Greggs — More than just the vegan-friendly sausage roll

Following strong trading updates through the first half, Greggs has reported record revenue growth, which fed through to a higher operating margin, driven by gross margin improvements and good control of other operating costs, while investing in new initiatives to drive future growth.

Total sales in the first half increased by 14.7% year-on-year to £546m and like-for-like sales increased by 10.5%. The performance is described as ‘broadly-based’ and reflects the coming together of the many initiatives, including marketing and new product introductions, to broaden Greggs’ appeal in the growing food-on-the-go market. These have resulted in increased customer visits and number of transactions in more day parts as intended. The message from management is that the consumer is catching up with the innovations in the product offer, store environment and extended opening hours that have been under way for a number of years. While there is strong growth at breakfast, the fastest growing part of the trading day, there is good growth towards the end of the day too, due to offers such as the post-4pm offer of a slice of pizza and a drink for £2. The hot food cabinets required to help service these new day parts will be available in 500 locations by the autumn, versus the current 100, so these should help to maintain momentum in growing footfall through the trading day.

An interesting side effect of the increased footfall, from new and returning customers attracted by the new product offers, has been a resurgence in demand for the traditional sweet and savoury products. The vegan-friendly sausage roll has helped to drive growth in the broader savoury category.

The LFL growth moderated from the 11.1% growth reported at the AGM, which covered the 19 weeks to 11 May. H118 saw significant variations in weather, which affected the sales performance through the period. The net result was that Greggs’ comparators strengthened towards the end of the period (H118 1.3%, H218 1.8%), therefore a moderation towards the end of H119 was expected. It is encouraging that management expects the two-year growth rate towards the end of the first half of c 10% to continue into the second half as comparatives strengthen. Management expects LFL growth to normalise through H219 with the two-year rate of growth to continue in Q319, and then for the two-year growth rate to fade by one percentage point in Q419, post the current deadline for Brexit.

During the first half a net 31 new shops were added to the portfolio to bring the total to 1,984. The target for 100 net new shops for FY19 remains, implying a similar H2 skew of new space as in FY18.

The trend towards repositioning the store portfolio to capture work, travel and leisure-related trade continues as 38% of the estate now services these customers, from 35% last year. The availability of these locations can be a challenge given restricted supply and a high level of interest from competitors. Management continues to be surprised by the success of new formats eg drive-through locations in what previously may have been considered as already-saturated towns. The investment in marketing and new products is feeding through to an improvement in the brand perception, such that Greggs is now being invited into locations such as the Trafford Centre in Manchester.

The click and collect pilot has been expanded to a seventh city and Greggs is now available on the Just Eat delivery platform, as well as Deliveroo, having come off Uber Eats. The key challenge for management is fulfilling the two ‘new’ customers ie click and collect and delivery from a store that typically has a relatively small footprint, while not frustrating the core walk-in customer.

The gross margin increased by 230bp from 63% in H118 to 65.3% in H119. The key drivers to this were:

The first two bullet points should be considered as sustainable, and, therefore are a step change in gross margin. With respect to the third point, management is indicating greater input cost inflation in H219 (it is now expecting 4% inflation versus 3–4% previously), due to the price of pork as a result of the swine flu epidemic in China. The last bullet point refers to more own-sourced/higher margin products sold this year (eg a return to favour of the traditional baked goods) versus more externally sourced products sold last year (cold drinks given the warm weather) so is likely to vary depending on the weather.

The clean operating profit increased from £25.9m in H118 to £43.9m in H119, the operating margin increased from 5.4% to 8%. Therefore, in addition to the gross margin increase, good cost control of other operating expenses enhanced the operating margin further, albeit there was a modest enhancement from the adoption of IFRS 16 as discussed below.

The company has adopted IFRS 16 from 30 December 2018, using the modified transition approach, and comparatives for H118 have not been restated. As a result, comparison of individual line items between H119 and H118 can be a little misleading. In H119, the net additional cost to PBT was £2.1m, with a benefit to operating profit of £1.2m offset by an £3.3m incremental financial expense. For the full year, the net impact is as previously guided with a net cost to PBT of £4.2m. At the end of June 2019 the balance sheet reflects right-of-use assets of £276m with a similar offsetting lease liability.

In line with the policy of distributing excess cash on the balance sheet, defined as a net cash position of more than c £40m at the year-end, a special dividend of 35p per share was declared. This is in addition to the interim dividend of 11.9p, which grew by 11.2%. Both dividends will be paid on 3 October 2019 with a record date of 6 September 2019. The cash cost of the dividend of £35m will take our forecast net cash position at the year-end down to c £60m. Heading into 2020, management wishes to retain an incremental £20m net cash above this ‘buffer’ in order to fund incremental corporate tax cash payments in 2020. It is a transition year for cash tax as UK corporation tax payments are being brought forward so that payments are made in the year they were earned rather than with a lag as at present. Therefore, in FY20 roughly half of FY19’s corporation tax will be paid as well as all of FY20’s corporation tax, with the greatest impact to cash flow in the first half.

Given the increased scale and potential further investment requirements of the business, management believes the £40m ‘buffer’ may be too low so may consider raising the floor in future years.

Our net forecasts for FY19 and FY20 are broadly unchanged albeit the assumptions for key line items, notably LFL sales growth and gross margin, have changed as discussed below.

Based on the strong H119 performance we raise our FY19 forecast for LFL growth to 7.9% from 7.3%. We assume the current two-year growth rate is sustained through Q319 and fades by one percentage point in Q419. These assumptions produce LFL growth of 6.5% in Q319, 4% in Q419 and 5.3% for H219.

We model a slight deterioration in gross margin in H219 of 30bp from 64.3% in H218 to 64% in H219, which we rationalise as a one percentage point increase in food inflation and which represents c 30% of the cost base. In aggregate, this produces a gross margin for FY19 of 64.6% versus 63.7% in FY18.

The normalised tax rate for the FY19 is now expected to be 20.4%, down from our previous assumption of 21%. The lower rate reflects disallowable expenditure for tax representing a smaller proportion of profits given the strong trading performance. Beyond FY19 the normalised tax rate is expected to be 1.75% above the headline corporate tax rate.

Our assumptions for revenue growth in FY20 are unchanged, gross margin increases from 64.0% in FY19 to 64.8% due to the gains made in FY19, and the normalised tax rate falls to 19% from 20.3%.

Our DCF-based valuation of 2,028p has reduced modestly from our prior valuation of 2,059p. As highlighted above, our earnings forecasts are broadly unchanged but the timing of cash outflows for corporation tax have been brought forward. After FY21, our assumptions include a conservative fade in revenue growth from 6% to 2% and a perpetuity EBITDA margin of 16% versus 15% in FY21. Therefore, we believe the share price is discounting more optimistic revenue growth and/or operating margins.