EUR 850.00 For Business Accounts Only

Morningstar | Strong Execution and a Niche Business Model Drive ABF’s Prospects; Shares Fairly Valued. See Updated Analyst Note from 20 Jul 2018

After reassessing our assumptions for Associated British Foods, we are lifting our fair value estimate to GBX 2,660 from GBX 2,600. Our estimate implies fiscal 2018 adjusted P/E of 20 times and enterprise value/adjusted EBITDA of 10 times. We reaffirm our no-moat rating, as we believe that opportunities to support sustainable competitive differentiation in the company's fast-fashion and grocery units are limited. We see the shares as fairly valued, properly accounting for Primark’s strong value-accretive growth prospects, its competitively positioned sugar assets, and its stable but growing grocery, ingredient and agriculture businesses.

Reduced performance forecasts offset the benefit of U.S. tax reform to our valuation. We are trimming our top-line five-year CAGR and average operating margin expectations to 5.6% and 9% from 6.5% and 9.5%, respectively, owing to higher competitive pressures for Primark and lower sugar prices after a recent EU production quota change. This countervails our reduced effective tax rate assumption (21% versus our earlier 31%), reflecting U.S. corporate tax reform.

ABF’s main growth engine is Primark, its deep-discount fast-fashion retailer (46% of fiscal 2017 sales). Primark's differentiated business model calls for low prices and high volume, focus on a narrow range of collections and sizes, negligible advertising expenses, an upscale store experience, and virtually no online offering apart from a strong social media presence. Its manufacturing, supply-chain, and operating efficiencies, as well as its best-in-class sales densities, drive a lean cost structure, enabling it to offer the lowest prices in the market.

In other segments, grocery and sugar (22% and 14% of fiscal 2017 sales, respectively) are particularly noteworthy, with the former exhibiting profitable sales growth aided by the Twinings tea and Ovaltine beverage brands, with the latter being the most cyclical part of the conglomerate, owing to volatile sugar prices.

Our fair value estimate implies a P/E ratio of 21 and enterprise value/EBITDA of 12 for Primark, with the unit accounting for 61% of our overall valuation (and 46% of fiscal 2017 sales). This places it roughly in the middle of the valuation range relative to larger and more mature peers Inditex and H&M (P/E of 27 and enterprise value/EBITDA of 16 for Inditex, and P/E of 18 and EV/EBITDA of 9 for H&M). We expect like-for-like sales, average store size, sales densities, and store count to grow, contributing to a 9% top-line CAGR for Primark over the next five years. Growth should be supported by a moderate pace of store openings (one fourth that of H&M in corresponding countries), mid-single-digit cannibalisation rates in continental Europe and the U.S., and low-single-digit like-for-like sales expansion in the U.K. We anticipate that cost leverage and competitive pressures should largely offset each other, leaving segment operating margins near their 11% two-year average.

Further, our valuation implies enterprise value/EBITDA of 7.7 times for ABF's sugar division (8% of our valuation) and 10 times for grocery, ingredients, and agriculture (32% of our valuation).

We are revising our moat trend rating for ABF to stable from negative. We now contend 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.