Diversification Benefits Associated British Foods

by fool.co.uk - 28/06/2011

"A long term play on the global food and agricultural theme."

June has been a mixed month for the PR department at food-to-fashion conglomerate Associated British Foods (LSE: ABF). On the plus side, after three years and £0.5m of legal fees the company has forced an apology from the BBC over a Panorama programme that accused its fashion chain Primark of exploiting child labour in India.

In the words of the company secretary, the programme made it "the poster boy for child labour". Now the BBC Trust has determined that Panorama's footage was probably faked.

But in the same month the company's Twinings subsidiary was finally turned down for a controversial EU grant which would have seen it receive £10m to subsidise the transfer of tea processing from the UK to a new factory in Poland, with the loss of 400 British jobs. The unions and local politicians had been incensed at Twining's application for public funding to export jobs and reduce wages.
Margins

If these matters cause some queasiness amongst more ethical investors, the market is more concerned by the effect of rising commodity prices on ABF's margins.

Primark, in particular, has been squeezed between higher cotton and wool prices -- as well as higher wages in South East Asia -- and tighter consumer spending. Input costs have a disproportionately high impact at the budget end of the market, but the company has made a conscious decision to protect its reputation for value and so has not passed on increased costs.

In consequence, margins in the first half of the year were below last year and it is forecasting even lower margins in the second half. This may be making a virtue of necessity: if Primark lost its fashion-on-a-budget image it would lose a lot of customers. Nevertheless it supports its market position, and ABF/Primark has deeper pockets than many of its competitors, such as the latest high street chain to go into administration, Jane Norman.

The food sector has also suffered from rising raw material prices, but ABF's businesses cover a broad spectrum of the food value chain so it is less vulnerable to commodity prices than pure food manufacturers such as Premier Foods (LSE: PFD). It suffered from increased wheat prices, but benefitted from the rise in world sugar prices.

Sugar is one of ABF's main businesses, accounting for about a fifth of turnover. The largest segment, grocery, manufactures branded and own-label foodstuffs, and is directly comparable to Premier Foods. It generates over a third of turnover. The other businesses are agricultural feeds and food ingredients such as yeast, as well as Primark.
Nuggets

When I last wrote about ABF I identified three nuggets of value in its business:

* Primark,
* The global sugar processing business,
* The collection of consumer brands.

Whilst Primark is undergoing a temporary squeeze on margins, it remains a growth story with further stores opening in the UK, Spain, Portugal and Germany.

The sugar operations are geographically diversified with production spread across the UK, Spain, China and Southern Africa, so a poor UK harvest last year was more than compensated for by strong performance in Spain and China. And China is the big growth opportunity with potential for vast efficiency improvements in the fragmented agricultural sector serving the increasingly sweet tooth of a more affluent Chinese population.

Meanwhile the consumer brands -- which include Silver Spoon, Kingsmill, Patak's, Twinings, Ovaltine, Ryvita and Allinson -- have defensive qualities and, though intangible, count as valuable assets in my analysis.
Diversification

Arguably those three nuggets would have more value separately than combined, but there is no sign that the controlling Weston family, with 55% of the shares, has any plans for a break up. But at least shareholders are benefitting from the diversification in ABF's business, and the grocery segment is naturally negatively correlated with the agricultural and ingredients segments.

Since my article in November ABF's shares fell to a low of 940p before recovering to today's 1,085p, around November's price. The company is a play on the global food and agricultural theme, plus Primark's budget fashion format.

I'm happy to top up my shares when the price dips, with a view to a long term holding.

Tony has shares in ABF.

More Details: http://www.fool.co.uk/news/investing/company-comment/2011/06/28/diversification-benefits-associated-british-foods.aspx