Greggs reasons to remain invested

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).

I was prompted to produce this post after a comment from John Hulton (who writes this informative blog) on my last Greggs post here.  He wrote on 9 October:

"...Following the recent warning on profits, I decided there were better opportunities elsewhere and sold out.

 

I am not particularly convinced by the new ceo and feel there may be more disappointing announcements to come over the next year or two. As you say, the company are unlikely to make much headway with increasing the dividend and I would not be surprised to see the share price slump.

 

My general feeling is the current strategy of moving to compete in the highly competitive food-on-the-go area is the wrong direction..."

The Background
These are valid comments and I can understand why investors might seek alternative opportunities, but two views make a market.  I am prepared to accept a difficult 12-18 months on the basis that I believe they have the correct strategy, have investment plans for the right projects and with a continuous 28 year history of increasing their dividend, do not intend to cut it.

Greggs have consistently returned around 25% on the capital employed in the business, compared to a WACC of about 9%.  This margin between the two is the value that management are adding to the business and for a retail or food manufacturing business is very good.  So if management can add to this with a higher growth profile, it would be very attractive.

The market
As we know, all is not well at Greggs.  The market is changing and over many years the company's sales mix has moved from a purveyor of breads and rolls (55% of sales in 1978) to mainly sandwiches and savoury products (64% of sales in 2012, bread and rolls were just 6% last year), this is typical fayre for the Food On The Go (FOTG) customer - in fact 50% of the FOTG market is accounted for by sandwiches.

Greggs already believe that 72% of the visitors to their shops are FOTG customers, their market share though is only around 8% and whilst the market has been growing at 9% pa, Gregg's growth has been half of this over the past 5 years.  They believe that their lack of focus on this market, operating as a bakery retailer that just happened to sell to FOTG customers, was the reason behind their lower performance.

Future plans & the competition
As part of their plans to focus more effectively on this market, they are:

• closing/relocating some stores that do not fit with the footfall of FOTG customers,
• undertaking shop refits to better attract the FOTG customer,
• expanding their food offering to items such as pizza slices,
• extending their opening hours and
• introducing loyalty schemes.

They also need to update and improve their processes and systems that will cost £25m over the next 5 years, but management believe the improvements will produce benefits of £38m over the same period.

The main competitors in the FOTG market (representing the 92%) are:

• supermarkets such as Sainsbury's & Tesco, where they are supplied with the product from companies such as Greencore the convenience food supplier - 22% market share,
• Cafes and sandwich bars, such as Pret A Manger, Subway and Costa Coffee - 23%
• Other retail bakeries such as Sayers & Cooplands - 9%
• Various canteens both in-house and public, some operated by companies such as Compass Group - 14%
• Other - 24%  

This is a difficult market to compete in, but Greggs are already selling in to it in an unfocused way and, they should have the added benefit of their USP as the country's leading retail baker supplying own sourced freshly baked produce.

Although management have stated that there will be limited net additions in the estate over the next 2-3 years, due to the concentration on refits and relocations, they do believe that there is eventual scope for an additional 600 (+35%) shops to their current number of 1,693 as they believe that 50% of the UK population do not have easy access to a Greggs shop.  Further confirmation of how realistic a 600 shop increase is comes from Subway, who had 1,423 shops in 2012 and were planning to open 600 within 3 years (the speed of expansion is greater with a franchise operation).  It is worth noting that Greggs opened 303 shops (including 10 franchises) over the past 5 years to December 2012.  So I have assumed within my valuation model below a similar rate of new shop openings of 60 shops pa. being well within management's capability.

Valuation
Next based on the assumptions detailed above I'll look at the intrinsic value of Greggs, by discounting the estimated free cash flows of the business.  As a base I will use the current year assuming that the trailing twelve months (second half of last year plus the first half of this year) is a conservative indication of how the year might turn out.

Early years of valuation	2013	2014	2015
Operating cash flow	67	70	73
Capital expenditure	-45	-50	-52
Free cash flow (FCF)	22	20	21
Dividends	-20	-20	-21
Opening net cash	19.4	21.4	21.4
Closing net cash	21.4	21.4	21.4

Capital expenditure has been uplifted in 2014 & 2015 for the addition £5m of process and system investment needed.  I have assumed flat operational cash flow for 2014 & 2015, but a £3m benefit pa from the process and system improvements.

For the following 10 years I have assumed an expansion plan of 60 shops pa, delivering growth of 3.5% pa. and organic growth of say 5.5% to achieve the expected market growth of 9% pa.  This should produce an operating cash flow growth of 5.4% pa assuming 60% margins and I have reduced this by a further 1% to allow for increased working capital/overheads linked to growth, but for the years 2016-2018 I have taken the remaining £32m benefits from the process and systems improvements.  Capital expenditure has been increased by 3% pa to reflect the increasing costs of fit-outs and refits, but discontinued the £25m process and systems improvement project in 2018 as planned by management.  This should produce FCF by 2025 of £55m, a CAGR of just over 10% pa. from 2015.

Using a 2.5% FCF growth in perpetuity and a discount factor of 9% (cost of GRG's equity) the intrinsic value of Greggs is about 520p a 19% premium to Friday's close of 437p.  More importantly to an income investor Greggs will have the capacity to increase dividends during the 10 years of 2016 to 2025 by well over 10% pa.

Risks 
The main risk is execution.  With so much change being undertaken on refits, relocations and improvements to processes and systems, they have made a wise decision not to increase the number of shops over the next 2-3 years, but it is here where the plan may fall apart.

The new CEO Roger Whiteside, who took over in February from Ken McMeikan,  has a good track record in retail, having started his career in M&S - he was there for 20 years at one time as head of their food business and for four years to 2004 was joint MD of Ocado.  He joined Threshers in 2004 and by 2007 turned the off-licence chain around.  Punch Taverns where he had been for the last 5 years was less successful, although he seemed to have inherited a company in poor shape but this may cast some doubts about his judgement.

Conclusion
On balance, I believe the current share price is somewhat discounting the risk and the prospect of substantial dividend increases over a good many years keeps me invested.  Although patience is required, as I am assuming a freeze in the dividends this year and next.  Clearly though Greggs have the capacity to continue with their dividend growth record despite the current problems; it will certainly be a big decision to call a halt to that 28 year record.