Greggs — Update 25 April 2016

Greggs owns and operates a vertically integrated supply chain for bakery food-to-go products, from production through distribution to point of sale. Today’s Greggs is a very different proposition from the one that floated in 1984. No longer is it the local baker’s shop selling bread, rolls and cakes to nearby residents. The lifestyles of customers have changed substantially in the intervening period and Greggs has adapted accordingly. Bread and rolls, once a quarter of the business, now represent a small single-digit percentage of sales. The gap has been filled by pastry savouries, sandwiches, hot drinks, especially coffee, cold drinks, pizza slices and soup, among other ‘takeaway’ items. Locations are changing too, with a move away from traditional high streets and towards travel and workplace locations. Nine bakeries service c 1,700 shops, a total that management aims to increase to more than 2,000.

We have valued Greggs using a DCF analysis. There are too few genuinely comparable listed companies for us to feel comfortable benchmarking traditional metrics such as P/E or yield. Our model delivers a valuation of 1,158p per share. That price would place the shares on an FY16e P/E of 19.3x, which would fall to 17.5x in FY17e. The respective yields would be 2.6% and 2.8%. While these are not compelling metrics, they reflect investments (detailed later) that Greggs is making in the short term that offer significant returns in the medium and longer term. They also overlook Greggs’ net cash balance sheet. The FY16e and FY17e EV/EBITDA ratios at 1,158p are 9.6x and 8.9x, hardly expensive for a growing retailer.

The FY15 preliminary results represented the second straight year of like-for-like sales gains and earnings growth. While this owes something to a more favourable economic backdrop – increasing real consumer incomes and low cost inflation – it owes much to the strategic direction set in 2013. There is much more investment to come as part of that strategy and, based on the success of previous substantial change programmes at Greggs, we expect improved returns too.

Greggs will have no difficulty funding its capex plans. Strong cash generation has been a constant feature of its performance since it listed. Cash conversion is high, hence it has been able to fund major investment programmes, such as the supply chain initiative on which it has just embarked, internally. The year-end balance sheet always boasts net cash (£42.9m at the end of FY15).

Despite that net cash position, Greggs carries substantial leverage as a result of its leasehold store estate. Like many retailers, Greggs runs a negative underlying working capital position, reflecting its high stockturn and product margins; this clearly helps underlying cash flow. The small defined pension liability is immaterial in relation to net assets.

Greggs’ current model is slightly more dependent on the consumer economy than that of 30 years ago. The business is also sensitive to moves in the prices of energy, proteins and soft commodities. Government interference in the industry remains an ever-present challenge. This ranges from food safety measures to taxation, the most recent example of which is the new ‘sugary drinks’ tax. Greggs is successfully managing radical change on the high street, but this may have unforeseen effects. Although it has managed major change programmes successfully in the past, and returns from the current plan have been impressive to date, one cannot ignore execution risk in respect of the strategic plan.

Greggs owns and operates a vertically integrated supply chain for bakery food-to-go products, from production through distribution to point of sale. That allows it to deliver a differentiated product offer to the mass market at affordable prices but healthy margins. The outlet strategy is adapting to the changing nature of the market in which Greggs operates. At the time of its flotation in 1984, Greggs operated local retail bakery shops supplying bread, rolls, savoury and baked confectionery products. Today, its offer focuses on the growing food-to-go market. As a result, new stores tend to be located away from traditional high streets, increasingly in travel and work-based locations. Although the nationwide store network numbers close to 1,700 units, management is persuaded that there remains scope to expand the chain to more than 2,000. There is further potential in upgrading the entire estate to the latest trading formula and further still from rebalancing store numbers away from the historic high street bias. The vast majority of these stores will be company owned but, in the longer term, around 10% will be franchised units operated by a select group of companies such as current partners Moto and Euro Garages.

Greggs’ strategy builds on changes that the business has been making over several years. Nevertheless, the five-year plan launched in 2013 followed a thorough review instigated by incoming CEO Roger Whiteside. Greggs describes that strategy as having four pillars: great-tasting food, a great shopping experience, simple and efficient operations and improvement through change.

