EQUITY RESEARCH 27th September 2018 Associated British Foods plc Stock Rating BUY We started coverage of Associated British Foods (ABF) with a Buy recommendation and a price target of 2470p. Country United Kingdom Industry Consumer Defensive Ticker ABF About ABF ISIN GB0006731235 ABF is a diversified Food and Retail business with market-leading positions in the Price 2,282p Price Target 2470p businesses/countries in which it operates. The Group is a diversified international food, ingredients, and retail group, with sales of £15.4 billion and operations in 50 Market Cap £17.98b countries across Europe, southern Africa, the Americas, Asia, and Australia. Shares in issue 791.70m Dividend Yield 1.82% P/E 17.22x Business is split into five segments: Grocery: manufacturing and selling of grocery products; Twinings and 52-week 2,186p - 3,387.p Ovaltine being the global hot beverage brands. Range Sugar: growing, processing, and selling sugar beet and cane to industrial users. Agriculture: manufacturing and selling of animal feeds, among other products. Ingredients: manufacturing of yeast and other bakery ingredients. Retail: buying and merchandising clothing and accessories through the Primark and Penneys retail chains. Investment Rationale ABF shares have fallen roughly 18 per cent this year, compared with a 2 per cent decline in the FTSE 100 index. We see the weakness in the share price as a buying opportunity. The weakness was brought mainly by its; Weakness in Primark sales due to a long hot summer (which is a one off) as well as; Weakness at its sugar business, which is suffering from lower prices brought on by global oversupply and the end of EU production and export restrictions for European producers. Though the sugar business only accounts from 14% of revenues. Never-the-less Management confirmed that profits from Primark and ABF’s grocery, agriculture and ingredients businesses are expected to “more than offset” falling EU sugar prices. This allowed it to confirm its annual guidance for improved operating profit and earnings per share. Margins at Primark also recovered after shrinking in the first half of the year. Operating margins for the full year would be approximately 11 per cent compared to 10.4 per cent last year. We like ABF particularly because of its value retail business, Primark (c60% of group operating profits). Primark offers a unique combination of lowest pricing in the Calamatta Cuschieri Research | Associated British Foods plc. EQUITY RESEARCH 27th September 2018 market and keeps up with fashion trends. We believe the chain has further room to grow in both the markets it operates in as well as new markets, continuing to contribute positively towards the group. ABF’s year end is September and will reported results for the full year on 6th November 2018. Risks Predicting what will happen to Primark’s margins in 2019 is complicated by uncertainty about Brexit and its effect on currency values. Operating margins at Primark next year will be stable at 11 per cent, if the group can secure its spring/summer merchandise at current exchange rates. Whether it can do so will depend largely on Brexit negotiations and their impact on sterling. Valuation Our 12-month price target of 2470p factors in a discount rate of 10% and a forward Price-to-earnings ratio of 20x. We like ABF particularly because of its value retail business, Primark (c50% of group profits). Primark offers a unique combination of lowest pricing in the market and keeps up with fashion trends. We believe the chain has further room to grow in both the markets it operates in as well as new markets. Financials Sales – We are forecasting growth in sales of 2% over the next 3 years. This is in line with market expectation. Although we believe the company has the potential to grow its top line at a faster pace, an strength in the Sterling (from a potential Brexit deal) would result in a hit in foreign sales once converted to GBP. For this reason we prefer to keep our forecasts in line with market expectation and revise them accordingly. EBIT – We are forecasting an improvement in EBIT margins going forward (a continuation from historical trends) of 8.67%, 8.82% and 9.08% in 2018, 2019 and 2020 respectively. This is mainly coming from a reduction in operating expenses as a percentage of sales. Given that around two thirds of the company’s operating profit is generated outside the UK, the weakness of the sterling had a very favourable effect on the translation of overseas results last year. Earnings per Share – we are forecasting EPS of £1.31, £1.35 and £1.42 in 2018, 2019 and 2020 respectively. Calamatta Cuschieri Research | Associated British Foods plc. EQUITY RESEARCH 27th September 2018 H1 2018 Performance At constant currency, group revenue of £7.4 billion was 3% ahead, and