Primark's Second Half Might Be Sweeter Than You Think

(Bloomberg Gadfly) -- At first glance, when it comes to 2017, the first half may be as good as it gets for Associated British Foods Plc.

The conglomerate, which includes the Primark discount clothing retail chain as well as sugar and grocery businesses, said it expects to increase operating profit for the full year. However, nearly all of the pickup will be limited to the "excellent" first half. 

There are several factors behind this.

ABF was a winner from the sterling devaluation following the Brexit referendum. With some 60 percent of sales coming from outside the U.K., it will have an around 50 million pound ($62 million) benefit from translating overseas earnings into pounds in the first half. But the second half will compare with a period when sterling was already lower, so there won't be a repeat of that windfall.

And Primark's pain from the currency decline will hit more fully in the second half of the year, as hedges at more favorable exchange rates come to an end. The company has said that it won't lead the industry in raising prices, so it will have to take the adverse impact in its margin.

ABF shares have fallen 24 percent over the past year, amid concerns that even cheap chic Primark may not be immune from weaker consumer confidence in the wake of the Brexit vote, while higher sourcing costs are generally more troubling for retailers offering low prices. Today's 1.2 percent drop reinforces the gloom. 

But actually, there are several reasons why ABF's second half need not be all that downbeat.

First, as Gadfly has noted, the global slump in clothing that's been hurting retailers in Europe and the U.S. is also hitting suppliers. That means there is plenty of capacity at factories, and so some wiggle room in negotiations for retailers trying to offset the impact of sterling. If ABF can secure better deals, then the hit to Primark's margins might not be so severe.

Second, earnings from sugar may skyrocket this year as a global deficit continues. Shore Capital forecasts that sugar earnings before interest and tax will increase to 210 million pounds in the fiscal year ending in September, from 34 million pounds in the year earlier. Shore expects supply to remain tight, so the benefit to sugar should continue.

In the short term, the lift to ABF's cashflow from the recovery in sugar is well-timed as Primark continues to invest in its U.S. build-out. Its assault there has been steady rather than spectacular so far, though plans to extend its first U.S. store in Boston bode well. And with a raft of north American apparel retailers and department stores closing outlets, Primark will have plenty of attractively priced real estate to choose from as it expands. 

But on a longer-term horizon, as Primark's business becomes entrenched in the U.S., and perhaps as sugar's current sweet spot fades, separating the retail unit makes sense, as Gadfly has long argued.

Primark trades on 25 times Shore's forecast of its earnings to Sept. 2017, on a par with Zara parent Inditex SA. But Primark's growth potential, particularly in the U.S., means it should be trading at a premium to its Spanish fast fashion rival.

On the other hand, sugar trades on about 15 times Shore's forecast of 2017 earnings, at a discount to Suedzucker's 20 times.

So there's clearly value in a break up. But given the potential for 2017 to have a dual personality, and the current divergence in the fortunes of Primark and sugar, that scenario looks unlikely for now.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Andrea Felsted is a Bloomberg Gadfly columnist covering the consumer and retail industries. She previously worked at the Financial Times.

To contact the author of this story: Andrea Felsted in London at afelsted@bloomberg.net.

To contact the editor responsible for this story: Jennifer Ryan at jryan13@bloomberg.net.