Greggs plc — Value discovery

Over the past five years Greggs has transformed itself from a national bakery chain into a food-on-the-go retailer with a broad offering. There are four strategic pillars supporting the current aim of becoming the customers' favourite for food-on-the-go. These are: (1) great-tasting freshly prepared food; (2) the best customer experience; (3) competitive supply chain; and (4) first-class support teams. Greggs has widened its food range to encompass healthy options such as salads and wraps, as well as its traditional baked products. It has developed competitive hot drinks and is extending its hot food ranges, giving the potential for evening opening. Substantially the whole estate has been repurposed to the food-on-the-go operating model and image, and a modernisation of the supply chain is approaching its peak investment phase. A major SAP development is streamlining support functions, and a central stock ordering system relieves store staff of clerical distraction while reducing cost. Greggs does not advertise above the line, and as a result we believe non-customers will be relatively slow to understand the transformation of the brand. In a way this is an advantage since it implies investment in the brand will have a relatively long and sustained return.

Greggs has a good record of like-for-like sales growth, averaging 3.5% over the last two years. In 2017 our expectations were met with 7.4% revenue growth to £960m and, after successful management of inflationary pressures, 4.7% growth in operating profit to £81.7m. Our trading forecast for 2018 is slightly upgraded by 2% at the PBT level, although higher tax means that our EPS forecast is barely changed. We forecast EPS growth of 3.2%, 7.6% and 8.6% over the next three years. Greggs has a strong balance sheet with £54.5m net cash at December 2017: after a high level of capital investment in the estate and particularly the supply chain in 2018, we still forecast £40m net cash by the end of 2018. The dividend yields 2.7% and there is a progressive dividend policy, with the potential for special dividends to be paid if there is excess cash.

We see the main sensitivities as:

We add a peer comparison to our previous DCF valuation metric. On a DCF basis, we apply a 6.9% cost of equity (previously 5.1%), with a 2% perpetuity growth rate (previously a terminal multiple of 8 times). As a result of these assumptions we now define a valuation of 1,536p per share (previously 1,226p). Against a disparate multi-site retail peer group, Greggs stands at a c 20% premium on a P/E basis, and a c 16% discount on EV/EBITDA and EV/sales measures. Adjusting to peer group averages for both forecast years would produce a valuation of 1,051p on a P/E basis, 1489p on an EV/EBITDA basis and 1,465p on an EV/sales basis. These in turn average to 1,335p. Our blended valuation is therefore 1,436p (previously 1,226p), implying an FY18e P/E multiple of 21.6x and EV/EBITDA of 8.6x.

With origins in local bakeries, Greggs adopted a strategy in 2013 of transforming itself into a value food-on-the-go retailer. This has now evolved to the current aim of becoming the customers' favourite for food-on-the-go.

Greggs’ strategy is built on four pillars:

We go on to examine where the company is now and where it is going on the main planks of its strategy.

Greggs has purposefully evolved its food selection to appeal to a wider range of customers, while retaining existing ones.

Non-traditional ranges adopted as part of the strategy include:

Greggs has made decisive progress in moving its offer from that of a high street baker to the current food-on-the-go brand. The store refurbishment objective has been emphatically achieved, with substantially all its sites now refurbished on a food-on-the-go format.

Active estate management has resulted in gross churn of 46% of the estate since 2012:

The emphasis within estate development is now shifting to locate the brand in its most appropriate market. This is not necessarily on high streets, and 34% of the estate, some 630 stores, are now located in travel and workplace locations, up from 20% in 2012. These include transport hubs, bus stations, train stations, petrol stations, office developments and drive-thrus. In March 2018 Greggs opened its first shop on the London Tube, at Westminster, and there is scope for this to be followed by others. In addition, the medium-term objective is for 40% of the estate to be in such locations.

Greggs is expanding its geography to new territory such as the county of Devon, and is adding to its footprint in Northern Ireland, currently 10. The business model is evolving, with 202 shops now trading in franchise formats, an increase of 45 in the year. Franchise offers some protection from reduction of footfall in traditional retail locations.

Looking forward, management sees potential in digital order pads of the kind adopted by McDonald’s, although these would be subject to appropriate system changes. In addition, delivery trials are underway with Uber, which could result in further revenue opportunities.