Encouragingly, the first pillar is about product. Ultimately, success in retailing stems primarily from the relationship between product and price. Other elements of the marketing mix are important, but nowhere near as important as this chief element. Greggs has always adapted its offer to changing market conditions. Hence, bread and rolls, which would have accounted for close to a quarter of sales – say, 30 years ago – now represent a tiny fraction of sales. On the other hand, coffee, porridge and pizza, to name but three items in the present range, did not feature in the offer when Greggs floated. Range innovation continues: the success of the coffee offer is leading Greggs to increase capacity by adding a second coffee machine in many shops; it is extending the Balanced Choice range of healthier sandwiches; it has launched a new ‘heat-to-eat’ sandwich range and continues to develop its breakfast offer. Throughout this innovation process, Greggs maintains the competitiveness of its offer: its ‘value deals’ at £2 and £3 were important in driving sales growth in 2015. The brand is unashamedly mass-market, so it is vital to maintain price competitiveness.

Linking the product-price proposition to the stores-based shopping experience is Greggs’ Rewards scheme, a pre-pay loyalty scheme that has been running for a couple of years and provides additional value to regular customers. Greggs is upgrading this scheme with a new app that eliminates the pre-pay requirement, thereby further increasing customer value.

Greggs has invested in store labour scheduling to both improve customer service levels and control costs. The strategy will also upgrade ordering systems to ensure stock availability, a critical element of customer service. In addition to the investment in the app, Greggs has invested in other payment methods, such as contactless, to quicken customer service.

Much of the activity under this heading focuses on reshaping the store portfolio. This has three main elements: increasing the number of stores, rebalancing the location mix to reflect changed shopping patterns and upgrading existing stores to the group’s latest and most potent format.

Although Greggs has reduced the size of its estate over the past three years, it plans to recommence increasing it in 2016, by c 50-60 units, en route to a long-term target of more than 2,000 stores.

In the medium to longer term, the proportion of franchised stores will increase from c 6% to c 10%. Greggs only works with significant corporates. They are likely to locate shops away from the existing ‘owned’ estate. The proportion described as ‘away from high streets’ will increase to c 40% of the estate. 90% of 2015’s openings were ‘away from high streets’.

Greggs divides its estate into three groups: bakery stores, food-on-the-go (FOTG) stores and bakery food-on-the-go (BFOTG) stores. The most potent is the BFOTG format.

Of the 308 bakery stores, 119 will close or relocate as leases expire over the next few years. Greggs will refit the remaining 189 during 2016 to incorporate as many elements of the BFOTG format as possible. From 2017 onwards, the 654 FOTG shops will upgrade to the BFOTG format. The result of these moves will be a more consistent presentation of the brand to consumers across the country and a more productive and profitable estate. In 2015, refit investment returns exceeded their hurdle rate.

Through the 1980s and early 1990s, Greggs was a major consolidator of the bakery store industry, eliminating duplicate costs and substantially increasing its scale. In the intervening period, it has done an effective job of achieving regional economies of scale and harmonising the offer under a single brand. The most recent example of this was the project to consolidate the final 79 in-store bakeries into Greggs’ regional bakery network. Nevertheless, national economies of scale remain to be captured. The major supply chain investment programme is substantial enough to merit separate discussion later. However, smaller-scale projects to improve procurement, supply and support functions and manufacturing efficiency contributed, along with the in-store bakery closures, £12m of cost savings in 2015. There is more to come from such smaller schemes.

The Improvement through change programme, launched as part of the strategic plan following the 2013 business review, also aims to capture national economies of scale. It is a five-year, £25m investment in systems targeting annual net benefits of £6m per year. Since launch in 2013, benefits from the initial phases of the programme have so far exceeded expectations. Greggs first implemented workforce management and supplier relationship management systems. Subsequently, it has installed the infrastructure to support its chosen ERP system, SAP, and launched a new customer contact system. During H116 it plans to migrate its existing finance systems from Coda. Thereafter, it will launch modules covering shop ordering, ranging and logistics.

