primark’s pricing was far more attractive than comparable US retailers.

“Morgan Stanley’s survey included 14 stores across the Boston area with 100 like-for-like items. Express pricing was 399 percent higher, American Eagle Outfitters 360 percent higher, and the Gap brand 332 percent higher, all showing the greatest discrepancies.”

Primark suffered during COVID-19, not so much because of customer caution but rather due to government-imposed lockdowns and forced store closures. ABF is guiding for 2022 Primark operating margins of 10%, but probably somewhat higher than that next year.

The overall picture

You can tell from the below chart that the key driver of rising operating profit up until the pandemic was driven by the expansion of the Primark retail chain (blue bars).

Profits in the sugar segment (green bars) are significantly more volatile, being driven by global sugar prices (which peaked in 2012).

The other segments are more stable, by virtue of being in the consumer staples category.

The company reportedly uses ROCE as a measure of operating performance, but the group’s return on capital has historically been on the low side, perhaps because of the acquisitive nature of the group.

What is going to change?

Semi-annual profits have already started to recover from the store closures of 2020-21 to an annualised level of around GBP 1,200-1,300 million.

Going forward, I see following shifts in ABF’s business:

• Primark has more or less recovered from the pandemic with Google seasonally-adjusted search query data suggesting a full recovery by 2022. In the latest earnings call, it was reported that latest quarter Primark revenues were +4% higher than than comparable pre-COVID period three years ago. Like-for-like sales are still 9% below pre-COVID levels but should be improving as continental European stores only started recovering by early summer 2022 and Primark reported a 4 percentage point improvement by the end of calendar Q2.

• Primark will build another 12-13 stores by the end of year 2022 across the US, Iberia, Italy and France. Two stores in Ireland and Florida will be reopened as well. The 2026 store target is 530 stores, implying yearly growth in the store count of 7%.

• A new Primark website was launched in April 2022 and customer reception has been excellent. Click-and-collect is being launched on a trial basis later this year starting with kids clothing. Do not expect home delivery as the management team does not believe the unit economics work. Given that Primark’s clothing can cost as little as GBP 5-10, it’s plausible that delivery could cost as much as the item itself. Primark’s website’s customer engagement has been strong with traffic reportedly increasing 60% and customers are viewing twice as many pages per session. Over the past few years, in fact Primark’s website traffic been on an upwards trajectory.

• Global sugar prices have reached the highest level since 2017, and EU sugar prices have shown a similar trend. If history is any guide, we should be seeing operating profits exceeding GBP 200 million on an annualised basis in the near future.

• Food price inflation is hurting margins in the grocery segment, causing analyst downgrades from late 2021 onwards. There’s also a concern that rising energy prices will cause a UK recession, thus hampering overall retail sales.

• There’s been a persistent fear that Chinese online retailer Shein will take business from Primark. I share that worry. But I also hesitate to draw any conclusions from a one-in-a-century pandemic. And Primark has performed well despite Shein’s popularity. It’s also worth mentioning that Shein products have repeatedly been found to contain hazardous materials. The company is benefitting from the fact that it’s operating in a regulatory grey zone. That tailwind will probably not last forever.

• High shipping costs have been a headwind for discount retailers for much of 2021. But container shipping rates have been dropping consistently since the peak in August last year.

• John Bason retired as CFO for Associated British Foods in July 2022 and was replaced by former Marks & Spencer CFO Eoin Tonge. Tonge was at M&S for only two years, and before that at Greencore Group as a managing director in the grocery division and chief strategic officer. From 1994-2006 Eoin worked at Goldman Sachs at various roles across finance, treasury and capital markets. He seems competent but his investment banking background makes it likely that he’ll continue ABF’s history of engaging in potentially value-destructive M&A.

• The UK tax rate will increase on 1 April 2023 to 25% for companies with taxable profits > GBP 250k. ABF is certainly in that category and will therefore be burdened with a greater effective tax rate.

• Management has said that it will consider a share buyback late in calendar year 2022, after some investors expressed frustration about the lack of clarity on this point.

Valuation

Historically, ABF has traded at around P/E 21x and EV/EBIT of 16x, far above current price levels.

Inditex is a decent peer for the retail segment and Unilever a decent peer for the food segment. It’s hard to say what the appropriate multiple should be, but it’s probably closer to 20x P/E than the current 11.6x.

With Primark already close to recovery I expect operating profit to reach well above GBP 800 million, while the sugar segment should reach above GBP 200 million in operating profit as well. Grocery segment margins should fall to ~8% in the near-term due to raw materials price pressures causing overall profit profit to end up at close to GBP 1,400 million for 2023e.

Assuming a 16x EV/EBIT you’ll end up with a GBP 22.7 billion EV, a GBP 20.9 billion market cap and a share price of GBp 2645, providing upside of +69%. That would be equivalent to a P/E ratio of 20.2x, which I think would be reasonable for a high-quality food product company with some growth potential (primarily Primark).

The company has historically paid out about 40% in dividends, which on the above projections will lead to a forward-looking dividend yield of close to 4%.

A number of insiders including Wolfhart Hauser (director), Emma Adamo (director) have purchased shares in the past few months. But the George Weston family have on the other hand been persistent sellers during COVID-19, for unknown reasons.

Risks

• Poor acquisitions: I’d prefer for the company to grow organically rather than via M&A, which I think is the primary reason why the ROE has has remained subpar. 

• Online competition: A major risk is that Shein continues to take market share from Primark. But the data remains fairly positive for sales/store rising every year prior to the pandemic. The data does not yet support that the business model is broken in any way.

According to YouGov, the brand perception index value score even rose from 15.1 in 2014 to 25.7 to 2018 and rose across all demographics. So Primark has clearly become more popular, at least until 2018.

Discount retailers in the US and Japan have done well in the face of competition from e-commerce. The reason is most likely that shipping is costly and that many want to try on clothes before purchasing. The below chart from the Office for National Statistics show that before COVID-19, in-store retailer spending actually rose steadily. Especially in the discount category.

Catalyst

• Primark foot traffic recovering post-COVID-19

• Food prices stabilising or starting to drop

• Positive contribution from Primark’s click-and-collect initiative

• Regulatory action against Shein or cross-border e-commerce in general

• Higher sugar prices