In March 2017 Greggs announced a substantial programme to upgrade its national manufacturing and distribution infrastructure. Over 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. The plan is to create national centres of excellence in specified products, capturing national economies of scale and ensuring consistency of product quality across the brand.

In 2016 Greggs opened a new distribution centre in Enfield, and closed bakeries at Twickenham and Sleaford that were unsuitable for upgrade. In 2017 the company completed the transfer of its Edinburgh operations to its Glasgow bakery, which has been extended to become a centre of excellence for Yum Yum production. The Leeds bakery has been extended to create a centre of excellence for cake and muffin manufacturing. 2018 will be the peak year for investment, including the creation of a centre of excellence for doughnuts at the Gosforth Park bakery.

The following table sets out management’s financial assessment of the programme, phased over the five-year period (investment is due to peak in 2018). Although it includes significant capex, it also avoids spend that would have been invested in the previous establishment. On that basis, and including disposal proceeds, the project as a whole produces an annualised net return on investment, after five years, of 23%.

Greggs’ vision of FOTG depends crucially on prompt and efficient service. This is particularly important in Greggs’ small physical format. While management is working to even out differential demand between dayparts, queues at busy times such as lunchtime remain common and there is an obvious risk of losing customers as well as causing dissatisfaction. Conversely, an improved rate of service can directly contribute to revenue.

Greggs invests in technology and processes to free staff time to devote to customer service, as well as to reduce absolute cost. The supply chain investments covered above should support progressive improvement in stock availability. Following the deployment of SAP Finance in FY16, the company successfully rolled out its central forecasting and replenishment process in FY17, replacing traditional, shop-based, manual ordering processes. This brings benefits in terms of improved product availability, and management expects lower wastage as staff become more experienced with the system's capabilities. In addition, the system should bring staff efficiency and better customer service by freeing store staff from a regular clerical exercise. In 2018 the remaining SAP support modules, human resources, payroll and property management, are to be implemented.

Greggs is a national brand: its footprint of 1,854 stores compares well with competitors such as Marks & Spencer (c 1,000), Morrisons (c 500) and MacDonald’s (c 1,200). The comparison is not exact, but Greggs management considers its competitive set to be supermarkets, convenience stores, delivery outlets and coffee shops (in that order).

While customers’ acceptance of Greggs’ wider and more contemporary offer is reflected in its consistently improving like-for-like sales, we think wider awareness of the change in the brand among non-customers is likely to be a slow burn.

Greggs does invest in marketing on social media. It has 685,000 followers on Facebook, 139,000 on Twitter and 15,000 on Instagram. Its social media sites are managed to generate a flow of ‘fun’ content. They typically publicise product offers, promotions and events, examples being free coffee with a local newspaper, or dinner for two at Greggs on Valentine’s Day. They also serve as a channel for customer reaction both negative and positive to the company’s products and service, giving a valuable opportunity for dialogue with the customer.

Unlike competitors such as McDonald’s, Tesco, and Domino’s Pizza, Greggs does not invest in above-the-line advertising. Management takes the view that direct sight, word of mouth and social media channels are a more cost-effective and efficient method. However, these channels are also slower than above-the-line advertising and, like any fast-changing offer, it takes non-customers longer to appreciate that the offer may now be relevant to them. It is also true that increasing frequency of visits among existing customers is a relatively easy target, which it would be inadvisable to ignore.

It is beyond the scope of this note to gauge the effect of direct advertising on a brand repositioning exercise, but logic dictates that there is one, and Burberry, McDonald’s and Tesco are among major companies that thought it advisable to communicate brand repositioning using the media. We make three deductions:

This is good and bad for the company’s prospects. The benefit of changed market perceptions may take longer to be reflected in the top line. However, the significant costs of above-the-line advertising are avoided.

Management analyses that its shop investments currently pay back in two years for a relocated shop and three years for a new shop (both take an additional year when the supply chain is taken into account). In addition, improving brand perception should pull in new customers over time, enhancing like-for-likes and lengthening investment returns.

We consider Greggs in the context of the eating out market and also as a value food retailer.

