Greggs (LON: GRG): Grab the bargain before it’s gone

In its 83-year history Greggs (LON: GRG) has made very few missteps. There was the time it tried to start serving sourdough pasties as a ‘healthy choice’ and the incident when a questionable parody of the company’s logo ended up on Google images. But that’s pretty much it. Customers and shareholders have benefited equally from Greggs' unwavering quality.

But will those customers keep buying sandwiches and pasties during a recession at a rate which keeps sales rising ahead of inflation-elevated costs? That’s a question which is clearly playing on shareholders' minds.

After a 33% fall in the year to date, Greggs’ shares are trading on 18 times forecast earnings. Could this be a rare entry point for investors who have not been able to stomach this quality operator’s previously exorbitant price tag?

Key Figures

• Annual sales (year to December 2021): £1.2bn (5% 5yr CAGR)
• Annual revenue per store: £559,000 (from £518,000 in 2018)
• Annual operating profit: £153m (8% 5yr average operating margin)
• Return on capital employed: 23% (19% 5yr average)
• Operating cash conversion: 180% (140% 5yr average)

Profile: From delivery to bakery and back again

In 1909 John Gregg bought a pushbike so he could begin delivering eggs and yeast from his family’s bakery business to working class homes around Newcastle. While he was fighting in World War II, his wife upgraded to a van and used it to deliver confectionery as well as ingredients for bread. By 1939 the Greggs had founded their own bakery business and in 1951 it opened its first store on Gosford High Street.

The Greggs bakery chain expanded quickly throughout the late 20th Century, selling its own baked goods via its store estate in the North of England. In 1985 the company listed on the Main Market of the London Stock Exchange, a constituent of the Consumer Cyclicals industry group.

Earnings rose every year between 1991 and 2006, providing investors with a steadily rising share price and a healthy dividend on top. But the financial crisis and rising competition from the emerging bakery counters in supermarkets put paid to the reliable returns.

In 2013, Roger Whiteside was brought in to steady the ship. By now more than 80% of Greggs’ sales were coming from food to be consumed on the go. And so the company shifted gears. Rather than bakeries, it would strive to become the UK’s leading food-on-the-go retailer.

Today the store estate stands at 2271. The majority of these (1860) are company-managed shops in high footfall locations (high streets and transport hubs), but the business also has a growing franchise unit (411 stores at the last count) which has allowed it to begin operating in petrol stations, educational and health centres.

And consumers don’t buy their steak bakes and sausage rolls exclusively from physical stores any more. A 2020 partnership with JustEat and a new website and app means 7% of Greggs sales now come from online. In 2021, 2.17m customers ordered 8.5m Greggs meals online - many of which were probably delivered via pushbike.

Fundamentals: Quality at all levels

Fully integrated supply chain

Greggs’ original bakery business is still up and running. In fact it provides the core of the company’s fully integrated supply chain. With the exception of farming the produce and creating meat-free alternatives for its famous vegan sausage rolls, Greggs owns every aspect of its operations, from baking the goods and delivering them to the stores, to serving customers and designing and operating the digital channels. This structure provides management with full control, allowing the company to be flexible with its expansion and (as demonstrated during the Covid-19 crisis) closures.

Greggs vertical integration:

• Manufacturing: Including bakeries, cold storage units and factories
• Logistics: Warehouses, distribution centres and a fleet of vehicles
• Customer Channels: Company-operated stores, franchise stores and digital channels

Financially robust

Since transitioning to the food-on-the-go market in 2013, Greggs’ financial performance and position has strengthened:

• Revenue rose at a compound annual rate of 5.5% between 2013 and 2021 to £1.2bn
• Operating profits rose at a compound annual rate of 18.4% to £153m
• Costs are relatively evenly distributed at the gross and operating level. Gross profit margins rose from 59.8% in 2013 to 63.6% in 2021. Operating profit margins rose from 4.4% to 12.4% in the same period.

Excluding the 2020 financial year, when Covid-closures saw every one of Greggs’ stores shut and the majority of the staff put on furlough, the company’s recent growth has been similarly impressive. Like-for-like revenue growth (which accounts for store estate changes) rose to 9% in 2019 and pre-tax profit was 31% higher year-on-year at £108m. In 2021, the company bounced back from its Covid losses with revenue of £1.2bn up 5% on 2019 and pre-tax profits of £145m up 34%.

The balance sheet was strengthened by a fundraising during 2020. Net cash stood at £147m in June this year and the company also has an unused debt facility, which could provide £70m for any expansion projects. Greggs has a strong track record of using its capital efficiently - in the last five years, return on capital employed (ROCE) has averaged 19.4%.

In the business of selling fresh baked goods daily, inventory and receivables are relatively low and Greggs’ working capital position has historically been negative. But the company is rich in less liquid assets including land and buildings for manufacturing sites and fixtures and fittings for its store estate (most of the stores are operated out of leased premises). And Greggs is proficient at squeezing profits out of those assets. In the last five years, return on assets has averaged 14%, even including the non-profitable Covid-year.

Cash inflows are also impressive. In the year to December 2021, the company generated £286m of cash from operations, equivalent to an operating cash conversion rate of 187%. In the last five years, operating cash conversion has averaged 140%.

