:Greggs is the UK’s leading bakery retailer specialising in freshly made bakery food. With over 1,671 shops across the UK served by ten regional bakeries, our 20,000 employees are proud to serve six million customers each week. - Annual Report 2012.History: Greggs was founded as a bakery in 1939 and opened its first shop in 1951. After the death of the founder, his son Ian and his brother Colin took over. They expanded soon afterwards and bought bakeries such as Rutherglen in 1972, Thurstons in 1974, Broomfields, Price’s, Tooks etc in 1976. It started expanding outside UK by opening stores in Belgium in 2003, but failed to gain traction. They closed all these shops in 2008 and instead concentrated on the home front. They rebranded all their stores with a common Greggs brand so that they will benefit from a nationwide campaign. In 2012, the company began selling frozen pasties through food stores in Iceland. The company’s CEO at the moment is Roger Whiteside who held this title since Jan. 2013.
Greggs has been paying increasing dividends for the last 28 years [source: fool.co.uk].
The Bull Case: Greggs has a very easy to understand business. It has good brand recognition in the UK and has performed very well, even during the financial crisis post 2008. Let us look at some key figures of the company.
We see a growing business with very stable margins. We also see that the company pays nearly half of its income on dividends and has sometimes used the extra cash to buy back shares. The book value has doubled during the last decade and the company has achieved nearly 20% return on invested capital with no long term debt.
This says loads about the company, the business and its management. We quickly realize that the business is stable, the financial situation is exemplary and the management is able and shareholder friendly.
Let us now turn our attention to valuing the business. Given that the company pays dividend of £0.2, the question is: How much should the yield for such a business be ? I would venture that 4% is a very good yield to get for owning such a business. This puts the price at £5 a share (NOTE: This is a very superficial analysis. If you continue reading the article you will be surprised as to a clear cut investment like this may not look that great after an hour or so of research and some critical thinking. But this will come later. For now let us continue our little enterprise here). Let us look at the price chart of the company.
We predicted the market sentiment quite well with our valuation. The stock has been trading in the £5 range since the last year or so (even before). The drop in the price at the end of the graph i.e., now needs a closer inspection. Following is the chart for just the last year.
The price drop is explained by the outlook section of the Interim Management Statement of Greggs:
:The stock has already dropped from a high of £5.23 to £3.99 - at which it is trading now. The question is - Should we go ahead and buy a business with 5% yield, no long term debt, net cash of £15.38mn and a fantastic track record of near 20% RoIC with shareholder friendly management?
We do not expect a significant improvement in the difficult underlying market conditions in the short term. The business is focused on continuing with our plans to invest in core sales performance whilst taking action to reduce costs. Although we are only four months into the year, based on current own shop like-for-like performance we believe that profits for the year are likely to be slightly below the lower end of the range of market expectations. We believe that analysts’ expectations for the financial year ending 28 December 2013 are in the range of £47.5 million to £55.2 million.
A Closer Inspection: Following is the cash flow data from Greggs Plc from the last 10 years.
The company bought back most of the shares during 2006, 2007 and 2008. During this time the stock was trading in the range £3.56-£5.23. Observing the price graph, we may assume an average buy price of around £4.5 a share. This gives us a total of £85.5mn on share buybacks. The cumulative value of FCF, Dividend and Buyback has been shown in the table below.
Given that the company has not used debt, it did not need to pay a lot in interest expense. The FCF has gone into either funding the dividend or buying back shares. The company has spent £1 on buyback for every £1.65 on dividends.
A troubling development, in the meantime, is the fact that FCF has gone down over the years while the dividend has gone up. So much so that the trendline for the dividend has decidedly gone above the trendline of the FCF. What is not obvious from the graph below is that the total dividend paid is 1.8 times the free cash flow (for 2012). A situation like this is not likely to go for long - unless one of these three things happen: i) taking on debt to fund the dividend, ii) increasing operating cash flow, or iii) reducing capital expenditure.
i) Taking on additional debt is the most viable option in my opinion. Given that lack of debt was one of the most important attractions of Greggs as an investment case, I decidedly reject such an option as a basis for investment. Furthermore, given that the management has been loathe to any debt, this will be a “never before” situation for them - questioning such a move.
ii) Increasing operating cash flow is a good idea - if such a possibility exists. The 10 year revenue growth has gone from 13.23% in 2003 to only 4.9% in 2012. Greggs has tried to counter the decline by opening stores in different formats compared to its old high street bakery format. They now offer “food on the go” located away from the high street, “Greggs moments” in a coffee shop format, “Wholesale” by offering dedicated Ice cabinets in over 750 food stores across UK/abroad, and the recently planned 30 stores in Moto Service Areas. At least in 2013, this is not going to help. The company came out [BBC] and said that the sales have been down 4.4% so far this year. It blamed bad weather i.e., less opportunities to go out and “under pressure” consumers for the downfall. Given that Greggs already has twice the number of Starbucks and 200 more shops than McDonald’s in the UK (source [BBC]) - I doubt that opening new stores is a solution.
iii) Decreasing CapEx is the most reasonable idea which will also keep the investment thesis intact. The problem here is that the management already seems to be moving on with ii) and has planned to increase the CapEx instead.
Another fact I want to point out is that the capital expenditure has been quite close to the depreciation for Greggs - for a while.
In a situation like this, a dividend cut is the most probable outcome - if the sales continue to suffer in the short term.
Risks: Dividend cut is a very likely risk. Given that our superficial valuation rested on the track record of growing dividends - a cut will destroy our £5 fair value. On an FCF basis the company is very expensive. It has cash of £19.4mn and pension liabilities of £4mn. At £4 a share, the market cap is £404mn and the EV is £388mn. At £11mn in FCF the EV/FCF ratio stands at 35 ! Far from being cheap, this is an expensive price to pay for any business.
Like McDonald’s the company does not really sell healthy food. The health conscious crowd will probably not be a customer. Starting in 2003, Greggs opened 10 stores in Brussels as a “controlled, low cost, experiment”. This was seen as a launchpad for opening the business in France, Germany and rest of the Europe. By 2008 the company realized that it was unable to gain traction in the Belgian market, closing the stores at £3.5mn “exceptional loss”. The failure could be due to several reasons including not developing the brand, not giving it enough time, pricing, and any number of differences between Belgium and UK. The main outcome is that Greggs will not venture outside UK for the near future.
At first glance, the business does not seem cyclical. But the management report that I quoted above seems to disagree. Lack of consumer spending and seasonal changes can affect the business. I guess customers might think Greggs’ products as a “treat” and hence would cut down on it if they are suffering financially. Similarly, the business of Greggs is predicated on customers going out of their houses in large numbers. Good weather definitely helps the business.
Another significant risk is the possibility of increasing raw material prices. Greggs will have trouble passing these on to the customers. This will either decrease margins or decrease the revenue.
Additional Disclosure: I do not hold any shares. I got the idea from BBC while browsing their business section. The data/news has been taken from BBC, ft.com, and morningstar.com.
About the author:
Chandan DubeyI invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.