UK bread a challenge for Kingsmill owner ABF

UK bread a challenge for Kingsmill owner ABF

The headlines on the mainstream business pages may have talked about a "sales surge" at Primark and sugar profits may be especially sweet but Associated British Foods' grocery operations have proven a mixed bag in the last 12 months.

ABF, which owns food brands including Jordans cereal in the UK, Mazola cooking oil in the US and Tip Top bread in Australia, yesterday (11 September) reported annual underlying profits would be "substantially ahead" of last year.

However, when the results are announced in November, it will be Primark and a bumper year for sugar that have boosted ABF's profits, not its grocery arm.

Sales will be up, thanks to growth from hot beverage business Twinings Ovaltine and a "strong" performance from UK brands like Jordans and Ryvita crispbread. However, ABF said adjusted operating profit from its grocery business will be lower year-on-year after the fiercely competitive bread sector in the UK and "difficult" trading conditions in Australia hit the business.

In truth, City analysts had expected 2011/2012 to prove a tough year for ABF's grocery arm. The trading challenges in the UK and Australia were compounded by restructuring charges in both markets; yesterday, ABF reported a A$150m (US$156.8m) impairment charge on its meat business in Australia. The news prompted some further downward revisions of analyst forecasts of profits from ABF's grocery business for the year to 15 September.

There was not a huge amount of reflection on ABF's grocery arm in the analyst notes issued yesterday on the company's trading updates. In some ways, that is to be expected. Grocery accounts for a small portion of ABF's profits. Around 75% of earnings now come from Primark and sugar, although the bumper year for the commodity may have inflated that proportion a tad.

According to Martin Deboo, an analyst at Investec, investors do not place a huge amount of importance on ABF's grocery business. "You have an absolute retail jewel in Primark that people want to own and will live with a bit of distraction from elsewhere to have the opportunity to own that. Sugars is ill-understood but is delivering the numbers at the moment. Then comes grocery and the rest," Deboo says.

However, some in the City argue ABF investors are frustrated and disappointed by the performance of its grocery business.

There are mitigating factors. The bread market in the UK is very competitive, dogged by promotions and has excess capacity. ABF and its two main competitors Premier Foods plc and Warburtons find it tough to grow profits. Australia is renowned as one of the most challenging developed grocery markets and a number of multinational food manufacturers have recently complained about the tough trading conditions in the market.

However, ABF's involvement in meat processing has perplexed parts of the investment community. "Everyone is scratching their hands in wonder at why ABF got involved in the first place. Why would you enter the meat processing industry in Australia?" Deboo says.

At Shore Capital, Darren Shirley argues ABF is seeing "early signs of winning volumes" in the meat category after the investment the company has made but others are not sure about the company's prospects.

"The inefficiencies of running the plant, they can get to grips with that but they can't do anything about the market structure. The rate of decline in Australian meat is slowing but it's not obvious they've reached the bottom there quite yet," Julian Lakin at Mirabaud Securities says.

Shore Capital's Shirley acknowledges "a lot of investors share analysts' frustration" with ABF's grocery operations, which he describes as "two distinct businesses". There are, he says, "good brands" like Jordans, Ryvita and Twinings and a business "masked by continuing under-achievement in Australia".

However, he argues "it's not all doom and gloom" for ABF in grocery. Shirley says CFO John Bason was "as positive on the prospects for Allied Bakeries as he has been for a number of years". As well as improvement in Australia, Shirley also points to the absence of GBP50m of restructuring costs in ABF's new financial year.

Nevertheless, Lakin argues of a "strange imbalance" at ABF's grocery arm and he is on the money. "It's not a terribly bad business," he says. "But you can't see bread making them a lot of money. Australia as a region has been disappointing for as long as I can remember. They are good at hot beverages, not bad at ethnic foods, but they are pretty average at edible oils. I've always felt that was a disappointing experience. Jordans has done quite well, that was quite a decent acqusition for them and the general retail sugar business hasn't done too bad either. However, it's not inherently a growth platform."

Investors also need to remember that the last 12 months have been a bumper year for ABF sugar and the upcoming year is unlikely to see the same level of profits, meaning other divisions, like grocery, will need to show some improvement.

Sure, the company will benefit from restructuring costs not being as high but there could be fresh charges. Lakin argues the "normal run-rate" of restructuring costs is around GBP25m.

And the relenteless challenge of operating in UK bread, uncertainty over whether ABF can get real improvement in Australia and patchy performances elsewhere could mean the prospects for grocery are unclear as we head into the company's new financial year next week.