Reinvesting that cash in new fixed assets, including revitalising the existing store estate and the roll-out of new stores has been key to fuelling growth. In 2021, the company spent £54m on capital expenditure - roughly in-line with the five year average.

Happy staff, high incentives?

Earlier this year, Roger Whiteside retired from Greggs, paving the way for the company’s first female chief executive Roisin Currie. Her goal, according to the company’s most recent annual report, is to carry on the plan set out by Whiteside and to preserve the company’s family-led values.

Staff are well cared for and remunerated, meaning churn is low even among the lowest paid retail staff. At the start of 2022 and in light of impending inflation, management took the decision to bring forward a 3.5% staff pay rise and have agreed to a further pay rise this year.

The remuneration of senior staff members is tightly wound into company performance. Currie’s annual base salary, including pension and basic benefits is £541,000 but outperformance in profits, sales and share price could give her the opportunity to earn over £2m in cash and shares.

Employees to benefit from the company’s strong performance. Every staff member shares in the 10% of company profits which are set aside each year and all staff members are given the opportunity to buy discounted shares.

Beloved brand

The surge towards ESG investing has tempered as market conditions have weakened. But that doesn’t mean that steps companies take to do right by all their stakeholders should be overlooked. Good ethics makes for a healthy brand.

In the early days, Greggs would deliver a ‘Pie n Peas’ supper to elderly residents in the poor communities where it had its store estate. That scheme helped raise its profile in the North of England, where it remains a much loved brand. Today, Greggs provides a Breakfast Club to children in impoverished areas on free school meals. Further cementing its position as a ‘brand of the people’.

Alongside genuine acts of generosity, Greggs has mastered the skill of marketing. In 2019, amid much fanfare (and off the back of a big nudge and major publicity campaign from Peta), Greggs launched its vegan sausage roll. Finding the balance to satisfy a growing number of health-conscious vegans, while not disillusioning the core of meat-eating customers was no mean feat. The vegan sausage roll (followed by the vegan steak bake) have become staples of the Greggs menu and major talking points for the company’s Twitter followers. The former was singled out for the company’s phenomenal financial performance in 2019.

More recent marketing stunts have included the hugely popular launch of a Greggs inside a Primark store, alongside a range of Primark x Greggs clothing, which have proved alarmingly popular among the company’s growing younger customer base. Tickets for the inaugural festive bake brunch (marking the return of the annual seasonal menu) sold out in five minutes. Very few retailers, let alone food retailers, enjoy that level of commitment from their customers.

Outlook: Double revenue but at what cost?

In October 2021, Greggs’ management set out their vision to double sales. To do so will require major investment in the store estate and management plans to open at least 150 new stores every year to take the total store estate up to 3000. This year, that ambition has seen the company open new stores at two of London’s major travel hubs - Tottenham Hale and London Liverpool Street. Of the 150 new stores set to be opened this year, 40% will be run via franchises.

The expansion will not come cheap, but management identified the opportunity when many rivals went out of business during Covid-19 leaving premises vacant. A fundraising in 2020 has topped up the coffers to prepare the company for the expansion.

Higher revenues will also come from new extended opening hours, giving Greggs access to evening custom which accounts for 35% of the UK’s food-on-the-go sales. Greggs currently has 16% of the breakfast market, 10% of the lunch market but only 1% of the evening food market, meaning there is major scope for expansion. The food-to-go market as a whole is expected to grow more than 30% in 2022 to overtake its pre-Covid levels and the long-term outlook for the sector is optimistic.

Value of UK food-to-go sector by channel (£bn)

Aside from investment in the store estate, Greggs will realise its vision of doubling revenue by investing in the supply chain, including manufacturing sites and logistics. This year it has opened a brand new, automated frozen distribution centre and expanded its bakeries in Wales and Newcastle.

All this expenditure alongside an inflation-driven rise in costs means profit growth is not expected in this year or next. But rising revenues will fall through to the bottom line once the major capital investment has been completed.

Valuation: A rare opportunity

Greggs’ share price has fallen 33% in the year to date. Solid third quarter numbers announced at the start of October and a general recovery in the markets has seen an upward swing in momentum in the last couple of months, but still a price to earnings ratio of 18 times is a better entry opportunity than investors have seen for a long time.

In the last ten years, Greggs shares have only traded at 15 times forward earnings three times: in 2016, which was followed by an unbroken four year share price rise of 162%; in 2020, when the markets crashed at the start of the pandemic; and at the start of October 2022.

It would be remiss not to acknowledge the challenges facing cyclical companies. But Greggs’ low prices and loyal customer base has sheltered it from periods of economic weakness before. Like all retailers, Greggs’ growth might be constrained by rising costs in the short-term but bad economic times won’t last forever. The time to buy high quality cyclical companies is during moments of economic weakness, when everyone else is expecting the worst.

The investment case: An overview

Bull Points

• Fundamental quality: long-term track record for strong ROCE and cash conversion
• Ambitious expansion plans: Aim to double revenue by expanding the store estate
• Intangible quality: Well rewarded senior management, beloved brand
• Recent share price weakness reveals attractive entry point

Bear Points

• Inflation causing higher operating costs in the near term
• Expansion plans might put shareholder distributions on the back foot. The forecast dividend yield is 2.75% and dividends might not enjoy much growth while the company spends elsewhere.