Eating out in the UK is a £95bn market, which has grown strongly in recent years:

However, what was once a well-defined restaurant market has fragmented under the influence of lifestyle changes, time shortage and cost pressures. As the market develops, there is an increasing distinction between three categories: dine-in restaurants, takeaway and delivery.

Traditional terrestrial, sit-down restaurant models are being threatened by over-supply and at best flat demand, while margins have been threatened by higher food, labour and rent costs. The Restaurant Group, which first signalled trading problems in January 2016, recorded like-for-like sales down 3.9% for that year and 3.0% for 2017. Following a review, the company identified the loss of value-conscious customers as the primary cause, resulting from significant price increases and the removal of popular value offers. Byron, the premium hamburger restaurant, entered a restructuring deal in January 2018 in which 20 of its 67 restaurants will probably close. Jamie’s restaurant organisation also announced in January 2018 that 12 of its 37 outlets would close.

By contrast, Domino’s Pizza increased like-for-like sales by 4.8% in 2017. Just Eat’s app-based delivery operation recorded 40% UK revenue growth in 2016 and 27% at interim in June 2017. We believe the Just Eat example, while relevant to the sector as a whole, should be treated with caution. Just Eat, like its more premium competitors, Deliveroo and UberEats, is a platform for home delivery, which tends to convert existing takeaway and dine-in restaurants to its model to the extent they participate. This is not necessarily relevant to Greggs, whose customers are already out and about.

The takeaway sector itself has performed strongly. The number of dedicated takeaway outlets increased by almost 10% between 2013 and 2015, to 36,855. Spending on takeaways grew to £9.9bn in 2016, up 34% since 2009 (according to research commissioned by Just Eat). It is forecast to grow by a CAGR of 2.6% to reach £11.2bn by 2021. On this basis, Greggs would be supplying c 10% of the market, which seems questionable.

Not all commentators reflect the distinction between delivery and food-on-the-go, but MCA has publicised the forecast from its Food-to-go report that this market will grow by 2.8% in 2018, despite the headwinds facing the consumer economy. BFFF, the UK’s frozen food association, presented to its conference in June 2017 that food-to-go is growing 16 times faster than grocery, at 6.5%, and is forecast to continue growing at a CAGR of 6.2% to £21.7m in 2021. On that basis, Greggs currently has around 6% of the market.

While Greggs retains some seating, it is predominantly a takeaway operation, as the company’s strapline food-on-the-go indicates. In this way it is different from either dine-in or delivery models. Following refurbishments over the last five years, the vast majority of the Greggs shop estate now operates in a food-on-the-go format. To the extent it is represented on high streets it is exposed to declines in terrestrial shopping footfall. However, the company is taking action to address this, with increasing presence in workplace, travel and leisure locations.

In addition, the rebalancing of the offer towards food-on-the-go itself means that revenue is not so dependent on high street shoppers, as the customer base increasingly consists of working people, including those who are on the move in their jobs.

In 2016 the company relaunched Greggs Rewards, its digital loyalty scheme. Greggs Rewards includes an app which customers can scan in the shop to get free coffee and other products. The app extends payment options through a reloadable account. Greggs Rewards has now been upgraded to include satisfaction ratings and is growing rapidly, providing better information on customers and so helping the company meet their needs.

As noted on page 5 above, a trial partnership for ‘click and deliver’ with Uber is being tested under the name Greggs Delivered. If rolled out, this would expand the scope of social media to Greggs’ business model.

Another relevant dimension in which to view Greggs’ market presence is that of value food retail, its London Stock Exchange sector. With 2018 CPI inflation forecast at 2.4%, real household income growth at 1% (source: BoE), and personal borrowing set for some degree of correction driven by interest rate rises, consumers are increasingly under pressure. While staple food and drink is to some extent insulated from pressures affecting discretionary purchases, even here the consumer faces challenges. It is well known that value food retailers are gaining market share from traditional supermarkets. In the two years to December 2017, a group made up of Aldi, Lidl and Asda increased UK market share by 1.2% to 27.1%, whereas Tesco, Sainsbury’s and Waitrose slipped 0.9% to 44.4%, according to Kantar’s online indicator.

