Looking For Quality In Europe - Three Businesses To Consider

Summary

• Three family-owned businesses with long history and leading position in their respective fields.
• Each of the three having unique competitive advantages driving above peer average return on capital.
• Stable and high quality earnings with significant exposure to the FMCG sector.

Source: inc.com

What's do these three businesses have in common

The three businesses analysed here are of the highest quality within their respective industries. Each one of them have unique and sustainable competitive advantages that allows for above industry average return on capital. Thus as long as valuations are not prohibitively high each one of them makes for a compelling long-term investment opportunity.

All three are also mainly focused on Europe and although they can be described as global companies their main geographical exposure remains in Continental Europe and the United Kingdom.

This makes them good fit for investors seeking high quality companies outside of the U.S., which is now one of the highest valued equity markets.

Source: starcapital.de

The three companies are also family-owned and with a very long history within their respective fields. As such they are more likely to benefit long-term oriented shareholders, as family controlled businesses are often run with next generations in mind which often leads to long-term value creating decisions being favoured over short-term ones.

The most international beer brand

Source: theheinekencompany.com

Heineken is arguably the most international beer brand with more than 150 years of history.

The story of Heineken really began on February 15, 1864, when Gerard Adriaan Heineken took over the Haystack brewery in Amsterdam. Just 22 years old, Gerard had little brewing experience, but he had plenty of courage, self-confidence and entrepreneurial spirit.

Source: theheinekencompany.com

The company also owns a portfolio of strong regional and global brands, such as Amstel, Sol, Tiger, Dos Equis, Birra Moretti and Red Stripe.

As beer consumption suffered during the pandemic lockdowns, Heineken (OTCQX:HEINY) share price fell more than 30% from its February highs. As I wrote back in April, this drop represented a good opportunity for long-term investors to jump in or increase positions.

Source: ycharts.com

Heineken has one of the highest returns on capital within its peer group of global breweries. Although Carlsberg (OTCPK:CABGY) has recently improved its ROIC and surpassed Heineken, the company still remains heavily exposed to Europe with 72% of its revenue generated there, compared to around 50% for Heineken.

Another important implication is that inventory and fixed asset turnover falls with larger size, but big global breweries gain other very important competitive advantages that I described in detail in my last analysis on Heineken.

Source: author's calculations based on data from morningstar.com

Return on capital has also been one of the major factors impacting stock price performance since the market decline begun in end of February.

Source: author's calculations based on data from morningstar.com and Yahoo!Finance

Investors seem to be pivoting towards higher quality companies with solid balance sheets which is why companies with the lowest ROIC were the hit hardest, while small local breweries with high ROCI were among the best performers.

Why brands are so important

One of the most important trends in beer brewing industry has been the shift towards premium. Thus brands have become even more important in the industry as they drive distinctiveness and the customer experience of the premium lagers.

Heineken is likely to be the best positioned to take advantage of this trend with its most international premium brand aided by a portfolio of strong local brands - Amstel, Desperados, Sol, Tiger and Birra Moretti.

Source: Heineken Investor presentation

In addition, many large developing markets are still lagging behind the more developed ones in terms of premium beer consumption. Overall beer volumes in these Emerging markers are also expected to witness a much higher growth in the future.

Source: Heineken Investor presentation

Source: AB InBev Investor presentation

Heineken is set to outperform in that regard through its well-established operations in each of the large emerging markets - China, Brazil, Mexico, India and Vietnam. For example, China is where Heineken has the best potential to capture the vast premium market through its recent partnership with China Resources. In Brazil, the company has been narrowing the gap with the leader AB InBev by acquiring Brasil Kirin Holding from Asahi in 2017 and significantly expanding production. In Mexico, Heineken also relies on its strong local brands - Desperados, Sol and Dos Equis.

What also makes the Heineken unique is that in each of its markets the company relies heavily on its master brand - from Asia, Europe to the U.S. and Brazil. Thus the dominance of Heineken as the most global brand is indisputable.

It's important to recognize that the premiumization and increasing beer consumption in Emerging Markets are not occurring over a couple of quarters, but are rather multi-year and if not decade long trends. This makes long-term oriented decisions crucial rather than short-term cost cutting efforts in order to meet or beat quarterly expectations.

Strong grocery and sugar businesses hiding in plain sight

Associated British Foods (OTCPK:ASBFY) is another family controlled company and is based in the UK. It is most widely known as the holding company of the fast fashion retailer Primark, but it also owns a very high quality and growing grocery business and sizeable sugar, agriculture and ingredients units.

From its inception in November 1935 as Food Investments Limited and its rapid change to Allied Bakeries Limited five weeks later, the business grew dramatically as a broad-based food manufacturing organisation, becoming Associated British Foods Limited in February 1960.

Source: abf.co.uk

Source: author's calculations based on data from ABF Annual Report

I first covered the ASBFY two years ago where I provided a good overview of the business, while in my latest analysis I showed why the share price of £17.8 back in April was valuing the company on a way too conservative basis.

Source: abf.co.uk

The stock has been on a 5-year downtrend due to a number of external factors that have little to do with the overall quality of the business.

Source: ycharts.com

• At first the stock price was hit due to the slowing growth of Primark, as the management has taken a more long-term and conservative view on its expansion in the US. Although this resulted in a multiple compression, it illustrates how family run businesses tend to favour long-term value creation at the expense of near term high growth.

