Higher VAT and costs will hurt profits

IN recessions past, hard-up consumers have had to make do and mend. This time, they’re buying cheap and chucking away. Yesterday’s pre-close update from AB Foods showed that Primark, a leading purveyor of so-called “disposable fashion”, is going from strength to strength. Full-year like-for-like sales at the budget retailer are forecast to be six per cent higher over the year, more modest than the eight per cent gain in the first half, but still impressive considering the tough comparatives (Primark grew like-for-like sales by nine per cent in the second half of 2009).
Operating margins are also expected to have improved, thanks to Primark’s famously low operational gearing.

Sadly, this is as good as it gets. In 2011, Primark will be hit by a triple whammy of higher cotton prices, VAT hikes in the UK and Spain and increased freight costs. No business model – not even one as good as Primark’s – will be able to withstand such headwinds.

Elsewhere the picture is mixed. The sugar division is expected to be substantially more profitable than it was in 2009, with improvements in China and the UK offsetting the effects of heavy rainfalls on the Spanish operations. The grocery division is growing at a much more modest rate than the rest of the business. Its bread brands, Allinson and Kingsmill, are struggling to compete in a cut-throat market. They are in a race to the bottom – in terms of price and marketing cost – with Hovis, owned by Premier Foods.

AB Foods has done well to prosper in these times, but it has also been rewarded, with a valuation that is 17.3 times earnings. That is a hefty premium to the rest of the sector, and in light of worsening conditions ahead, it is frankly undeserved.