Primark now dominates Associated British Foods and its share price

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 3,650). 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.