Greggs plc — Strong H122 trading and progress on strategy

GRG reported H122 revenue of £694.5m, which represented y-o-y revenue growth of 27.1%. The strong growth included a full period of trading for the estate, unlike the prior year, which suffered from COVID-related closures (see Exhibit 2). On a l-f-l basis, revenue in company-managed stores grew by 22.4% in the period with a slowing rate of growth from Q122 (36.9%) to Q222 (11.2%) as comparatives naturally became tougher due to the easing of restrictions through H121. Management does not quantify the positive effect of product price increases on revenue growth, but believes that selective price increases were comparable to those of its peers, suggesting GRG’s price advantage has been maintained. Prices were raised in November 2021 and May 2022 to help recover increasing cost inflation and cover the recent return of VAT rates to pre-pandemic levels. According to management, customers received the most recent price increases as well as could be expected, with no negative effect on transaction numbers. With expectations of higher cost inflation than at the start of the year (see below), further selective price increases are likely.

Exhibit 2 illustrates how GRG’s l-f-l revenue (company-managed stores) to the end of July 2022 has fared versus the COVID-affected H121 and H119, the last period not to be affected by COVID. We note that through H122, l-f-l revenue growth has been a relatively consistent double-digit rate versus H119, which is very encouraging, despite footfall remaining below pre-pandemic levels.

Before looking at the individual cost lines, we summarise the overall drivers of GRG’s H122 operating profit of £59m, which was marginally below H122’s operating profit of £59.4m. Management attributes the 240bp decline in operating margin from 10.9% in H121 to 8.5% to positive volume leverage offset by higher cost price inflation than price inflation, the return of business rates following temporary relief in the prior period (£15m or 2.1% of H122 sales) and the return of VAT on food and non-alcoholic beverages to pre-pandemic levels, with phased increases from October 2021 to April 2022 (1.8% of H122 sales).

Gross margin declined by 160bp to 62.5% in H122 through a combination of the return of VAT, higher cost inflation than price increases and a minor impact from business rates (a small part of the £15m is allocated here). A stated lower relative contribution from delivery revenue to the group total, to what management describes as a more normalised level post lockdowns, was not a drag on gross margin, as had been the case in prior periods.

The c 32% increase in distribution and selling costs to £339m and growth relative to revenue (H122 48.9% versus 47.2% in H121) reflects the return of business rates (the majority of the quoted incremental costs of £15m is allocated here), implying some operating leverage when adjusting for this. There was also some operational leverage in administration expenses, which grew by only 9% to c £36m.

With limited growth in profit expected for FY22 and a consistent dividend policy (ordinary dividend covered around 2x by underlying earnings), the interim dividend was held flat at 15p per share.

The decline in operating cash flow generation to £91.5m in H122 from £120.2m in H121 was predominantly due to the £30m relative swing to working capital absorption from a release of capital in the prior period, as expected with the strong recovery in sales. The lower operating cash flow and higher anticipated capital investment as part of the five-year growth strategy (c £36m versus c £19m in H121) led to a decline in free cash flow of c £58m from c £102m in H121. Dividend distributions increased significantly versus the prior year as the ordinary dividend was resumed at the H121 results and a special dividend of £40.6m (40p per share) was paid.

GRG finished H122 with a relatively high net cash position of c £146m (£199m at end FY21 and £118m at end H121), which is consistent with management’s prior indication of aiming for a higher-than-average cash balance ahead of the peak investment levels in FY23 and FY24 under the five-year plan. Including IFRS 16 liabilities of c £291m, the net debt position increased to c £145m (c £85m at end FY21).

Management believes it is making ‘good progress’ on its strategy to grow revenue to £2.4bn by FY26, ie a doubling from the FY21 revenue base as set out at the capital markets day in October 2021.

As previously indicated by management, there is some uncertainty about the expected timing and size of the identified new revenue streams given the overlap between initiatives. However, management’s belief is that growing the evening daypart has evolved faster than originally expected and that delivery is a little behind expectations, likely due to the normalisation of trading post COVID-related restrictions and closures. Progress on the four key drivers of expected growth is as follows:

The four key growth drivers above are supported by higher investment in the supply chain and systems.

As shown in Exhibit 2 above, GRG continues to trade well into H222, with l-f-l revenue growth in company-managed stores of 13.1% in the first four weeks to the end of July. Albeit against an easier comparative of 3% before a higher comparative of 6% in August 2021, growth would likely have been better were it not for the extreme heatwave experienced by the majority of the country. This is testament to GRG’s value proposition against a backdrop of deteriorating macroeconomics.

With expectations of higher cost inflation on a l-f-l basis of around 9% in FY22 than the prior 6–7%, as well as headwinds from the return of business rates and VAT, revenue buoyancy year to date and confidence in the new growth initiatives enables management to reiterate its profit expectations for FY22, that is no material profit progression. In food and energy, the areas of greatest input price inflation, the average forward cover is five months.

Our forecast changes for FY22 and FY23 are summarised in Exhibit 3 below. We increase our assumption for l-f-l revenue growth in company-managed stores to 12% in FY22 from 10% previously to take account of the strong growth reported to the end of July. Naturally, further price increases would be supportive of revenue growth and margin. This leads to an upgrade to revenue forecasts in FY22 and beyond of 1.5%, so that total forecast revenue growth is 18% in FY22 and 14% in FY23. We trim our forecast for FY22 gross margin to 62.7% from 63.1% to allow for further input cost pressures highlighted by management. The dilution in gross margin is offset by expected better operating leverage than previously assumed, and as demonstrated in the H121 results.

Our DCF-based valuation reduces to £29.70 per share from £31.60 per share previously. The increase in valuation derived from rolling forward the valuation in time is more than offset by the higher debt position at the end of H122 and an increase in our estimated WACC to 8.7% from 8.2%, which reflects an increase in the UK 10-year bond yield to 1.8% from 1.2% since our last update. Our WACC estimate includes a market premium of 6%.

Below we show GRG’s sales growth, profitability and valuations versus three peer groups: UK restaurants and pubs, US restaurants and UK food retailers, all annualised to GRG’s December year-end. The EV-based multiples include the capitalisation of leases.

Our forecast revenue growth for GRG of 18% in FY22 and 14% in FY23 compares favourably with the majority of peers in both periods. Growth rates in CY22, particularly for UK pubs and restaurants, are elevated given the negative effects of COVID-19 in FY21 and subsequent expected recovery. Our estimated EBIT margins for GRG of 10.6% in FY22 and 10.5% in FY23 are attractive versus the median for UK restaurants and pubs (8.2–8.8% in both years) and food retailers (3.8% in both years), but lower than for US restaurants (c 17–18%), which tend to have a more global presence and business model, for example including high levels of franchises.

GRG’s share price is trading at a premium to its UK-based peers on most metrics, which we believe is justified by its better expected revenue growth rates and profitability.