With its December 2015 preliminary results, Greggs announced a substantial programme to upgrade its national manufacturing and distribution infrastructure.

Over the next five years, the £100m investment programme aims to create additional national manufacturing centres of excellence and increase capacity to serve more than 2,000 outlets. Initially, three subscale bakeries – at Twickenham, Edinburgh and Sleaford – that are not suitable for upgrading, will close. Greggs will invest in the existing Enfield and Glasgow bakeries, not least so that they can absorb transferred activity from Twickenham and Edinburgh. However, the plan is to make them national centres of excellence in specified products, capturing national economies of scale and ensuring consistency of product quality across the brand. This follows the model of the Balliol savoury production facility in Newcastle. Greggs has already acquired additional distribution capacity at Enfield that should come on stream in H216. An additional Southern distribution centre, in Wiltshire, is likely to be added towards the end of the programme.

The following table sets out management’s financial assessment of the programme. Although it includes significant capex, it also avoids spend that would have been invested in Twickenham and Edinburgh, as well as capex that would have had to be spent in other depots to compensate for the inefficiencies in those units.

Greggs is pursuing these self-improvement measures against the background of an expanding market. The Project Café2016 UK report from Allegra World Coffee Portal valued the total UK coffee shop market in 2015 at £7.9bn. That was 10% higher than in 2014. The branded segment that includes Greggs accounted for £3.3bn of this. Encouragingly, Allegra, which has studied this market for many years, estimates that it could reach £15bn by 2025.

The market contains many formidable competitors. The supermarket chains, Boots and other general retailers carry takeaway food offers. In its recent interim results, WHSmith announced plans to extend its coffee shop operations. The major coffee chains, Costa, Starbucks and Caffè Nero, are well-established. So are the major sandwich chains such as Subway, McDonald’s, Pret and Eat. The point that we would emphasise is that none of these major players is new. Greggs has been competing successfully against all of them. Furthermore, over half of the current market is not in the hands of the branded majors; the potential for consolidation is substantial.

One of the features explaining the consistency of Greggs’ performance since its flotation in 1984 is the stability of the senior management team. In that time, the group has had only three CEO/group MDs and two finance directors. The senior executive team is as follows.

CEO Roger Whiteside began his career at Marks & Spencer, where he spent 20 years, ultimately becoming head of its food business. He was then one of the founding team of Ocado, serving as joint MD from 2000 to 2004. From 2004 to 2007 he led a turnaround as chief executive of the Thresher Group off-licence chain before joining Punch Taverns, ultimately becoming chief executive. Roger was appointed chief executive of Greggs on 4 February 2013, having previously joined the group as a non-executive director in 2008.

Finance Director Richard Hutton qualified as a chartered accountant with KPMG and gained career experience with Procter & Gamble before joining Greggs in 1998. He was appointed finance director in May 2006.

Retail Director Raymond Reynolds joined Greggs’ retail management team in 1986. As general manager during the 1990s, he built a significant new business for the company in the Edinburgh region and was appointed MD for Scotland in 2002.

The changes in product mix and location types over the past three decades have made Greggs more UK-procyclical than it was. Levels of shopping activity clearly affect major shopping locations and employment levels are relevant to workplace locations. One might argue that the growth of travel locations, particularly in the franchise network, makes traffic volumes and therefore the petrol price important. During the past two years, these factors have all tended to work in the company’s favour. Employment and spending have held up well; petrol prices have remained depressed. Meanwhile, commodity prices – not least energy prices – have been constrained, limiting pressure on gross margins. Any or all of these factors could reverse at some point.

Greggs is relatively unusual in being a highly vertically integrated retailer. The 2013 strategic review concluded that the benefits of this structure – a differentiated offer, innovation potential, quality control and scale economies – outweighed the loss of flexibility that a dis-integrated model would deliver. The downside to the structure is the high operational gearing should there be a downturn in revenues.

