2024-01-08 15:16:27 ET
Summary
- Associated British Foods plc stock outperformed the equity market by a very wide margin.
- The long-awaited expansion into the U.S. is progressing well, with plans to reach 60 stores by the end of 2026.
- Primark's margin is also returning to historic levels, leading to confidence in the future of the business.
- Lastly, the conservative capital allocation would continue to serve long-term shareholders well.
Over the past year or so, Associated British Foods plc ( ASBFF , ASBFY ) has turned into one of my best-performing high conviction ideas posted in my investment group.
Even though I first covered the stock back all the way back in 2018 , in November of 2022, and later on in 2023, I highlighted the huge opportunity to double down on this opportunity. Since then, ASBFY has returned an impressive 82%.
To an extent, these results were due to ASBFY's strong business performance over the past fiscal year, with total group revenue increasing 15% and adjusted earnings per share coming roughly 8% above prior year.
Of course, these results alone are hardly enough to justify a total return of more than 80%. What caused this sharp reversal of the stock price was the extremely negative view by the market that in my view was not justified.
I explained this in detail back in November of 2022, but to put it briefly, Associated British Foods was experiencing temporary headwinds that drove its return on equity to record low levels - see 2020 to 2022 periods on the graph below.
The market reacted very negatively to all that, and as we see from the graph above, the stock was priced as if the record low return on capital would persist indefinitely.
In my view, this was an unlikely scenario and I was looking forward to the recovery of the company's retail business - Primark. I described this process for my subscribers and took advantage of the situation myself by increasing my position within the company, just when the market was pricing-in an extremely unlikely scenario for the business.
As we see from the graph below, return on capital within Primark rebounded strongly in fiscal year 2022 while all other business divisions also held their ground extremely well in recent years.
With revenues of Primark also recovering, ASBFY's total return on equity also improved in FY 2023 which caused the market to reconsider the stock's extremely low valuation multiples.
As we saw on the graph above, at present, ASBFY trades more in-line with the company's current and historical return on equity which has largely diminished the short-term mispricing opportunity.
Although a repetition of 2023 is highly unlikely when it comes to shareholder returns, I still see Associated British Foods as a very attractive long-term investment and I would continue to hold the stock - both in my personal account and within my investment group's portfolio. In the following lines, I would explain why ASBFY is slowly turning into a growth stock and why the conservative capital allocation by the management is so important for its success.
Long-Awaited Primark Expansion
The overseas expansion of Primark has been a topic of conversation on Associated British Foods annual results for quite a while now. Investors have been relatively unimpressed by the gradual expansion across Europe and the seemingly lack of progress of the much-anticipated expansion across the United States.
To understand why this is, one should understand that ASBFY is managed with the long term in mind and its management is not rushing to achieve better than expected quarterly or half-year results. Instead, the focus is on the long-term sustainability of the business and more specifically its high return on capital.
That is why, Primark's expansion in the highly attractive U.S. market has been taking longer than what the market is used to in order to guarantee that the company has a functioning business model that is poised not only for topline growth but high return on capital as well.
After years of waiting, 2023 saw a meaningful progress and sales in the country increased 24% with 8 new stores opening during the period.
Even though 8 stores might not sound as much, we should keep in mind that as of the end of fiscal year 2023 Primark had a total number of 432 stores with 21 being in the United States.
During the annual results conference call, the management reiterated its ambitious target to growth this total number to 530 by the end of fiscal year 2026.
Well on track to grow to 530 stores by end of 2026 financial year
Source: Associated British Foods Investor Presentation
The reason why the market has been reacting so positively on these targets is the fact that the number of stores in the U.S. is expected to triple within this short time frame.
In the US, total net sales were 24% higher than last year driven by space expansion. We opened eight new stores in the period, largely in the Northeast, taking the estate to 21 stores trading from 0.9 million sq ft and are on track to meet our US store expansion target of around 60 stores by the end of 2026 .
Source: Associated British Foods FY 2023 Earnings Release (emphasis added).
Having said all that, it is not only the top line figure that investors care about. Margins are just as important and even though they declined on an adjusted basis during FY 2023, the year was marked by an unprecedented increase in freight costs and other input costs.
Thus, Primark's margins remain below the historical average, with the management expecting costs to normalize in the coming year.
With Primark margin now moving back to its historic levels, we view the future for this business with confidence.
Source: Associated British Foods FY 2023 Earnings Release.
Capital Allocation Masterclass
The other main factor behind Associated British Foods' success over the long-run is the company's conservative approach towards capital allocation. Usually, this is something that investors are rarely excited about as it does not involve aggressive expansion through high leverage or excessive dividend payments.
In terms of capital expenditures, Associated British Foods' management has been consistently reinvesting more back into the business than the annual depreciation and amortization expense. This, however, has changed during the pandemic when many growth projects were put on hold in order to preserve cash as Primark stores closed during the lockdowns.
Now that lockdowns are hopefully in the past, the company is returning into growth mode as far as capital expenditures are concerned.
By postponing growth projects during the pandemic, the management has built a significant cash pile of more than a billion British Pounds and also avoided having to take on significant amounts of debt. This now results in the company having negative net debt and the ability to expand its retail business at a more aggressive pace.
The management has also been taking advantage of the low share price in FY 2023, by authorizing £500m share buyback program and during the last conference call yet another one was announced.
Initial £500m buyback programme concluded end of October. Additional £500m buyback programme announced
Source: Associated British Foods FY 2023 Earnings Release (emphasis added).
Similarly to the capex cut 2020, ASBFY's management has taken a similar route when it comes to the dividend . The total amount of dividends paid in FY 2022 included a special dividend, which is why we see a decline in FY 2023 even though the below extract from the latest investor presentation shows a 37% year-on-year increase.
To put the above numbers into perspective, the company's operating profit and cash flow from operations stood at £1.4bn and £1.7bn respectively which not only provides significant safety, but also allows for consistent annual increases.
Conclusion
After an exceptionally strong year, Associated British Foods stock is unlikely to repeat the returns seen in 2023 into 2024. Nevertheless, the company remains as an attractive long-term opportunity, and I remain bullish. Expansion of Primark into the attractive U.S. market is going well, and the management remains committed to its conservative capital allocation.
For further details see:
Associated British Foods: When High Quality Businesses Deliver