Greggs — Update 3 August 2016

Greggs summarises its interim results as “in line with our plans”. In its outlook statement it notes that “we expect to deliver full-year growth in line with our previous expectations as well as further progress against our strategic plan”. In short, a strong H116 and good start to H216 position Greggs well to meet our FY16 estimates.

Total sales for the 26 weeks to 2 July 2016 grew by 6.0% to £422m, with LFL sales in company-managed shops up by 3.8%, against a tough comparison of 5.8%. Greggs recorded increases in both customer numbers and average transaction values. Once again, the refurbishment programme contributed c 1pp to LFL growth and there was a small contribution from additional trading hours, especially in the morning. Marketing support was broadly unchanged during H1.

Total sales growth has several origins. First, Greggs continues its product innovation: by way of example, the Balanced Choice healthier options range increased sales “strongly” in H1. Greggs extended its coffee range and invested in improved service to meet continued growth in coffee sales. Breakfast remains the fastest-growing day-part in the business, reflecting wider market trends and benefiting as the offer evolves. Second, Greggs continues to emphasise its value credentials through its ‘value’ offers. Additional loyalty benefits from its relaunched Greggs Rewards app enhance that value message. Third, Greggs continues to refurbish the tail of its estate in its latest ‘bakery food-on-the-go’ format wherever appropriate, improving the customer offer in those units. It refurbished 86 stores in H1 and remains on target to update 200 outlets. Fourth, Greggs has stepped up its store opening programme. It opened 68 shops in H1 while closing 36 to give a net addition of 32. At the end of H1, Greggs traded from 1,730 shops, of which 136 are franchised, including 31 opened in H1.

H1 gross margin increased by 40bps as food and packaging input costs continued to be deflationary. Operating expense declined as a percentage of sales, partly in response to the operational leverage benefits of LFL sales growth and partly reflecting the benefits of the systems and process investments made as part of the strategic plan. That said, the impact of the National Living Wage was not felt until Q2, at which point it applied pressure to store costs as reflected in the increased proportion of H1 sales represented by selling and distribution costs.

Property disposal gains have been a regular feature of Greggs’ income statements over the years. There was an unusually large gain of £2.2m in H1 following the sale of the previous head office in Jesmond, Newcastle and a London store.

The strategic plan to transform and develop the supply chain is on track. The new distribution facility in Enfield should be operational in October, allowing the closure of the existing Twickenham bakery in Q4 as planned. In addition, Greggs has secured planning permission for the extension of its Glasgow bakery, which will allow closure of the Edinburgh bakery during H217, as previously announced. Management is therefore now able to plan the next phase of investment in its remaining sites, which is designed to increase logistics capacity and consolidate manufacturing to create centres of excellence, with benefits in product quality, consistency and efficiency.

In April this year Greggs implemented SAP to handle its core finance processes. Reassuringly, that implementation went well and provides the base on which management will build enhanced capabilities across logistics, procurement, product lifecycle management and centralised ranging, forecasting and replenishment. Greggs intends to trial improved shop-stock-replenishment processes in H2 as previously planned.

Greggs indicated at its preliminary results in March that it would incur exceptional charges of c £7m this year in connection with the supply chain transformation plans. The initial phase of this plan involves the closure of three bakeries with associated one-off costs now advised to be £7.6m. £4.8m of this cost was recognised in H1 and this, combined with a £0.8m release of historical shop closure provisions, resulted in a net exceptional charge of £4.0m in the period. Greggs expects the overall cost and exceptional charges arising from the plan to be in line with previous guidance.

Greggs increased cash flow from operations from £34.6m in H115 to £44.7m in H116. Nevertheless, there was a net cash outflow of £7.9m during H116 (H115: £2.3m). Capex plus investment in intangible assets totalled £31.2m, £0.1m lower than in the comparable period. The larger outflow resulted from a c 32% increase in dividend payments and an increase in share purchases. Nevertheless, Greggs ended H1 with £35m of net cash and generated net interest income, albeit of only £16k in H1.

Our FY16 estimates have changed only immaterially, although their structure is a little different to that in our May note. Although Greggs will open a net 70 stores this year, it describes the opening programme as ‘back-end-weighted’. That being so, we have edged down the sales contribution that we expect from new space. Our new revenue estimate is c £4m below its predecessor. Our gross margin assumption remains unchanged. There may be some input cost pressure later in H2 following sterling’s recent decline that might reverse some of the recent deflation in product input costs. However, this will depend on other factors applying at the time that Greggs comes to negotiate fresh terms on ingredients. Meanwhile, with coffee (above-average gross margin) being the fastest growing product, there is a mix benefit to gross margin.

We model a 10bps reduction in the EBITDA margin versus our previous expectation, reflecting the impact of the reduced sales growth estimate.

Greggs is maintaining guidance that FY16e capital investment will be c £85m. That leaves c £54m to be invested in H2. Nevertheless, we model a net cash inflow during H2: it is seasonally the stronger half for EBITDA and we model a working capital inflow.

Despite the sharp increase in the interim dividend from 7.4p to 9.5p, we are leaving our full-year dividend estimate unchanged. Greggs is seeking to re-balance the annual dividend in favour of the interim but still targets full-year dividend cover of 2x.

We have reduced our FY17 PBT forecast from £84.8m to £84.0m. The major driver in the change is lower revenue, partly reflecting the base effects of our reduced FY16e revenue estimate but also assuming a smaller contribution from new space in FY17e. At this stage, we maintain our assumption of maintained gross margins. This will depend upon further currency moves, changes to underlying commodity prices, retail pricing, production efficiencies, wastage rates and sales mix, among other factors. A small change in our depreciation assumption results in an FY17e EBITDA margin that is 10bps higher than our previous estimate, but our operating margin estimate remains unchanged.

We summarise the changes to our forecasts below.

We have again valued Greggs using DCF techniques. Since our previous DCF valuation, risk-free rates have fallen again. On the other hand, Greggs’ beta coefficient has increased slightly. Nevertheless, despite the small reduction in PBT estimate for FY17, our valuation has edged up from our 1158p DCF valuation in April and multiple-derived 1,169p in May to 1,179p. The following table shows the sensitivity of that valuation to changes in the cost of capital and the multiple that we apply to terminal post-tax cash flows. Our base case terminal multiple is 8, which we regard as conservative in the prevailing interest-rate environment.

In the context of sector valuations, a price of 1,179p would appear a full valuation. Exhibit 5 summarises the resulting valuation metrics. However, given the strength of Greggs’ track record, its financial strength, underlying growth in the food-to-go market, scope to increase store numbers substantially and the longer-term potential in extending the trading day further, a premium rating is appropriate.