Government interference in the industry remains an ever-present issue. This ranges from food safety measures to taxation, the most recent example of which is the new ‘sugary drinks’ tax. In the 30+ years that our team has followed Greggs, the company has coped successfully with these interventions. We expect the meddling to continue and Greggs to cope with it.

We have already explained the logic behind Greggs’ change in location strategy. The high street faces pressures on both sides. Demand is declining as shopping switches to online and mobile channels. Meanwhile, costs increase in response to the National Living Wage, upward-only rent reviews, apprentice levies and business rates. This toxic combination will lead to shop closures, which, as they increase in number, will take some retail locations to tipping points from which they cannot recover. Awareness of this inevitability is one of the reasons why Greggs has identified 119 stores that do not merit investment. The risk is that a larger number of outlets is threatened by this wider trend.

During many years of following Greggs, we have seen periodic spikes in capex such as the one management now proposes in relation to the supply chain development. Those previous spikes have been well managed and we therefore assume that the new programme will also deliver benefits broadly as planned. There is, clearly, a risk that that might not be the case.

We have valued Greggs using a DCF analysis. There are too few genuinely comparable listed companies for us to feel comfortable benchmarking traditional metrics such as P/E or yield. That said, in absolute terms, the valuation metrics are not outlandish. The FY16e P/E of 17.3x and yield of 2.9% are not outrageously attractive, but nor do they appear stretched for a low-risk, growing retailer. Howden, also a highly cash-generative, vertically-integrated business, trades on 16x FY16e earnings, yielding 2.5%. Other FTSE 250 retailers, excluding online pure-plays, range in forward P/Es from 11x to 23.5x, with yields varying from zero to 2.9%. Moreover, Greggs’ FY16e EV/EBITDA ratio of 8.2x is arguably low for such a retailer. However, Greggs is a vertically integrated operator and therefore carries a substantial depreciation charge that it would be dangerous to ignore.

Our DCF model delivers a valuation of 1,158p per share. This benefits from Greggs’ low cost of equity capital. At this stage, we have treated it as being entirely equity-financed. One could capitalise Greggs’ lease obligations and treat them as debt financing. After tax, such debt would still be lower cost than equity, thus increasing the valuation. Hence, we have opted for the more conservative approach.

We have sought to keep the model simple. It takes free cash flow from our detailed estimates to FY17, extends those to 2020 using company guidance on capex and then assumes five years of 5% pa growth in operating cash flow to 2025. The model concludes with a deliberately conservative terminal value based on 8x post-tax free cash flow.

As ever, the valuation is sensitive to changes in the discount rate and the terminal multiple. The following table shows the value per share that our model generates at varying levels for those two variables. Our valuation assumes a cost of equity of 6.9%, reflecting Greggs’ low beta of 0.72, and a 2026 terminal multiple of post-tax cash flow of 8x, which we regard as conservative.

At a valuation of 1,158p, the shares would offer the following valuation metrics.

Greggs has had the benefit of economic tailwinds in the past two years, after a period, following the crisis of 2008, that was decidedly unhelpful and led to earnings declines. As the UK economy has continued to recover from that crisis, employment levels have been strong and, more recently, average real earnings have begun to recover. At the same time, cost inflation has remained depressed, anchored by weak oil and commodity prices.

Greggs has taken full advantage of the improving trend. The strategic plan it launched in 2013 has delivered sales, margin and therefore earnings growth (+41% in FY14 and +31% in FY15). It is noteworthy that even during the period of weaker trading, when like-for-like sales declined in 2012 and 2013, despite dipping, margins and earnings remained healthy.

Although FY15 revenues increased by 3.7%, the effect of a 53rd week in FY14 depressed the underlying rate of growth. On a comparable 52-week basis, sales grew by 5.2%. Own-store, like-for-like sales increased by 4.9%, the second successive year of like-for-like gains. That said, one should acknowledge that the rate of growth slowed steadily from more than 6% in Q2 to 2.3% in Q4. That should also be seen in context: many retailers endured a tough Q4 on weak footfall.

