Associated British Foods PLC: A quality company with a share price to match

Associated British Foods PLC (ABF) is a solid defensive company.  It’s exactly the sort of company I’d be happy to buy, just not at the current price.

It’s a bit of a throwback to the days of diversified conglomerates, which is a business model I always thought was a good idea in theory but seems hard to do successfully in practice.

ABF’s businesses are grouped into five segments:

• Sugar (AB Sugar) – A world-leading sugar producer, generating around 20% of group revenues and 35% of operating profits
• Agriculture (AB Agri) – A major international agri-business, generating around 10% of group revenues and 4% of operating profits
• Retail (Primark) – A leading high-street discount fashion retailer, generating around 30% of group revenues and 40% of operating profits
• Grocery (Brands include Twinnings, Ovaltine and Ryvita) – Leading global consumer grocery brands, generating around 30% of group revenues and 20% of operating profits
• Ingredients (AB Mauri and ABF Ingredients) – Producers of baking ingredients, enzymes and other high-value ingredients, generating around 10% of group revenues and 2% of operating profits

At the centre of the group is corporate HQ, which provides non-core services to group businesses such as investor relations, pensions and insurance expertise.

Of more importance is its capital allocation responsibility.  Corporate HQ gets to act like Warren Buffett, extracting excess cash from each business and reallocating it where returns on capital meet some predefined hurdle rate.  And a remarkably successful system it has been in recent years.

As you can see, the company has grown smoothly and steadily for a long time.  Looking at the results above, you wouldn’t even know there had been a financial crisis and, as a defensive value investor, that’s exactly what I want to see.

Fast, consistent dividend growth

The company has produced reliable dividend growth of more than 7% a year over the past decade.  That growth has been supported by growing revenues and profits so that overall the company has been growing at more than 9% a year, far above the FTSE 100 average of just 2% or so.

As well as fast, it’s also very defensive growth.  In the period above, the company has made a profit and paid a dividend every year. 98% of the time, revenues, profits and dividends have increased as well.  That’s considerably better than the average company.

So it’s produced a wonderful set of results for shareholders in recent years, but it isn’t without its risks.

Most of the growth has come from Primark.  In 2006 Primark revenues and operating profits were £1.3 billion and £185 million, respectively.  Now they’re £4.3 billion and £513 million, so Primark has quadrupled its revenues and tripled profits in 7 years.  That growth rate is unlikely to be sustainable in the longer term.

The other parts of the group have had significantly slower growth rates, so over time, it seems that ABF may become dominated by Primark, although that’s not necessarily a bad thing.

Big, prudent and international

The returns from corporate growth are likely to be above average, but what about risk?

To reduce risk, I prefer to stick with big companies.  They’re generally safer than smaller ones and less volatile, and if you can value them consistently, you can still get solid returns by occasionally buying low and selling high.

Associated British Foods is definitely big, with a market cap of more than £20 billion and a FTSE 100 listing.

It also seems to be prudent, with borrowings of just over £1 billion, which is only about one times current operating profits.

And it’s quite international too, generating just 43% of revenues from within the UK.

Overall it appears to be a great business, growing quickly and consistently.  It’s diverse, both operationally and geographically and doesn’t carry much debt.

So what’s not to like?

No company is worth an infinite price

The share price, as I write, is 2,810p.  At that price, the dividend yield is just 1.1%, and the PE ratio is 28 (giving an earnings yield of just 3.4%).  Both of those yields are much worse than average since the FTSE 100 at 6,658 has a dividend yield of 3.5% and an earnings yield of 7% (giving a PE ratio of 14).

It’s also very expensive using my preferred cyclically adjusted valuation ratio, PE10, where the company is priced at 45 times its average earnings over the past decade.

Let’s quickly revisit where equity returns come from.  One way to think about equity returns is to say that they come from dividends (which are always positive), dividend growth (which can be positive or negative) and changes in the dividend yield (which can either increase or decrease as the share price goes up and down).

If Associated British Foods keeps on growing dividends at 9%, or let’s say 10%, then shareholders get that growth plus the dividend yield of 1.1%.

On that simplistic basis, if valuations (i.e. yields) stay the same and the share price goes up at the same rate as the dividend grows, shareholders will get 11.1% per year.

That’s a reasonable rate of return but nothing special.

To get higher returns, we have to expect that either the company will grow the dividend faster than 10% a year (while the yield remains static at 1.1%), or that the share price will go up faster than the growth of the dividend, thereby reducing yields below 1.1% but more than compensating for that through additional capital gains.

How likely is either scenario?

On the dividend growth side, there is perhaps some chance of growth increasing beyond 10% a year as Primark becomes the dominant driver of returns.  Accurately predicting future dividend growth is difficult without a fully functioning crystal ball, so we’ll just have to wait and see on that one.

As for increasing valuations and reducing yields to get additional capital gains beyond the rate of dividend growth, the company’s current valuation ratios are already among the highest in its peer group (other companies that have grown at 9-10% a year with better than 90% consistency).

For that group, average growth has been 10% a year, but the average PE is 21 (not 28 as it is for ABF), and the average dividend yield is 2.5% (not 1.1% as it is for ABF).

To expect additional capital gains from valuation increases seems like an exercise in extreme optimism, although, of course, that’s not to say it won’t happen.

It’s a long way down from the top

More importantly, the current high valuation means there is a massive valuation risk, i.e. the risk that the valuation and share price will fall significantly if there is even so much as a hint of a problem.  These can easily negate any gains from dividends and dividend growth.

If you look back in history, you’ll see that the share price was about half what it is today just over a year ago.  The financial results chart above clearly shows that the company didn’t double its economic output in the last year, so the share price increase was almost all down to expanding valuations as Mr Market became more optimistic about the company’s future.

For now, Mr Market is happy, but what happens if ABF does something to make him unhappy?

Currently, ABF ranks at number 184 out of 233 consistent dividend payers on my stock screen, so it’s right near the bottom in terms of value for money because of the high valuation and low yield.

If the share price dropped to 1,500p from where it is now at around 2,810p, the dividend yield would increase to 2.1%, and the PE would improve to 24.  Its rank on my stock screen would improve to 76 out of 233, and that’s around the point where I might begin to think about investing.

But anything above 1,500p is definitely too expensive for me.

Disclosure:  I don’t own any shares in Associated British Foods PLC