Associated British Foods: Solid fundamentals and promising growth make it a top pick

Investment thesis

Associated British Foods (ABF.L)(OTCPK:ASBFY) is a diversified conglomerate comprising a wide range of food and ingredients businesses. The company operates in a number of sectors through its subsidiaries, including food, ingredients, agriculture, sugar and retail, with its well-known store, Primark. Its products are distributed globally to retail, wholesale and catering companies. With a market capitalization of £18.3 billion, Associated British Foods has a weighting of 0.39% in the FTSE 100 Index and ranks 46th in the market capitalization-weighted index.

In this article, I will analyze the potential investment opportunity the company presents and explain why I believe it deserves a buy recommendation.

Latest earnings

In April, the company’s adjusted operating profit showed a solid increase of 39%, driven by stabilizing market conditions and resolution of supply chain disruptions. Revenue The expansion was largely supported by a 6 per cent increase in sales at Primark, which can be attributed to both strategic new store openings and an effective pricing strategy. The division achieved a significant 45% increase in profit to a total of £508m, while its operating margin increased significantly from 8.3% to 11.3%..

Profit at the food unit rose by a third, helped by improved demand in the US and narrower losses at the Bakeries brand. The sugar division posted a 29% profit rise as production improved significantly despite some poor weather. However, revenue fell at the ingredients and agriculture units due to issues including stock withdrawals and lower demand for animal feed.

Future perspectives

The lack of an online delivery option for Primark’s retail business may have hurt sales during the pandemic, but avoiding a major move towards e-commerce seems to be paying off, with the company’s click-and-collect service now rolling out in stores after an encouraging trial, offering a strong future growth prospect.

Following an update in January that highlighted improved profitability and cash generation, the company now believes it is on track to deliver strong growth for the full year. The balance sheet looks promising looking ahead, reflecting the resilience it has shown to date. A key indicator of this strength is its financial leverage ratio, which has been reduced to 0.9 times (financial leverage has consistently been below 1.0). In addition, net cash before liabilities increased by 14% to £668 million. These positive financial indicators suggest a capital surplus that could be returned to shareholders in the form of special dividends or share buybacks.

At the end of 2023, the company announced a significant 45% increase in its interim dividend, signalling confidence in its growing earnings potential. The total dividend is 60.0p per share, up 37% from the total dividend of 43.7p per share in 2022. The chart below shows the dividend yield over the year, reflecting the company’s positive outlook and commitment to delivering greater value to its shareholders.

Macroeconomic environment

From a macro perspective, as interest rates start to fall and inflationary pressures recede further, I expect a more enthusiastic return to shopping as disposable income increases. The first cut is expected to come in August this year. Secondly, the rise in UK consumer confidence to a 34-month high, supported by growth in real wages, suggests people are more prepared to spend, which could lead to a stronger autumn/winter season for the company.

Shareholder returns

The company completed a share buyback programme worth £446m of its £500m, completing the remainder recently. With a strong outlook, a solid balance sheet and strong cash generation, the company has decided to continue to return additional capital to shareholders. Share buybacks can benefit investors by increasing earnings per share and potentially increasing the share price, as fewer shares in circulation can lead to a higher value per share. As such, the company continued its share buyback programme, buying back a further £500m during the year, with £225m of the buybacks having already been completed.

Brief Technical Summary

ABF has not fully embraced the uptrend yet, as evidenced by the stock’s year-to-date gain of just 5.59%. The stock’s Relative Strength Index (RSI) is sitting at 44.47, suggesting the potential for modest upside momentum, as it is above the 30 level, which indicates oversold conditions. However, it has not yet approached the 70 level, which typically indicates overbought conditions. At the time of writing, the stock is trading 8.11% and 1.13% above its 200-day MVA and 100-day MVA, respectively, but remains 2% below its 50-day MVA.

A beta of 1.04, which measures a stock’s volatility relative to the FTSE 100, indicates that the stock is slightly more volatile than the market, although the difference is minimal. Volatility, a statistical measure of how much a stock’s returns fluctuate around its average over a specified period, is calculated from the standard deviation of the daily logarithmic price changes.

Over the last 30 days, the stock’s price volatility, expressed as the annualized standard deviation of price changes over the period, was 17.3%, compared to the index’s standard value of 8.05%. However, compared to its peers, ABF’s volatility index is relatively lower.

Heart	30 day volatility
ASBFY	17.35%
GLB	46.08%
KYGA	55.62%

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Quotation

To value the company, I used the DCF model with the following assumptions:

– Equity risk premium: 4.57%

– Beta version: 1.04

– Risk-free rate (10-year government bond yield): 4.12%

– 5-year free cash flow growth rate: 2.33%

Based on these assumptions, the discount rate was calculated at 8.88%. While a growth rate of 2.33% may seem low, it reflects the average growth in free cash flow over the past five years. Given these assumptions, along with the current market price and shares outstanding, the current discount is 41%.

However, the DCF valuation model does not take into account the seasonality of the consumer staples sector or any future capital requirements. Therefore, it does not provide a complete picture of the company’s valuation. Furthermore, small changes in the growth rate significantly affect the discount percentage. For example, in the above model, if the growth rate is adjusted to 3.5%, the discount increases to 50%, while reducing it to a conservative level of 1.5% results in a discount of 36%. Therefore, I also examined and compared additional financial metrics.

The stock is trading at 16.33 times PE, below the median average of 21 and represents a 22% discount to the 5-year average of 23.29. Furthermore, the price-to-cash-flow ratio is a 42% discount to the 10-year average of 13.8. These discount values ​​are closely related to the discount derived from the DCF model.

Application

In summary, Associated British Foods presents a compelling investment opportunity, underpinned by a strong balance sheet, low leverage and increased net cash. The recent significant increase in the interim dividend and the continued share buyback programme reflect the board’s confidence in the company’s prospects and its commitment to returning value to shareholders.

From a valuation perspective, the stock is trading at a significant discount, both in terms of PE and P/F. While the DCF model highlights potential sensitivity to changes in growth rate assumptions, the current discount is closely tied to valuations derived from other financial metrics.

Combined with the positive macroeconomic outlook, expected interest rate cuts and growing consumer confidence, the company should be given a buy rating.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.