Greggs share price takes battering: has it still got the recipe for success

Lower footfall and tighter purse strings has been testing the resilience of UK retailers, but Greggs has outshone its neighbours and proved there is still appetite among consumers. But the slowdown has started to bite and Greggs shares have suffered.

Joshua Warner @JoshWarner_IG
Analyst, London

Publication date : 2018-05-17T15:31:00+0100

Source: Bloomberg

‘I think baking is very rewarding, and if you follow a good recipe, you will get success,’ – Mary Berry.

Investors have become accustomed to tasting success when it comes to Greggs, the hardy, no thrills baker famed for its sausage rolls. While not immune to the current downturn in the UK retail sector, Greggs has thrived at a time when other eatery chains like Prezzo and Jamie’s have fallen. The baker has been treated as a safe haven for investors looking to put their cash into the ailing high street over the last two years – a port in a storm.

Greggs has delivered four consecutive years of like-for-like growth while rapidly expanding its business, and shareholders have been further sweetened with reliable lifts to the dividend payout. Investment has held profit back, but Greggs has no plans to stop spending and has earmarked at least another £125 million of investment going forward.

Shareholders have previously thrown their support behind the company’s plans and spending priorities because growth had remained stable. But it has been slowing, and Greggs is starting to feel the pinch after issuing a profit warning earlier this month, sending Greggs shares to their lowest level in over a year. So, has Greggs still got the recipe for success or have things turned sour?

Greggs is investing heavily in its supply chain, manufacturing and IT systems

Greggs has left no stone unturned when looking for ways to deploy its cash and improve the business. The company has been overhauling its systems and processes for the past four years and 2017 was the biggest roll-out yet, but investment will continue for a fifth year in 2018 with £25 million budgeted.

Elsewhere, Greggs continues to undertake a far bigger £100 million investment that was started last year. The company is taking more control of its supply chain and consolidating its manufacturing operations so it can become more competitive on pricing and quality, while improving product availability and, twinned with better IT, lower costs in the long run.

With stores to continue opening at a rapid pace, Greggs is looking to increase the capacity of its logistical operations, while manufacturing sites are being reorganised and turned into ‘centres of excellence’ that will specialise in certain products. Having moved its manufacturing from Edinburgh to Glasgow last year, the site was then extended to become a centre of excellence for Yum Yums. The factory in Leeds specialises in cakes and muffins, and the newest addition (to be introduced later this year) will be in Newcastle, where the Gosforth Park bakery will look to lead the way in doughnut production.

The £125 million programme will reach peak spending this year, and ultimately the plan should see all three elements – the supply chain, the manufacturing operation, and the IT systems - all come together sometime around 2020.

Greggs refreshing its stores and opening new branches at rapid pace

The investments being made in the back-end of the business are designed to propel its plans to continue opening new stores.

One element behind the baker’s resilience during the downturn that hit other retailers has been its network of stores in areas with reliable foot traffic, regardless of economic conditions (such as travel hubs like service stations), and locations that target workers, including industrial parks and office estates. While people are used to seeing a Greggs on their high streets and in their shopping centres, it is clear that the company sees better opportunities away from the high street, where it has traditionally capitalised on its neighbour’s footfall.

Although the growing network of stores is fuelling much of Greggs sales growth, the baker has proven it can choose the right stores in the right locations, and is willing to shut any branches that are failing to perform. The baker opened 41 new shops in the first three months of this year alone, and closed 12. Like-for-like sales have grown annually for four years, and the return on investment from stores that it opened in 2016, which are now part of its mature portfolio, have been better than expected, proving its strategy is on the right path.

Greggs opened a record amount of new stores last year, adding 131 new branches while closing 41. That record could be broken again in 2018, which will see between 110 to 130 additions on a net basis, including those opened and closed in the first quarter (Q1). The focus for its existing network has been on transforming its older bakeries to fit its ‘Food-on-the-Go’ format, which centres on convenience. Greggs understands customers don’t come out specifically for a sausage roll, and that it has to catch the footfall provided from neighbouring retail outlets.

Greggs targets new locations to escape ailing high-streets

The high street is struggling to find its role as shopping moves online (something food retailers can only have so much success in), and competition for the hunger of the people left has increased with the likes of supermarkets (and firms like McColl's Retail) pushing their ‘meal deals’, which has also hit the likes of Wetherspoons.

Greggs is, once again, being proactive and pursuing new locations that aren’t suffering from boarded-up windows and lower custom.

The baker has said that any hospital that wants a Greggs can have a Greggs, and its presence in travel hubs has taken a step further after it opened a branch in Westminster Underground Station in central London in March. Interestingly, stationary and book seller WH Smith, while struggling on the high street, has seen its travel and hospital stores continue to deliver.

Convenient food for on the go and a drive-through are synonymous. Whitbread, the owner of Premier Inn and Costa Coffee, bravely took a new tact when it opened its first drive-through store in Nottingham back in 2011, which has since seen a large network emerge across the country. Greggs has opened its first drive-through in Greater Manchester and has been pleased with the results, suggesting more could be opened in the future.