adjusted operating profit of £648 million was 1% ahead of last year. Good sales and profit growth were achieved by all segments at constant currency, except for Sugar, where the reduction was expected. Particular margin improvements in Grocery and Ingredients. Development of new products and expansion into new markets highlight this result, and should lead to continued progress throughout the second half. Revenue from Operating Segments Grocery Sugar Agriculture Ingredients Retail 3,477 3,222 720 730 615 552 938 1,081 1,672 1,658 First Half 2018 First Half 2017 First-Half Results Revenue Profit Margin 2018 2017 2018 2017 2018 2017 Grocery 1,672 1,658 159 151 9.5 9.1 Sugar 938 1,081 90 123 9.6 11.4 Agriculture 615 552 24 23 3.9 4.2 Ingredients 720 730 63 61 8.8 8.4 Retail 3,477 3,222 341 323 9.8 10.0 Grocery First-half revenue and operating profit well ahead of last year, driven by growth in Twining Ovaltine, led by its major markets Thailand and Switzerland, through product launches and marketing investments. Jordans achieved good overseas growth and AB World Foods reported further share growth following the launch of paste posts with the endorsement of Jamie Oliver. The acquisition of Acetum contributed also to the positive results, with its integration showing good progress. Calamatta Cuschieri Research | Associated British Foods plc. EQUITY RESEARCH 27th September 2018 Margins increased at George Weston Foods in Australisa and New Zealand, due to better trading and a reduction in overhead and operating costs. As a result, the Grocery margin increased to 9.5%. Sugar The reported reduction in profit reported resulted from lower EU prices, which affected its UK and Spanish businesses. These lower prices were part of the EU’s plan to end the sugar regime, the removal of domestic sales quotas, and an increase in sugar supply. AB Sugar continues its progress towards cost reduction and increased sugar production. British Sugar, at current exchange rates, is believed to be the lowest cost producer of sugar in the EU. The business has been focused on delivering a satisfactory shareholder return over the medium term. Agriculture Revenue growth driven by high feed volumes, while high raw material costs in the UK impacted feed prices and sales growth in new business ventures. Sales increased by 13% and adjusted operating profit by 9%. Volumes at AB Vista driven by higher sales in Europe and North America. Profitability in China’s feed business was much-improved. Ingredients First-half revenue was 5%ahead of last year; operating profit growth strong at 11%, with a further improvement in margin. Progress was recorded in both AB Mauri and ABF Ingredients. Trading performance in Europe was ahead of last year; and the UK Technical Centre delivered a number of differentiated products to customers. A new research & development milestone was reached through the opening of the Global Bakery Centre in the Netherlands. Retail At constant currency, Primark sales were ahead 7% of last year. Like-for-like sales for the group declined 1.5% during the first half. Sales held back by unseasonably warm weather. Primark performed well in the UK; and the Retail business in the US made progress in the same period. Calamatta Cuschieri Research | Associated British Foods plc. EQUITY RESEARCH 27th September 2018 Primark Selling Space No. of Stores 184 176 44 42 37 37 44 36 25 22 18 16 UK Spain Germany Republic of Netherlands Other Ireland H1 2018 H1 2017 Geographical Information Revenue for First-Half 2018 Asia Pasific, 14.3% United Kingdom, The Americas, 37.1% 10.1% Europe & Africa, 38.5% Expectations for 2018: Further acceleration of profit growth at Primark. Continued growth within the Grocery, Ingredients, and Agriculture businesses. Offsetting and regaining on the decline of AB Sugar’s profit. For the full year, the company expected progress in both the adjusted operating profit and the adjusted earnings per share. Market Share Associated British Foods plc operates in a wide and diversified market, and has established its presence as a competitor. It shows good potential for growth. Calamatta Cuschieri Research | Associated British Foods plc. EQUITY RESEARCH 27th September 2018 Peer Analysis £ billions 73.47 51.92 22.94 18.08 18.58 15.48 17.21 10.87 7.71 7.78 4.13 4.41 NEXT plc Zalando Associated H&M Kering Inditex SA British Hennes & Foods plc Mauritz AB Revenue Market Cap The company’s P/E ratio is lower than its industry peers. Top Holders Howard Wittington Capital BlackRock Investments Investments Group Cos Inc. Inc. Ltd 50.95% 2.52% 7.94% 3.56% Associated British Foods Plc About the Company Associated British Foods plc operates as a diversified food, ingredients, and retail company worldwide, through five segments: Grocery, Sugar, Agriculture, Ingredients, and Retail.