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Morningstar | ABF Issues Pre-Close Update With Primark Growth Lower Than Expected; Thesis Intact

Associated British Foods has reported its pre-close period trading update for fiscal 2018. Although Primark's sales growth and sugar operating profit were both lower than expected, management reiterated full-year guidance on the back of higher margins achieved in retail. We maintain our no-moat rating and do not anticipate a material change to our fair value estimate of GBX 2,660, as lower like-for-like, or LFL, sales growth in Primark was counterbalanced by higher operating margins in the segment, driven by a weaker U.S. dollar exchange rate and better buying.

More specifically, in Primark, retail selling space increased by 0.9 million square feet, as expected, with 15 net new store openings. Management anticipates over 1 million square feet of additional selling space in the next fiscal year, including the first store in Slovenia, Primark's 12th country of operations. Although the company's plans for expanding Primark and intact and operating margins in the segment stand at a very healthy 11%, Primark's negative 2% LFL sales growth in 2018 implies an almost 5% LFL sales decline for continental Europe, in line with recent trends, highlighting no progress in the company's efforts to improve trends in this important market. In contrast, in the U.K., LFL growth for the full year is expected to be 1.5%, with the retailer continuing to gain significant share of the clothing market. In the U.S., Primark opened its ninth store in Brooklyn, continuing to reduce selling space per store and improving store profitability according to management.

In sugar, operating profit is expected to be significantly lower, mainly due to lower-than-expected EU sugar prices. Management anticipates continued weakness in EU sugar prices to weigh on profits in the next fiscal year, with Illovo maintaining its profitability (estimate around GBP 100 million).

In other segments, grocery, agricultural, and ingredients are expected to increase earnings and sales, in line with our estimates.

Moreover, on Primark's profitability, management guided for 11% operating margins in fiscal 2019, broadly flat on this year's estimate, with uncertainty regarding Brexit negotiations arising in the second half of the year, likely affecting sales on the back of a more volatile British pound.

Further, on AB Sugar, the company reiterated its proposal to shut down operations at the Vivergo bioethanol plant in Hull, which by our calculations is loss-making (close to GBP 50 million loss), as management does not anticipate improvement in the current market conditions.

We consider shares undervalued, trading roughly at a 15% discount to our fair value estimate at the time of writing. Our long-term thesis on ABF is intact, with Primark being the only pure brick-and-mortar clothing retailer that is still growing. In fact, Primark continues to dominate the U.K. clothing market and carefully expand in the U.S. and continental Europe. We think Primark's strong value proposition and growth potential will continue to drive strong sales growth numbers and best-in-class sales densities, which in turn enable the company to be the indisputable price leader in the market. In sugar, we think Illovo's (Africa sugar business) bedrock of profitability (around GBP 100 million) will continue to support the segment, while gradual adjustments to the new reality of lower EU sugar prices will benefit scaled producers with financial flexibility such as AB Sugar.

We maintain our stable moat trend rating for ABF, as we believe that the recent EU regime change in sugar production quotas will not affect the division’s competitive positioning relative to peers (both global and regional), while scale-based benefits from Primark’s growth will likely be balanced out by the need to invest any savings back into lower prices. In other divisions, we do not see any meaningful change in ABF's competitive standing.

The company will announce its full year results for the 52 weeks to Sept. 15, 2018, on Nov. 6.