The gross margin expanded from 62.2% to 63.5% reflecting a combination of a richer sales mix and the benign markets for ingredients that we discussed earlier. The operating margin, after share-based payments, widened from 7.2% to 8.7%. Distribution and selling costs declined by 70bp to 49.3% of sales, resulting from positive operational leverage and the benefits of the investments in processes and systems. Offsetting this improvement, administrative costs increased by 40bp to 5.4% of sales, reflecting the investment in the integrated systems platform.

The 30% increase in EPS led to a 30% increase in the ordinary dividend, in line with Greggs’ aim to maintain dividend cover at 2x. This excludes the 20p special dividend paid during FY15.

Strong cash generation has been a constant feature of Greggs’ performance since it floated. Hence it has been able to fund major investment programmes, such as the supply chain initiative on which it has just embarked, internally. The year-end balance sheet always boasts net cash, a factor we will discuss in the next section. High cash conversion is mainly the result of a relatively high depreciation charge. Nevertheless, even in relation to EBITDA, operating cash flow remains healthy, especially as the returns from the strategic plan feed through alongside the stronger consumer economy.

Net cash flow from operating activities increased from £97.1m in FY14 to £103.7m in FY15. The principal factor driving the increase was the sharp increase in profit. That allowed Greggs to increase investment in capex.

Closing net cash was £42.9m, down slightly from FY14’s £43.6m, but very much in line with the group’s aim to maintain year-end net cash of c £40m.

To the casual observer, Greggs’ balance sheet has always appeared conservative, boasting net cash. This reflects management’s understanding of the extent of leverage provided by the leasehold property estate that it inhabits. New accounting standard IFRS 16 will highlight such leverage by bringing estimates of the debt and associated assets onto the face of the balance sheet by 2019. Operating lease charges in FY15 were £46.2m. In common with many retailers, Greggs runs a negative underlying working capital position, reflecting its high stockturn and product margins; this is clearly helpful to underlying cash flow. The existence of a 53rd week in FY14 distorts the impact of working capital on cash flow in the past two years. In FY14 the movement in working capital contributed £16.1m. This fell to £1.2m in FY15. A better guide to the annual cash flow benefit of negative working capital might be the £5.4m generated in FY13. There is a small defined pension liability, but it is immaterial in relation to net assets.

We model FY16 sales growth of 5.5%, incorporating like-for-like growth of 2.7% and a 2.8pp contribution from the return to opening net new stores. Our assumed like-for-like sales growth is below the +4.2% achieved in the first eight weeks of FY16. We expect a positive move in H1 gross margin to lead to a gain of 10bp in the full-year gross margin. Greggs has highlighted its decision to award shop team members a 5% pay increase and store managers 4%, which will add an incremental £3m to distribution and selling costs. The continuing investment in the various elements of the strategic plan will see depreciation and amortisation continue to increase. Nevertheless, the gross margin gain and operating leverage should allow the operating margin to hold at 8.7%. Underlying EBIT increases from £73.1m to £77.0m. This is before £7m H116 exceptional charges relating to the closure of facilities as part of the supply chain investment programme. Greggs has guided that the FY16 tax rate will be c 22%, with the rate in subsequent years being c 2pp above the headline rate.

Greggs believes that capex will be £85m in FY16, £75m in FY17 and £70m in each of the next three years. The increase in capex in FY16 pressurises free cash flow. After increased ordinary dividends, in line with the EPS increase, we model broadly neutral net cash flow, which leaves Greggs with net cash of c £43.2m at the end of FY16.

Our preliminary estimates for FY17 see an increase in sales growth to 6.8%. This assumes higher background inflation, the impact of new stores, the maturing of stores opened in FY16 and the benefits of converting older formats to the BFOTG format. We assume that any ingredient cost inflation is merely recovered in retail prices and that the gross margin does not change. Operating leverage generates a small increase, 30bp, in the EBIT margin. The drop in the annual capex bill mentioned earlier leads to a c £15m net cash inflow and a year-end net cash balance of c £58m.