Greggs plc — Growth moderates, but strategy on plan

At 18 weeks, total sales were up 4.7% year-on-year, with like-for-like sales in managed shops up 1.3%. That compares with eight-week growth reported with preliminary results, of 6.2% and 3.2% respectively. By implication, the intervening 10 weeks saw actual declines. Those were the product of lower transaction numbers despite higher average spend per transaction.

It is hardly a surprise that unseasonal weather conditions in March and April affected trading, with some shops actually unable to open in the worst days. The so-called Beast from the East, combined with Storm Emma in early March and the “mini Beast from the East” in mid-March, affected retail as a whole in the month, with total retail footfall down 6% year-on-year, according to data from the BRC-KPMG monitor quoted in the press. April comparative sales were affected by the early date of Easter and by variable weather, but underlying consumer weakness also appears to have been an element in the BRC’s like-for-like, year-on-year sales decline of 4.2% for the month.

Although such analysis can never be precise, management estimates that adverse weather affected the 18-week numbers by up to 1%, implying that ex-weather, like-for-like growth would have been c 2%. That is not a bad result, although it does imply some overall flattening in demand growth. Notable areas of growth nonetheless have been innovative ranges such as the £2 breakfast offer, hot food products and healthier options such as salads and dips.

Net openings of 29 stores are comparable with the 19-week position of 28 last year. Then, openings were significantly back-ended, and that is likely to be more pronounced in 2018:

Greggs is reaching out into new locations, with recent openings in Westminster tube station, Birmingham New Street station, Glasgow Buchanan bus terminal and East Midlands airport. Such locations are part of a deliberate strategy to move up to 40% of the estate away from the high street in the medium term, providing insulation from secular declines and a more direct connection to customers whose lifestyles fit the on-the-go model. The strategy does mean that increased numbers of openings are dependent on third parties such as Euro Garages, where Greggs already has 125 franchised units. This does increase the risk around openings and management is indicating that it may be more realistic to expect net openings at the lower end of its guidance range.

2018 is the peak year for investment in the project to consolidate manufacturing operations in Greggs’ nine centres and extend distribution capacity. Progress is on plan, with work underway in Leeds, Newcastle and Manchester. Planning is also well advanced for work commencing in H2 at other sites. The quality of production from new manufacturing lines now operational in Glasgow and Leeds has been excellent.

Sales in the first five days have been stronger than over the entire March to April period. However, that is likely to have been a function of the equally unusual warm weather, which in any case is too short a period on which to base expectations. We are therefore reducing our forecast like-for-like sales growth assumption for the second half from 1% to 0.5%. We also reduce our forecast net openings from 120 to 110, and assume that the shape of openings will be phased later in the year.

Management has not changed its view of the cost environment in 2018. Inflationary pressures are starting to ease in line with expectations of ingredient inflation at 3-4% compared with 6.5% in 2017. People costs are expected to rise by 3.6% against 3.1% in 2017, including the impact of the National Living Wage, while workplace pension costs are expected to bring a slight increase compared with the 2017 impact of the Apprenticeship Levy in 2017. As a result, we continue to estimate that these factors net out to a c 0.5% cost benefit for the year as a whole, and we retain our gross margin assumptions.

Our resulting 2018 PBT forecast of £81.9m fits new guidance of profit at around the same level as 2017 representing a 4% downgrade for the year.

For 2019 we also soften our like-for-like sales assumption from 2% to 1.5%. We assume that underlying conditions for the consumer will show little change in the first half at least, but that the extraordinary weather-related weakness of March and April will provide soft comparatives. By the second half of 2019 we assume that consumer pressures will ameliorate slightly, besides which, in a price-conscious environment Greggs’ value offer is likely to benefit on a relative basis. However, the combination of the weaker overall demand environment, now over a full year, and the lower base of sales and of store numbers in 2019, means that our PBT forecast reduces by 8% to £83.8m, representing 2.4% year-on-year growth. By 2020, with the benefits of efficiencies from the supply consolidation process, we forecast a return to more normal PBT growth of 8%. As we also explained in our March outlook note, Value discovery, we believe that Greggs’ brand transformation will take time to be fully reflected in sales terms, meaning that it should have a relatively long and sustained return.

Our forecast of net cash is still substantial, although reduced by £5m to £35.7m, which underpins the 3% yield.

We consider valuation on both a DCF and a peer valuation basis. In terms of peers, we take into account a range of multi-site consumer companies. There is no exact peer in the space, although the recent announcement of Whitbread’s intention to spin off Costa provides the conditions for greater investor attention to be focused on the subsector, with a search underway for valuation templates for the new plc.

We apply a 6.9% cost of equity based on an assumed risk-free rate of 2%, an equity risk premium of 7% and beta of 0.7. In extending our published forecast to a 10-year cash projection, we assume revenue growth fading from 5% to 2% and EBITDA margin rising from 13.8% to 14.2% between 2020 and 2027, which should be realistically achievable on the strategy of increased scale combined with business efficiencies. We have reduced our near-term free cash flow forecast to more fully reflect project capex.

As a result of these assumptions, we define a valuation of 1,265p per share (previously 1,536p). Varying the discount and terminal growth assumptions would affect the valuation as follows:

In terms of peers, we take into account a range of multi-site consumer companies. Although there is no exact peer within the group, we think that in the fast-changing, out-of-home space a range of different offers is as relevant to investors as it is for consumers. Our selection of approximate peers shows a wide range of valuations:

Following the lower profit guidance, Greggs’ shares trade at a discount of c 14% to the group on a P/E basis, and c 40% on an EV/EBITDA and EV/Sales basis, although arguably the latter is distorted by the outlying sales multiple of Patisserie Holdings, without which it would be c 15%. It is notable that Greggs trades on a 2019e EV/EBITDA multiple of only 6.6x, compared with peers at 11.6%, suggesting that the market is not recognising the value in this near-cash forecast. We suggest that this discount is unlikely to be sustained for any length of time.

Adjusting to peer group averages for both forecast years would produce a valuation of 1,172p on a P/E basis, and 1,741p on an EV/EBITDA basis. These in turn average to 1,456p. This is 9% higher than our previous valuation of 1,335p in March 2018, which is principally the result of higher market ratings, although the exit of Conviviality Retail has a 4% effect on the peer valuation average.

On a blend of DCF and peer-comparison metrics, we derive a valuation of 1,360p (previously 1,436p).