The team under Roger Whiteside has engaged with the change task with a sense of conviction and urgency. Whiteside is a career retailer originally from Marks & Spencer, where he acquired experience of operating multi-site food retail. He was on the founding team at Ocado, and CEO of Threshers before joining Punch Taverns. On becoming CEO of Greggs in 2013, he set out his vision for the brand’s transformation, which has since become his mission.

Greggs’ results improved in the second half, with marginally higher revenue growth and much higher operating margin than in the first. Also, at the operating and pre-tax level, they showed an expected turnaround from a first half that had lagged the previous year.

Revenue has showed a robust and consistent trading pattern, with sustained like-for-like sales increases averaging around 3.5% over the last two years:

Gross margins have been held consistent with ingredient cost pressure in the year mitigated by cost reductions, mainly emanating from the supply chain actions:

Distribution costs as a percentage of sales increased slightly as a result of wage rates contributing to 3.1% overall wage and salary inflation and training costs. Administrative costs are up in absolute terms in line with systems investment.

Property gains were at insignificant levels compared with an unusually high level in FY16.

During the first eight weeks of 2018 sales have moved positively. Managed like-for-like sales grew by 3.2%, and total sales were up 6.2%. At the same time, there is a clearer picture on the level of continuing food and packaging inflationary pressure, and it does show some slight easing, with ingredient inflation at 3-4% compared with 6.5% in 2017. On the other hand, people costs are expected to rise by 3.6%, compared with 3.1% in 2017, including the impact of the National Living Wage, while workplace pension costs bring a slight increase compared with the 2017 impact of the Apprenticeship Levy in 2017. Overall, with ingredient costs at c 25% and people costs c 40% of the cost base, we estimate that these factors net out to a c 0.5% reduction in cost pressures y-o-y.

As a result, we slightly upgrade our FY18 forecast, by 4.7% at EBITDA level, and 5.7% PBT (after reduced finance charges compared with the higher pension financing charge in 2017) although, as a result of higher tax guidance, our EPS forecast is little changed:

Both our 2019 and 2020 forecasts are new, and we continue to forecast modest growth in earnings as a result of continuing like-for-like positive growth, investment in site expansion, and the benefits of the supply chain improvement programme.

Greggs is very cash productive, with cash conversion from EBITDA of 99% in 2017 and 102% for 2018 on our forecast. It finished 2017 with net cash of £54.5m against our previous forecast of £40.1m. This was mainly the result of c £10m of delayed spend on supply chain investment, as well as smaller working capital differences. We do not expect those delays to affect the realisation of project benefits, although they contribute to an expected peak year for investment in the supply chain at £37m. Combined with consistent net investment of c £40m and the next phase of the systems project, this results in a high point for the expected capex total of £95m.

Management reiterates its guidance of a target of at least £40m of net cash flow, and we forecast that reducing to £43m in 2019.

We are broadening our approach to valuation. Previously, we valued Greggs purely on a DCF basis, on the premise that there were no realistic comparators. We now value the shares jointly on a DCF and a peer valuation basis. In terms of peers, we take into account a range of multi-site consumer companies. Although there is admittedly no exact competitor within the group, we feel that, like consumers, investors have a choice in the relevant consumer space and that it is more realistic to look at Greggs in context.

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. We previously used a 5.1% discount rate. We introduce a terminal value based on this rate and a 2% perpetuity growth rate, which is a more widely used approach than our previous assumed terminal multiple of 8x. 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 14.0% to 14.5% between 2020 and 2027.

As a result of these assumptions, we define a valuation of 1,536p per share (previously 1,226p). Varying the discount and terminal growth assumptions would affect the valuation as follows:

Compared with the peer group, Greggs stands at a c 20% premium on a P/E basis and a c 16% discount premium on EV/EBITDA and EV/sales measures. Adjusting to peer group averages for both forecast years would produce a valuation of 1,051p on a P/E basis, 1,489p on an EV/EBITDA basis and 1,465p on an EV/sales basis. These in turn average to 1,335p.

Our blended rate between the two metrics we use is therefore 1,436p (previously 1,226p), implying the following multiples:

In our view, these ratios appear reasonable for a business with Greggs’ track record and strong competitive position.