Source: author's calculations based on data from ABF Annual Reports

• After that came increased uncertainty around Brexit with a plethora of potential future complications for the business' operations in Continental Europe. The risk for Primark has increased with nearly half of its stores being outside of the UK, while concerns about supply chains of Associated British Foods' other businesses have also increased.

Finance director John Bason said the uncertainty was impacting the group’s current operations, noting it had packaged grocery products exports in transit on the sea.

Source: reuters.com

• Over the last couple of years, sugar prices also fell to rock bottom, dragging down the sugar business profitability and requiring some important restructuring efforts which made ASBFY one of the lowest cost sugar producers in Europe.

Sugar Prices

Source: macrotrends.net

• Finally, the coronavirus pandemic and lockdowns in Europe were the last headwind that resulted in closure of all Primark and will probably weigh on the business profitability for the rest of the year.

Source: bbc.com

All these developments have resulted in a multiyear stock price decline, while the overall business quality and its competitive advantages have not worsened. That is why I believe that current price levels present and excellent opportunity for long-term oriented investors to take stake in the business.

Why strong balance sheets are important

To weather the storm of the recent pandemic the company has been focused on minimizing cash outflow from Primark while maximizing the inflow from its food business.

Although the management expects to reopen all of its Primark stores in England early next week, the impact on the retail business will be significant even after the full reopening as asset turnover would only slowly return back to normal level.

The strong balance sheet and ample amount of liquidity with £801m cash at hand as of end of half quarter of FY 2020, has played a crucial role during the pandemic and allowed the company to avoid borrowing more debt.

Source: Associated British Foods H1 2020 Presentation

As most of Primark’s stores remain closed, and the discount fashion chain doesn’t sell online, it has gone from making £650 million ($805 million) a month in sales to zero. Even with efforts to cut costs, and a tax break, the retailer’s cash outflow is around 100 million pounds a month which although a large number is well within the boundaries of the company's available liquidity.

As a result of Primark stores closure during the pandemic, ASBFY's FY 2020 Free Cash Flow would come much lower (and perhaps negative) than that in 2019. However, the company's ability to generate FCF over the long-term remains intact, which is why the current FCF yield of around 6% represents an attractive entry point.

Source: author's calculations based on data from ABF Annual Reports

Innovation and customer relationships as a competitive advantage

The third business is a leader in an industry that is perhaps the least exciting - paper packaging. As I analyzed in detail back in April, Smurfit Kappa (OTCPK:SMFTF) has managed to build unique competitive advantages on the back of its culture of innovation and relationships with many of the world's largest FMCG brands.

Smurfit Kappa was founded in 1934, making cardboard boxes and packaging boxes for the Irish market. Acquired by Jefferson Smurfit in 1938 it quickly grew into a dynamic and forward-looking business, becoming one of Ireland’s leading manufacturers and listed on the Irish Stock Exchange in 1964.

Source: smurfitkappa.com

The company is also one of the most environmentally friendly packaging companies, focusing exclusively on paper packaging with a significant exposure to recycled paper.

Source: Smurfit Kappa Investor Presentation

Building wide moat in the packaging industry

As Europe's largest paper packaging company, Smurfit Kappa has built relationships with almost all of the large cap FMCG companies - from beer and beverages, through food and personal and home care.

Source: Smurfit Kappa Investor Presentation

By working alongside all these companies from designing the packaging to manufacturing and all follow-up services, Smurfit Kappa has acquired significant know-how. This, combined with the company's history of high innovation and focus on environmentally friendly packaging solutions has made Smurfit Kappa the best choice for large cap consumer staple companies that want to both improve their CO2 footprint while also reducing costs.

As a result Smurfit Kappa has been expanding into higher value added services, such as ShelfSmart and SupplySmart.

Source: Smurfit Kappa Investor Presentation

The ShelfSmart service combines marketing expertise with a large database of retail shelves to analyze and compare performance of different packaging designs. The service also incorporates eye-tracking tools to provide real-time assessment of new packaging solutions. Thus clients could easily test their shelf-ready packaging in real time and evaluate different strategies.

Source: smurfitkappa.com

SupplySmart, on the other hand, builds on the company's experience in packaging and helps clients reduce logistic costs, lower packaging costs and streamline production and simplify supply chains.

Innovative packaging solutions in combination with such value added services has allowed Smurfit Kappa to differentiate itself from its peers and achieve one of the highest Return on Equity within the industry.

Source: Author's calculations based on data from morningstar.com

High ROE in turn translates into high valuation multiple.

Source: Author's calculations based on data from morningstar.com

More importantly, the value added services offered by SKG would be extremely hard to replicate by its peers given the company's innovation focused exclusively towards paper packaging, years of know-how achieved through working closely with many of the largest FMCG brands and the company's large scale in Europe and Latin America.

Conclusion

The three companies analysed above present an attractive opportunity for long-term oriented investors looking for high quality, family-owned businesses with leading positions and sustainable competitive advantages in their respective industries.

An area where family controlled businesses excel is their long-term focus which also necessitates making capital investments with a much longer time horizon, while short-term decisions in order to meet or beat quarterly numbers usually take the back seat.

In my opinion all three businesses are making the right steps into securing higher market share in the future while building sustainable competitive advantages. Thus, any significant pullback caused by either external macroeconomic or industry specific events presents a good opportunity to open or increase existing positions.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long ASBFY, HKHHF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.