Associated British Foods has become a misnomer. Most of the company’s profits today are generated by its fast-fashion retailer Primark which has, as far as I am aware, very little to do with food.
A conglomerate, but not a dinosaur
This mismatch between core business and company name is due to the company’s structure, which is a throw-back to the days of the diversified conglomerate. If it wasn’t for Primark the company’s name would still be fitting as it has four other key business segments: Sugar, Agriculture, Grocery and Ingredients.
Unlike so many other conglomerates Associated British Foods appears to have mastered the art of multiple plate-spinning. It has done this, to keep the metaphor going, by having one plate spinner per plate and keeping the plates and their plate spinners a safe distance apart.
The result been steady growth for many years, but steady growth for the group has hidden widely differing fortunes for underlying businesses.
Agriculture, Groceries and Retail drive the company forward
The Sugar and Ingredients businesses have failed to grow their profits in the last decade while the Agriculture, Groceries and Retail segments (where Retail = Primark) have done exceedingly well. So well in fact that in 2015 they produced around 90% of the company’s total adjusted operating profit, rendering the Sugar and Ingredients businesses almost irrelevant from a valuation point of view.
Together the three successful businesses have growth their combined adjusted operating profits from £371 million in 2007 to £1,018 million today, which is an annualised rate of growth of 13%. This is impressive, but Primark has done even better. In 2007 Primark’s adjusted operating profits stood at £200 million; over the following 8 years those profits have tripled, growing at a compound rate of 16% to £673 million.
This positive track record has been built without a heavy dependence on borrowed money or acquired businesses. All told, this is exactly the sort of company I like to invest it, even if it is primarily a retailer rather than a food producer.
Success is baked into the share price pie
Primark is now likely to dominate the company’s future cash flows. That’s important because those future cash flows, discounted at an appropriate rate, represent the underlying or intrinsic value of the company and – as a value investor – I am only interested in buying companies where the market value is sufficiently far below the intrinsic value.
Associated British Food’s share price currently stands at 3,450p. At that price the dividend yield is a rather thin 1% compared to the 3.9% I can get from a FTSE 100 tracker (with the index at its current level of 6,350). The PE ratio of 32.0 is high, but more importantly so are the long-term valuation ratios.
The PE10 ratio (price to 10-year average earnings) is 46.2, compared to 13.6 for the FTSE 100. The PD10 ratio (price to 10-year average dividend) is 129.5 compared to 30.3 for the FTSE 100.
Both of those ratios are sky high for Associated British Foods; so high that they break two of my rules of thumb:
- Only invest in companies where the PE10 ratio is below 30
- Only invest in companies where the PD10 ratio is below 60
Investors are clearly optimistic for the future of Primark and are currently willing to pay top dollar to hitch a ride on the coattails of this successful business. But no business is worth an infinite price, and as Rolls-Royce shareholders are finding out, even “sure things” can falter badly.
My target share price is a long way below the current share price
For Associated British Food’s shares to be investable, i.e. to not break any of my rules of thumb, the share price would have to drop to 1,600p. That’s a decline of more than 50%. Impossible, you might say. Perhaps, but then again perhaps not, if the recent decline in Rolls-Royce’s share price is anything to go by (apologies for picking on Rolls-Royce, but it is an obvious current example).
A 50% decline might make Associated British Foods “investable”, but that’s not good enough by a long shot. At 1,600p the dividend yield would only be 2.1% which is still far below the market yield, and dividend growth would have to make up for that shortfall. If the dividend didn’t grow substantially faster than the market then the shares could be re-rated downwards, resulting in a significant capital loss.
Personally I would rather invest at a price that did not depend on a rosy future.
For me to seriously consider investing in this company the share price would need to drop all the way down to about 1,000p.
At that price the dividend yield would be 3.5% which is fairly close to the market’s yield, and merely half-decent growth rather than spectacular growth would be required from Primark for the investment to work out well.
Whether or not Associated British Foods’ share price will ever get near 1,000p again is another matter, but that is my target price until next year’s results.
There's Value says
Always assumed that Primark was the real driver behind abf, this confirms it. It’s such an expensive stock! Really, really not worth that valuation, despite great growth over the last 8 years.
It’s interesting that we don’t seem to go in for these big conglomerates anymore, unlike the Japanese markets which are full of them. I do find it interesting though, when companies/groups have wildly different businesses within them e.g. Stobart’s fuels division, although it’s more related to their main businesses compared to the abf setup.
John Kingham says
Personally I don’t like conglomerates as they’re harder to analyse, but other than that I see nothing wrong with them in theory; it’s just that in practice they seem to be hard to manage well.
There's Value says
Yes I guess conglomerates would involve a lot more work to distinguish profits, FCFs and so on between the various divisions, and then apply to the whole group. I wonder how this compares to something like JNJ which we mentioned recently, where there are only a few divisions and they’re closely-related to each other? I feel like that is a lot easier to manage.
Thanks for your thoughts and analysis, as always
John Kingham says
Actually that’s a really interesting point. Many of the large companies I invest in have diverse operations, although they’re not “conglomerates” in the traditional sense. But for example SSE or BP (which I hold) have widely differing parts of their businesses, it’s just that the differences aren’t so obvious or perhaps quite so extreme.
So I’m not sure conglomerates actually are harder to understand, but it feels like they are because the different internal business units are easier to see, and the figures for each part are more prominent.
There's Value says
Yes I understand what you mean – it’s like analysing separate companies, you feel like they should be separate, but they all belong together… if the divisions are closely related then it doesn’t seem unusual or difficult.
It’s perhaps a lot easier to look at a company which has a division that is more extreme in its figures and or operations, then you can kind of mentally separate it… plus it will probably get spun off/sold off or something anyway.
Good summary and one company I always look on in aghast at the valuation. You are spot on highlighting the risks here. Primark is a great business but it’s not difficult to see how it might lose it’s way or overextend, or the mood of the buyer in the street changes, or someone comes up with a better idea.
It also reminds me of the ridiculous over valuation of companies like Pearson, Aggreko, Weir, Drax, Centrica, Rolls Royce covered extensively here and companies like Serco and I expect Babcock will be next held up by aggressive accounting. BAE Systems also looks expensive with a 5 year declining revenue and profit regime. Vodafone looks off the scale, even despite the new found optimism from it’s slight return to one quarters lack of decline.
John Kingham says
Hi LR, thanks. Yes, I don’t see how Primark has any sort of moat, although it does have a head start.
As for the other overvalued companies, I guess I’ll have to disagree with you on some of them as I own them, but that’s interesting in itself as it highlights how reasonably sensible people (which I assume we both are!) can have widely differing opinions about company valuations. (I shall remain tight-lipped about which ones I own, although I’ve probably written about them on the blog at some point).
no worries, that’s what makes a market. I think we know where you are on RR and the pension issue. I was too early on RR, hence the term “difficult to time markets” — I suspect I’ll have a loong wait with it. I can’t imagine you still owning Serco, Aggreko or Weir (unless you bought the latter two of late) — the rest I’d be guessing.
Concerning the PD ratio, would you ever invest in a company that didn’t pay a dividend?
John Kingham says
Hi Andrew, not with my current approach no. I don’t think there’s anything wrong with investing in non-dividend payers, but they just don’t fit in with my valuation system.
Also, I just like dividend-paying companies. They have the sort of risk profile that I’m after, i.e. typically lower risk, more established companies. And eventually I want the option of living off dividends, so they’re necessary from that point of view as well.