Greggs Interims

The leading bakery retailer in the UK, with almost 1,700 retail shops throughout the country.  I have a holding in my income portfolio (epic code: GRG).

Greggs announced their interim results today.  Total sales grew by 3.4 per cent to £362m and although like-for-like sales improved in the second quarter, across the first half as a whole declined by 2.9 per cent. This lower like-for like sales in the first half led to a £4.7m decline in operating profit to £11.5m with a net operating margin of 3.2% (2012: 4.6%).

Diluted EPS were 8.5 pence, down 28.6% and the dividend was maintained at 6p.

Trading in the first five weeks of the second half to 3 August has been impacted by the heat-wave, with like-for-like sales falling by 3.2%. This, along with the change in the mix of sales from food items to lower margin cold drinks, has impacted profits by a further £2.0m.  As a result of this and the additional costs borne in the first half overall profits for the year are now expected to be around £3m lower than we had previously expected, so it looks like approximately £42m pre-tax.  This does not include one-off exceptional charges of £6-8m in the second-half, relating mainly to the impairment of asset values where the strategic direction of the business no longer supports the carrying value of these assets, therefore mainly of a non-cash nature.

The first half result includes one-off costs of £1.0m reflecting an updated assessment of the impairment of assets in under-performing shops and costs associated with the review of their strategy.  The company's strategic review, undertaken by new CEO Roger Whiteside, has concluded that the business will focus on their core market of "food on the go", a £6bn market growing at an annual rate of 9%. 

As part of this strategy Greggs will simplify their offering by merging their "food on the go" stores and their "local bakery" stores to create a "bakery food on the go" format. Whilst Greggs has defended its position as the leading retail bakery business, it has underperformed the "food on the go" market, as new entrants and existing competitors have rapidly expanded shop numbers and better met customer demands.  The expectation is that this new format will reposition the business for a return to growth.

As a more focussed business Greggs will not continue developing separate coffee shops and existing shops will be transformed, where possible, into the "bakery food on the go" format.  Although they will continue with their "bake at home" business with Iceland, they will not expand this offering to other retailers and they have no plans to develop an international business.

They have also stated that they will need to spend £25m over the next five years in process improvement and systems replacement.  They do expect to achieve £38m of benefits over this period, but I would have thought that the benefits will lag the cost outlays by 12-18 months.  This is always a difficult process within a business and may require a culture change along with the process and system changes.  

Assuming the normalised pre-tax guidance of £42m is achieved, then EPS will be about 31.4p, valuing the business on a P/E of 12.8 with a yield of almost 4.9% if the dividend continues to be maintained.  This would be an attractive price for the stock if management's plans were successful in returning the business to growth. 

My major concern is their free cash flow (FCF), that has declined steadily over the past 3 years, so that their average FCF yield on their capital employed* is just 6.7% compared to their weighted average cost of capital of 9.2%, this yield is likely to continue to decline in the short-term, as they make the necessary investments in re-focussing the business.

*FCF yield on capital employed is calculated using the 3 year average FCF (to allow for the cyclical effects of capital expenditure and working capital movements) divided by the average capital employed in the last year (opening equity + closing equity +/- opening net debt/cash +/- closing net debt/cash).