Thursday, 30 March 2017

Associated British Foods (LON:ABF): Nice company, shame about the valuation

Associated British Foods is a diversified consumer conglomerate incorporating a large sugar business, grocery products, an ingredients business, agricultural interests and the retail operation which is Primark.

ABF is a really good business. This is a good quality, diversified company with some outstanding  interests most notably Primark which has been a huge success in the last 10 years. I tend to get a feeling before I even start really analysing a company as to whether I will find value - just looking at the basic metrics and considering its popularity and drivers. I wanted to look at the valuation of ABF as an example of a quality company currently trading at a valuation which generally implies suboptimal returns going forward.

Amiable Minotaur ABF Model: Good returns on capital

The long run CAPE for the FTSE 100 is 12-14x, the S&P 500 around 14-16x or the FTSE 250 around 20-24x. This equates to earnings yields of around 8%, 7% and 4.5% respectively. I would imagine the difference between say the FTSE100 and the FTSE250 is earnings growth expectations as some of the biggest FTSE 100 stocks are very mature businesses like BP, Shell, HSBC, Glaxo and Vodafone. 

Considering that the long run return used by most pension funds for equities is 6-7% we should expect P/E ratio average of 14-16x assuming earnings are relatively stable. Now you may pay less than 14x for a lower growth company where most of the return is from the dividend e.g Shell or you may pay more than 16x for a growing company with usually a lower yield but better internal returns whose earnings may grow more quickly giving capital gains and converging in the medium term toward your 14-16x price to earnings. This is all theoretical and a bit simplistic but if gives you a guideline target value for most stocks that grow by between say 3% and 15% at ~15x P/E. You might pay 10x for a stock growing 3% or 20x for one growing 15% it all varies a bit and depends on the cycle. (Note: Stocks with extraordinary growth rates north of 15% require a different metric - but we are focusing on value.)

Obviously some of the P/E expansion in the market since 2008 is due to lower interest rates driving down required returns and therefore driving up P/E ratios. However at present this relationship looks overextended.

So back to ABF. ABF traded around 15x trailing earnings between 2007 and 2012 by my estimates. Then between 2013 into 2015 the multiple went up. A lot. before dropping down toward 25x where it sits today in 2016. This is explained in part by Sugar prices and in part by Primark I believe. Sugar prices boomed during the period 2009-2012 significantly raising the profitability of that division. This coincided with excellent growth in the period 2008-2015 for Primark. Essentially the market got way ahead of itself bidding up ABF on the basis of that period of rapid growth. 

If you had held the company back in 2010 when the multiple was about 15x you would have seen a 200%+ rise in the value of your shares to 2014. Yet earnings in the period 2010 to 2014 rose just 45%. Therefore the PE multiple expanded from a sensible 15x in 2010 to a lofty ~30x in 2014. This would appear to be a classic example of over exuberance as investors bid up the shares assuming this excellent growth would accelerate in future rather than decelerate. 

Google Finance: ABF vs FTSE 100 vs NXT

Typically, it decelerated. Earnings slumped 29% in 2015.

Sugar prices dropped. Substantially. Operating margins in sugar collapsed from 15% to 2% in 2015: 

Amiable Minotaur Model: Operating Profit Breakdown

Primark margins remained strong but the growth rate started to slow. This should be expected because as a company like Primark grows bigger it inherently should grow more slowly:

Amiable Minotaur Model: Revenue Breakdown

The point of this hindsight analysis is that even today ABF trades on 25x trailing P/E. The 10 year Earnings growth CAGR is 8.4%. This means ABF will trade at ~15x P/E multiple around 2022 if it sustains that growth rate (which is hard to do). As I stated before Next Plc with a 7.2% earnings growth 10yr CAGR will be - by my model - (includes decelerating earnings growth) - trading at 8x P/E in 2022. It already trades at 9.5x today! Therefore what I think this demonstrates is that either ABF will grow earnings substantially faster than Next into 2022 or Next will struggle to grow earnings at all but will shrink into 2022 to converge on our theoretical 15x multiple. Or the alterative hypotheses; Investors are overestimating the future growth rate of ABF and underestimating that of Next (essentially that Next EPS will be > 30% lower in 2022).

Now qualitative considerations need to be taken into account. ABF has a more diversified and less cyclical business (Grocery, Ingredients) so may command a higher multiple on average. ABF also would benefit from earnings growth if sugar prices normalise a bit and margins rise. 

However these companies are more similar than you think - or at least the bits investors want. I think ABF trades at such a high multiple due to Primark. Now if Next are guiding down retail sales as are M&S and Debenhams are in trouble I struggle to see how Primark, a high street retailer, cannot also be effected. Even if Primark is super low cost a general trend away from clothes purchases must hurt the business. The 10 year operating profit growth CAGR of Primark is 13.2% but due to a dip in 2015 and 2016 the 3 year CAGR is only 10.3%. Still healthy and a moderation in the growth rate is expected as the business matures.

Primark has more retail outside the UK (~50% space and stores are UK based) so is less effected by Brexit concerns. But Primark is not online like Next, it is solely high street retail. It seems surprising how much value investors place on Primark when it doesn't have an internet business- look at the crazy valuation of ASOS by comparison. Still Primark does have the advantage of being a real cash business. A lot of the excess margin of Next comes from their finance offering which is declining a bit.

ABF has low debt with ~£900m in debt (just to improve capital efficiency I presume) and plenty of cash on hand. The debt is only 1x profit and this is a low risk to equity holders. 

The pension scheme is more of a problem. The scheme has a gross liability of £4.3bn which is ~5x the 2016 annual profit. There is currently a £303m deficit on the scheme so this does present a bit of concern that additional cash contributions could be required. The liability is due for triennial valuation in April 2017 which could see it increase due to lower long term discount rates as rates have fallen further since 2014 (10yr GILT down from around 2.5% to less than 1.5% today.) I expect additional cash contributions being made over the next three years to the scheme but these should be manageable for ABF given the strong cash flow position of the group and low debt. This could however reduce medium term earnings and free cash flow.

I really struggle to square the circle on valuation for ABF. For instance they have a low dividend yield of 1.3% due to their strong internally generated returns. But it grows well and the payout could be increased in future as the business matures (albeit the growth rate would likely fall). Now given the 10 year CAGR of the dividend has been a healthy 6.4% this results in a DDM valuation of £22 at a Ke of 8.1% (Rf 1.5%, MRP 6%, Beta 1.1) with that 6.4% growth rate. At that price of £22 the trailing P/E of ABF would be 21x. 

I get a similar price of £21.70 a share on my DCF with the growth rate dropping from 6% in 2023 to 3% by 2043 and 3% for my Terminal value (WACC 7.65% due to low debt.)

Maybe the company trades at a premium following the Unilever bid (which has a similar grocery business.) But I struggle to see any impact on the shares around the Unilever bid newsflow. Besides the ownership structure of ABF does not lend itself to takeovers given it is controlled by a private family company.

I estimate the fair value of ABF to be around the £20 per share mark. Slightly less than my DCF/DDM because I think growth will struggle to be that strong, and I want some upside to fair value as a margin of safety. That is the price that if I were Warren Buffet I might consider buying ABF being a 'fair price for a wonderful business.' 

At £26 I think the stock is 30% overvalued as investors are overestimating the future growth rate of ABF. This is the sort of company that one wants to buy during a generalised market selloff/panic and  not at the end of a protracted bull market like the one we seem to be in.

Disclaimer: I have no interest in ABF shares at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

No comments:

Post a Comment