Geographically, Greggs has plenty of room to expand. In a nutshell, the further south of England you go the fewer Greggs you will find. Greggs thrives in the north of England, but is barely present along the southern coast or in the south-west of the country, where its stores are concentrated in the biggest cities like Brighton, Portsmouth, Bournemouth, and Plymouth. In addition, Northern Ireland is still a fresh venture since Greggs launched its first store in 2016. There are now at least nine stores in the country, with six in the Belfast region.

Greggs has 1883 stores, according to its latest update released earlier this month, and the ultimate goal is expand to a 2000-strong network. Based on its targets, it could hit this either this year or next. But some analysts believe Greggs has the potential to grow its network closer to the 2400 mark. Greggs is not the only food and drink retailer that is rapidly expanding, as other types of retailers selling the likes of clothes or housewares continue to shut. Sandwich shop Subway is expected to open thousands of stores before 2020 and Costa Coffee, which already has more sites in the UK than any of its rivals, is also still expected to open thousands of more stores as the competition continues to intensify with Starbucks and independent firms.

Greggs: expanding beyond sausage rolls and pasties

Greggs has responded well to the growing and gradual trend toward healthier eating habits and its ever-evolving menu has demonstrated the baker is much more than just sausage rolls. It started with a first and tentative step by selling coffee and salads, but now the baker offers a much wider range that includes soup, pasta and and gluten free options, helping boost its universal appeal. Coffee sales hit a record high last year and its cheap breakfast menu (coupled with its 7am opening times) has been popular.

Still, Greggs has no intention of turning its back on its bread and butter, or in this case sausage rolls and pasties. Greggs believes in balance, which bluntly means selling the unhealthy food that has made it so successful, and healthier options to appeal to a wider audience, following the path of fast food giant McDonald's.

The ‘balanced choice’ range of less than 400 calorie products is growing, but still represents a nominal amount of revenue. The range generates over £100 million of annual revenue and sales rose by £2 million in 2017. The range will play an important part in Greggs meeting its target to raise the sales of all its healthier choices by 10% this year.

While Greggs is famed for its affordability, the baker does not see much leeway when it comes to prices and therefore it focuses on introducing new products and focusing on quality. Lowering the prices of sausage rolls will do nothing to raise the footfall outside.

Customers want convenience and Greggs is catering to their needs

Greggs is looking for opportunity outside of its stores which will increase its interaction with the newer but still formidable kids on the block: Just Eat, Deliveroo and Uber Eats – who have carved out the food delivery market for themselves.

Greggs is building on its offer to the hungry workforce by trialling office deliveries to reinforce its mission to make things more convenient for its customers, but the firm has said it is a ‘slow burn’. It has confirmed it will introduce some type of ‘click and collect’ service, and it has admitted the idea of conducting home deliveries has not been ruled out.

The likes of Just Eat has transformed the market, by acting as a middle-man between small independent takeaways and the customer, providing a centralised online platform to supply traffic. Still, there are fast-food giants like Burger King (mostly franchises) that deliver to customer’s home and utilise Just Eat’s service to avoid the costs of setting up its own system. On the other hand, some segments have refused to cave in and give a slice of their profits to these online platforms, with the country’s two biggest pizza firms (Domino's Pizza and Pizza Hut) both hosting their own online platforms for deliveries.

Unless Greggs has considered launching a home delivery operation when drawing up its existing budgets then it is likely that any entry into the market would start out small, possibly concentrating trials in the biggest towns and cities that have the most stores. Depending on where any trial would be conducted there could be opportunities with either Uber and Deliveroo. However, Just Eat would be the only viable option for a nationwide operation after it bought out its biggest rival Hungryhouse last year to consolidate its position as the market leader.

Greggs will be monitoring the likes of McDonald's, which is rumoured to be considering its own service. Although the home of the Big Mac has successful delivery operations in other countries, it has tried and failed in the UK on more than one occasion.

On the digital front, the baker’s loyalty scheme, the ‘Greggs Reward’ app, has been downloaded by over one million people.

Investment by Greggs is holding back profit and special dividends

Greggs backs its investment with steady cashflow and a healthy cash pile, but profit has been held back due to ongoing investment and the prospect of a special dividend, which investors found an appetite for following a payout in 2015, remains low.

Net cash flow has grown 69% over the past five years, but remained flat in 2017 at £116.9 million, from £117.6 million the year before. Net cash grew by £9.5 million and sat at £54.5 million at the start of 2018, which is expected to fall to £40 million by the end of this year as spending peaks.

Having spent £70.4 million in 2017, capital expenditure will peak this year with Greggs setting aside a budget of £95 million. Substantial sums will be spent on opening new stores, and around £45 million will be spent on its manufacturing facilities. Most of the work on its IT systems is yet to come, and the bulk of the work won’t start until 2019, when spending will also begin to shift more toward its supply chain programme. On the assumption it will open around 100 new shops each year, Greggs anticipates capex will hold steady at £95 million in 2019, before dropping off to £80 million in 2020 when its numerous programmes draw to a close.

