Greggs: A Tougher Time Coming

Summary

• U.K. bakery and takeout brand Greggs has a unique proposition and a compelling long-term story.
• But its shares already reflect its strengths and this will be a challenging year for it.
• Unknowns around lockdown exist, the future of working and Brexit will limit momentum on the stock in the coming twelve months.

Greggs (OTCPK:GGGSF) is a British bakery chain whose business and shares have had a good run in recent years. I think that it is a good business and can provide a solid investment at the right price point. I continue to maintain confidence in the business and the current management, but I think the lockdown and economic downturn have thrown up a number of obstacles which make the share less attractive than usual on a short- to mid-term basis.

Greggs: A National Bakery cum Hot Takeaway

I haven't seen a direct corollary for Greggs in most countries so it's helpful to understand what its customer proposition is. Essentially it's a bakery and indeed it formerly styled itself as "Greggs the bakers". It does provide traditional bakery items such as bread and cakes. However, a large part of its business is its role as a takeaway food supplier, both hot bakery items and sandwiches. Some shops also offer the option to eat in, at a relatively small price premium. It also offers hot drinks in the same vein - competitively priced at around a pound or so, and just another twenty pence to sit in, with a store environment that is warm and bustling although lacks the sophistication of, for example, Starbucks (SBUX).

A lot of competitors would be small, local operators, so Greggs with over 2,000 outlets occupies a unique niche as a national (albeit unevenly so) hot food takeaway chain combining taste with competitive pricing. In that sense, its competitive set includes food operators such as McDonald's (MCD) as much as it would include traditional bakers.

Greggs Knows How to Run a Business

Greggs has a skilled management team able even to get strong growth from a mature business, as this slide shows. They have introduced innovative products to maximize their estate, including a breakfast offering. They have also used social media astutely to gain cult status and media attention for key products.

Note that even in the "weak" comparison set, there was still positive growth each quarter.

Source: company interim report 2019

Before COVID-19 took hold in the U.K., it was also showing a strong start to 2020. Shop like-for-like sales grew by 7.5 per cent in the nine weeks to 29 February 2020, according to its preliminary results announcement.

Long term, the historical record, unique proposition and astute management bode well for the company's success.

Greggs' Share Price Factors in Its Success

Greggs' shares have had a stellar few years:

Source: Google Finance

But even at today's price of 1,742 p (down from a year high of 2,550 p), the company is still trading at a significant premium to its historical levels. In the past couple of years, for example, its shares had a sharp run up, but its business results while strong were not stellar in my view.

Source: company annual report

At today's share price, the P/E (using the most recently reported earnings, 2019) is over 19. Using the 2018 earnings instead, the current P/E is 25. 2020 earnings will certainly be strongly hit by the lockdown, but if 2021 can get to 2019 levels again - no mean feat - the p/e will be 19, if 2021 continues to suffer from the long tail of lockdown and other disruption risks like Brexit, and retraces to 2018 earnings, the P/E at today's share price is 25.

Source: company annual report

A P/E in the high teens or low twenties is not low for a long-established retailer in a demanding market environment. I don't think the share price will reasonably support a much higher P/E on a sustained basis in coming months, and so I see limited price upside for Greggs' shares on that timeframe.

Why 2020 Will Be a Bad Year for Greggs

Greggs is a well-run corporate and has taken significant measures to counteract the impact of the U.K.'s lockdown (March announcement here). It suspended a lot of capex, paused its store opening program and also cancelled its previously announced dividend. Both the CEO and finance director bought shares at lows near the end of March, when the U.K. was in lockdown:

Source: Hargreaves Lansdown

However, in its update of 9 April, the company said that even with its mitigation actions, the net weekly cash outflow would be c. £3.5 million, and rental of £11 million per quarter, at a time when it only had £47 million cash at bank, which would not quite cover one quarter. It accessed the Bank of England's commercial paper scheme for a sum of £150 million, which would be enough on my calculation to keep the chain going for another 33 weeks, an ample margin of financing. This buys time - the issue is not about whether Greggs will weather the storm, but how it will look coming out of it.

There are a number of reasons why I believe 2020 will be challenging for Greggs, however, mostly related to the demand side.

First, the British retail sector is going through a torrid time and there is a long list of bankruptcies this year which will likely grow. This will reduce customer footfall in key areas. Greggs gets a lot of unplanned visits from customers out and about, as it's typically not an aspirational destination for shopping, as may be a Starbucks or Costa Coffee.

Secondly and more importantly, Greggs relies for town and city center workers for most of its business. Its store estate is in business and retail areas, not residential ones. So if the number of people coming into those areas to work sees a significant reduction, Greggs will see its trade fall off accordingly. This is already being seen in the lockdown impact on the sandwich trade - sandwich maker Adelie Foods collapsed last week, with over 2,000 job losses. This reduced demand for casual eating by out of home workers is where I see the main short-term risk to Greggs' share price. I expect that most workers will return to their former working patterns after lockdown ends. But it will not be immediate, which will depress sales for several months, and more significantly it will be most but not all workers. If half of office workers decide to work from home just one day a week, that will already be 10% less opportunities for them to visit a Greggs for lunch. After years of sales growth, the impact of this will be felt in the share price.

At this point, it's hard to know what the impact will be. