Is Greggs oven-ready for a return to growth?

Greggs Plc is the UK, quick-service bakery chain behind the nation's favourite sausage roll. It has over 2000 shops in the UK and has evolved in recent years to move further away from the highstreet, increasing its presence at transport hubs and out of town locations. Greggs delivered record results in 2019 (a product of increased store footprints), successful product launches (with the rollout of a vegan sausage roll) and fantastic marketing and PR combined. However, 2020 was a year that brought Greggs back to earth: forced store closures, empty high streets and the loss of a lucrative office worker lunch schedule due to Covid-19 crippled Greggs’ ability to deliver its usually consistent results. The effect of the pandemic is likely to remain with Greggs for some time, so is now a good time to look at the shares?

Two Greggs' sausage rolls balanced on Greggs' paper bags.

Photograph: Greggs

Greggs operates a very simple business model; it has a total of 2078 shops in its estate, to which 328 are franchises. Greggs endeavours to own the majority of its stores, unlike typical quick-service restaurant brands that operate a highly franchised model. Greggs will choose to partner with corporate and other large franchisees when owning a store is infeasible or unsuitable — for instance, in a petrol station, where the station owner would seek to own a franchise unit over renting the space out to Greggs. This means that Greggs can focus on what it does best, producing quality baked goods, sandwiches and pizzas at a considerable scale in its manufacturing facilities, then delivering these ‘oven ready’ goods to its 2000+ stores across the UK for sale. The scale and quantity of finished goods Greggs is able to deliver means the cost of production remains fairly low, and this can be passed on to consumers with relatively cheap prices compared to the other quick-service offerings on the high street.

You will often hear me chiming to the intrinsic value in operating a highly franchised model. For instance, in the case of recent articles on Domino’s Pizza or Wingstop; these franchise brands create steady cash flows from royalty payments and can scale quickly as the franchisee stumps up the initial capital for the store. However, in Greggs’ favour, operating a centrally owned estate can have its succinct advantages too. The trouble with franchising out your store estate is that franchisees tend to get pretty upset when you allow another franchisee to set up another store in the same catchment area. This issue was seen for Domino’s Pizza Group (UK plc) in 2019, when it decided to further split store catchment areas, resulting in lower profits for individual franchises. This unwillingness from existing franchisees to give up sole rights to a catchment area can result in heavy pressure on the company’s ability to further grow store count — a key contributor to growth for the industry. As most Greggs’ stores are owned by the central business, Greggs doesn’t have this problem, and it is also why Greggs has been able to amass a store count of over 2000 stores in the UK alone, which is more than McDonald’s, KFC’s or Starbucks’ individual store counts. This number is beaten only by Subway and Costa Coffee. For the years ahead, Greggs believes it can squeeze 3000 stores into the UK — a formidable feat. As stores are centrally owned, increasing the footprint of stores in areas that already have a store also keeps a lid on distribution costs, as Greggs will be delivering to multiple stores in that area.

Source: Google Finance, Greggs Share Price

In terms of recent performance, Greggs has had much success in the years to 2019, delivering stellar share price gains for investors. Share price performance has been volatile — as seen in the graph above — with large swings seen in the good year of 2019 and the subsequent challenging period evoked by Covid-19. In 2019, revenue grew 13.5% and earnings per share rocketed 30% higher, with operating margins touching a recent record of 10.3%. However, with the onset of national lockdowns and subsequent low footfall across UK high streets, Greggs’ revenue slumped 30% in the full year 2020, and 2019 profits were wiped out as the company swung to a loss in 2020. Greggs isn’t expected to return to pre-pandemic levels of revenue and profit until 2022, and even then, there are questions around the future of particular stores and their ability to grow with the likelihood of a reduction in the commuting workforce. News of vaccines and hopes of economic re-opening has since sent Greggs’ shares 90% higher from the Covid bottom, and one could argue much of Greggs’ return to growth has been baked into the shares at current levels.

So what strategies will Greggs look to employ to return to growth in a post-Covid world?

Source: Greggs' Final Results Presentation

Greggs has a new strategy it hopes will be the driver behind customer engagement in the medium term. Dubbed ‘Next generation Greggs’, new strategies diverging from the usual expanding store estate are focused on:

  • Delivery

  • Greggs’ loyalty programme

  • Drive-Thru

  • Click + Collect

  • Made to order customisation

  • Day/Evening shift

Greggs has already had some success leveraging its supply chain to facilitate new opportunities. In 2011, Greggs migrated its products to the freezer section of Iceland in efforts to capture a new set of customers from its existing production facilities. Delivery and evening shifts could also capture new customers (or existing customers who wouldn’t have purchased during the existing model), whilst not really increasing costs for Greggs.

As ever, Greggs is focused on new products. Much of the recent success has been in developing vegan alternatives to its existing product lines. The vegan sausage roll and the vegan steak bake got off to a fantastic start, with widespread media coverage and a helping hand from Piers Morgan who accused Greggs of "wokeness" — this helped drive footfall, with consumers who were curious as to what the vegan sausage roll was all about. Greggs intends to keep up the pace on vegan and health food options, which will help balance Greggs’ offering to more health-conscious trends.

Source: Greggs' Final Results Presentation, Growth Opportunities

The long term challenge for Greggs will be meaningful growth in store estate past its estimated capacity for the UK of 3000 bakeries. An intrinsic quality beholden to startups in the US or larger geographies is the scale and potential to grow in your home market. Popular food chains in the US can rack up store units in the tens of thousands; Subway’s US store count is over 25,000. Therefore, a risk to Greggs for the long term is a potential cap on the ability to grow units. International expansion could be done, but as shown by the question marks on the recent presentation, I am not sure management are convinced. Sausage rolls and pastries are quite a unique taste to the UK, and I am honestly not sure I could envision the Greggs offering going down too well outside the country. Shops could be opened in areas with a high level of British ex-pats missing a fond taste of blighty, but this really isn’t going to deliver a meaningful level of unit growth.

Source: Greggs' Final Results Presentation, Cost Pie Chart

Another key challenge for Greggs over the coming years will be navigating any rising costs. With a thinner operating margin than the typical quality businesses I like to look for, Greggs is at risk of inflationary pressure taking a further chunk out of profitability. With affordability key to Greggs’ offering, there isn’t much room to manoeuvre on price if Greggs wishes to remain competitive at the value end of the foodservice market. People costs and food & packaging costs are the two main inputs. Wage growth for those on the minimum wage in the UK typically outpaces inflation and minimum wage growth has outpaced nearly all international equivalents over recent years (according to the Low Pay Commission). This input cost however is typically low-risk as the increase is usually gradual and set by governing bodies and represents a significantly lower risk compared to companies exposed to high input costs from Oil, Metals, Energy or Cotton commodity inputs, which are typically much more volatile.

Looking at the key financials, we can start to understand more about Greggs’ financial performance over recent years. Growth for the years to 2020 had been pretty consistent in the range of high single digits, until a very good year in 2019. It’s pretty clear Greggs isn’t the type of business that will deliver blow-out revenue growth in any given year, but consistent growth at high single/low double digits can create a compelling financial return for shareholders. Operating margins have steadily grown as Greggs becomes more established and grows scale. However, in the difficult year of 2020, this operating margin was wiped out, with Greggs posting an operating loss of 7m. In a highly leveraged business (which Greggs isn’t), consecutive years of losses can be a warning sign for liquidation, but for a company like Greggs with 80 years of operating history and ample liquidity, the loss in 2020 represents a minor blip, which Greggs can amply bounce back from in the years ahead. Unlike many of Greggs’ hospitality peers, Greggs managed to get through the year without an equity raise (when a company issues more shares on the market, typically at a lower price to institutional shareholders to raise capital. This increases the share count and dilutes existing shareholders). A quote from Gregg’s full-year accounts reflect its financial robustness:

'Greggs sought debt financing to support its short-term liquidity requirements, which was forthcoming from both government and commercial sources due to the financial strength of the business and its significant contribution to the UK economy. Loans from the Bank of England under the CCFF facility were fully repaid by the end of the year and the business finished the year with net cash in the bank.'

As Greggs does not operate a majority franchise model, operating profits are thinner than typical quick service peers. However, Greggs does have a very good record when it comes to capital efficiency with an average ROCE of 21% in the three years to 2019.

Looking at Greggs from a valuation perspective, the market is certainly expecting a return to growth in the coming years. A price of 24 times expected earnings in 2022 is fairly full for a business that would usually grow fairly moderately with low-ish margins. This valuation is well above the average for businesses in the UK and realistically a little pricey for the current challenges Greggs is facing. Greggs is a well-run business, with a solid balance sheet and reliable customer base, and it will likely be selling Chicken and Steak bakes across the UK for many years to come. However, at current levels, Greggs just isn’t profitable enough or growing fast enough to justify the premium price.

The Twenties Trader owns no position in Greggs plc.