Greggs has vowed to return surplus cash to shareholders using special dividends, but has implied that its cash flow this year will only fund its costly investment plans and its progressive dividend policy, meaning shareholders will have to be content with ordinary dividends until beyond 2020, or possibly 2019 at the earliest. However, if all goes to plan then patience will pay off, as the company will emerge at the start of the next decade with plenty of cash, low spending requirements and a more efficient and profitable business to allow investors to reap all the rewards from years of work.

Annual budgets have largely aligned with profit since 2014, and the return Greggs receives from the capital it deploys has correlated with spending since 2013 following years of declines. Greggs delivered an adjusted return on capital employed (ROCE) of 26.9% in 2017 compared to 28.1% the year before, falling as a result of the higher investment in its supply chain.

But Greggs still delivers growth and higher dividends

Despite profit having stagnated for the past three years, investors have taken comfort from the consistent growth in sales, like-for-likes and the progressive dividend. Greggs performance last year was impressive.

Greggs sales hit record in 2017 but profit held back by investment

(millions)	2008	2009	2010	2011	2012	2013	2014	2015	2016	2017
Shop number	1409	1419	1487	1571	1671	1671	1650	1698	1764	1854
Revenue	£628	£658	£662	£701	£735	£762	£806	£836	£894	£960
Sales growth	7.1%	4.8%	0.6%	5.8%	4.8%	3.8%	5.7%	3.7%	7%	7.4%
Like for like growth	4.4%	0.8%	0.2%	1.4%	(2.7%)	(0.8%)	4.5%	4.7%	4.2%	3.7%
Adj Ebit margin	7.1%	7.4%	7.9%	7.6%	7%	5.4%	7.2%	8.7%	9%	8.6%
Pre-tax profit	£49.5	£48.8	£52.5	£60.5	£52.4	£33.2	£49.7	£73	£75.1	£71.9
Dividend	14.9p	16.6p	18.2p	19.3p	19.5p	19.5p	22p	48.6p*	31p	32.3p
Total return	(22%)	29%	11%	13%	(6%)	1%	70%	87%	(23%)	47%

^{(*includes special dividend of 20p), (Source: Greggs, revenue figures have been rounded).}

Greggs sees confidence temporarily knocked but long-term appeal firmly intact

Greggs had installed confidence that growth was still going strong in the early stages of 2018. But the 3.2% lift in like-for-like sales in the first eight weeks of the year still signalled that the tough conditions were starting to bite and growth was continuing to gradually slow. When it released its latest update this month it revealed like-for-like growth had plummeted, coming in at just 1.3% in the first 18 weeks of the year compared to 7.4% growth the year before. Growth in total sales slowed to 4.7% from 7.4%.

The same culprits that hit the entire sector were partly to blame, like the bad weather (and that only hit sales by 1%), but the ultimate message that investors took home was that Greggs is no longer the safe haven of the high street. Customers continue to spend more in Greggs, there is just less of them. Offering a wide range of products, opening early and on Sundays, and the gradual improvements that will come through its substantial investment will be all the more important as a result, and although investors are wary of the immediate challenge ahead the belief behind the long-term strategy should remain strong.

Greggs shares plummet to new lows following first quarter earnings

Greggs shares took a pounding in 2016 but started to recover from all-time lows as it entered 2017. Shares jumped 46% last year to climb to an all-time high of £14 in late December, but shares gradually dropped off as investors began to read across the weak retail sales data, inflationary pressures and weak results that were coming out from other retailers like Debenhams.

Q4 results were released in mid-January and its annual report followed at the end of February, and neither inspired much support behind shares as investors were wary from the rest of the sector. Their caution was justified following the recent profit warning, prompting the second biggest daily fall on record – erasing the gains it had built-up over the previous 14 months.

Greggs chart

Where next for Greggs?

Greggs tried to assure shareholders that sales in early May had picked up from the subdued levels seen in March and April and were better than expected. The baker said it is well positioned to compete with its new summer range and its new meal deal offers. Still, Greggs held off being too optimistic, and warned that underlying profits in 2018 would be similar to the £81.8 million reported in 2017.

Analysts lowered their forecasts after the warning. Edison Research trimmed its underlying profit forecast by 4% to bring it in line with last year’s result. Profit forecasts for 2019 were lowered by 8%, but Edison still expects annual growth of 2.4% to £83.8 million. Edison expects profit to normalise in 2020 as it starts to reap the benefits of its investment programmes, predicting an 8% year-on-year rise to £90.5 million. Based on the company’s policy and its own forecasts, Edison expects the dividend this year to rise from the 31p payout last year to 31.8p in 2018, and 32.9p in 2019.

When does Greggs report next?

The next set of results due from Greggs will cover the first half of 2018 and be released on the last day of July. The baker has also set a tentative date for when it will release its Q3 update, provisionally pencilling in 2 October.

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