Primark: The Crown Jewel Of Associated British Foods (OTCMKTS:ASBFY) (2024)

Source: liverpoolecho.co.uk

Overview

Primark is the retail division of Associated British Foods (OTCPK:ASBFY) which now makes nearly 50% of the company total sales and 63% of its operating profit.

Source: Author's calculations based on data from Associated British Foods annual and interim reports

Primark has also become the key growth driver for the company over the past decade with an average annual growth rate of 13.5%.

Source: Author's calculations based on data from Associated British Foods annual and interim reports

Amid the recent retail slowdown in the UK and Europe, Primark's top-line growth has also slowed down over the past year and a half. In response, the management's efforts have been focused on improving in-store experience and operating efficiencies as opposed to geographical expansion, with total store space expanding by 7% and 2% over the course of FY 2018 and first half of FY 2019, respectively.

Source: Associated British Foods investor presentations

The selling space is expected to increase by a total of 800,000 sq ft over the course of FY 2019.

Source: Associated British Foods H1 2019 investor presentation

The slowdown in space expansion seems to be only temporary as the company is re-evaluating its strategy in Germany, which was the worst performer over the past year. With an average store size of 62,000 sq ft, Germany has the largest stores from all Primark markets.

On a question, during the last conference call, the CEO indicated that their expectations are for store space expansion to be "safely north of 800,000 sq ft" over the next few years following FY 2019. The CEO has also indicated that expansion in the U.S. will happen slowly as they evaluate their strategy to successfully expand in the U.S.

Source: Author's calculations based on data from Associated British Foods investor presentations

The retailer that resists the e-commerce onslaught

What is quite unique about Primark is its business model built around high turnover and sales density. It also does not rely on any online sales, which sets it apart from most fashion retailers.

Most of the UK high street retailers have been struggling recently, with Debenhams (subscription required), John Lewis, GAP, and M&S all reporting on falling sales or store downsizing. Next, in spite of it growing its topline, it has relied mostly on its e-commerce division to offset falling in-store sales (subscription required).

A second group of fast retailers, such as TK Maxx, H&M, Zara, Boohoo, Asos, and Primark have defied retail exodus in the country.

Fast fashion retailers have become one of the most searched online retailers and captured higher market share over the past few years when compared to traditional clothing and department stores.

Source: pi-datametrics

Primark's strategy to not sell online and compete on price has been very successful so far.

Firstly, this business model is immune to the Amazon (AMZN) effect due to the extremely low prices. For example, it is not worth paying for delivery on a polo shirt for £3.5 ($4.4) or shorts costing £9.0 ($11.3).

"The cost to support home delivery can't be supported with our price points," John Bason, finance director of Primark parent company Associated British Foods, told The Wall Street Journal (subscription required).

Another reason why this model based on low prices and high volume is not suffering from the e-commerce wave is that a large number of clothes ordered online end up being returned.

According to Coresight Research:

Around 30-40% of clothing ordered online is returned, and these returns can be six times more expensive compared to in-store

By not selling online, Primark does not have to bear these costs, thus offering lower prices.

Primark main competitive advantage

Even though Primark has established itself as a price leader, competing on price is extremely difficult in the already very competitive fast fashion retail space.

To compensate for the lower gross margin, Primark has become one of the most efficient retailers when it comes to its fixed assets - store space.

Over the past 10 years, sales density has improved considerably, driving higher asset turnover.

Source: author's calculations based on data from annual and interim financial reports and investor presentations

Source: author's calculations based on data from annual and interim financial reports and investor presentations

Yet, due to the lower markup, Primark's asset turnover is still lower than that of TJX in spite of the much higher sales density. Primark's operating profitability, however, is much higher than that of its peers due to its efficient use of floor space.

Source: author's calculations based on data from annual and interim financial reports and investor presentations

Even other fast fashion retailers are finding it hard to replicate Primark's high sales density business model.

Source: expressandstar.com

For starters, as mentioned above, Primark relies only on its brick and mortar stores. By foregoing the e-commerce aspect, Primark could offer much lower prices as delivery and return costs of online-based sales would make that unprofitable.

The positioning of the Primark brand to offer more casual, sport, and basic clothes allows a more densely packed store layout, which, in combination with the low price level, allows customers to cover a larger range of needs with one store visit. This is in stark contrast with other retailers such as TK Maxx which offer big brands at a discount and can't achieve the same level of sales density due to the floor space needed to showcase these.

Primark's business model has proven very successful across Europe, and especially in the UK so far. One of the main questions, however, is whether that could be replicated in the US. For the time being, the management seems to be focused on expanding its presence across Europe, while evaluating its strategy for the U.S. market.

Primark Valuation

Primark's operating profitability has been relatively stable since 2007, staying between 10% and 12%.

However, the division's cash return on capital invested has increased dramatically over the period, highlighting the management's focus on high return on capital projects as opposed to the chasing sales growth at any price.

This is an example of the outstanding stewardship role Associated British Foods' management is taking.

Source: author's calculations based on data from annual and interim financial reports

Primark also has one of the highest Cash Returns on Capital Invested among its peer group.

Source: author's calculations based on data from annual and interim financial reports

In contrast with its peers, however, Primark also has a lot of room left for growth, with only a handful of stores across many large European markets and the US.

Source: Associated British Foods investor presentation

Calculating the value of the Primark business through a discounted cash flow model shows that even assuming a very conservative free cash flow growth in perpetuity (3%) results in business value of £11.2bn or £14.2 per common share of Associated British Foods.

Source: author's calculations based on data from Associated British Foods annual and interim financial reports, Yahoo Finance and Damodaran online

Using comparable brick and mortar fast fashion retailers, we can derive a relationship between their Cash Return on Capital and the EV/EBITDA multiple.

Source: author's calculations based on data from SEC 10k filings and Yahoo Finance

Using the equation above and Primark's CROCI of 33.1% results in implied EV/EBITDA multiple of x10.83.

Applying this multiple to Primark's current EBITDA, less tax expense, we arrive at a total business value of £10,371m, or based on the DCF above, an implied FCFF growth rate of between 2.0% and 3.0%, which is still very conservative.

This represents a significant increase since my last valuation back in December of £7.2bn, mainly due to market-wide repricing and the higher multiples for the retail peers since then.

Using the same number for the other divisions as in my article from December 2018, we could easily make a case for Associated British Foods being undervalued at these levels. Not to mention that its other businesses have improved since my last article, while the Sugar business has reached its bottom levels.

Source: author's calculations and data from Yahoo Finance

I will cover the rest of Associated British Foods businesses and especially the Grocery in one of my following articles.

Conclusion

Primark has become the largest division of Associated British Foods with significant competitive advantage and room for future growth.

The business model of Primark is unique and has been hard to replicate by other fast fashion retailers. On top of that, it is largely immune to the e-commerce onslaught in the retail sector.

Both conservative DCF valuation and one based on peer multiples show that either Primark is not fully valued within the Associated British Foods share price or other businesses trade below their fair value.

Finally, for a very long time, Associated British Foods management has been focused on creating high quality, sustainable businesses with significant competitive advantages as opposed to growing quickly. The company's negative net debt is just another sign of the rather more conservative stance of the management.

Investment strategy for those seeking steady and above-market returns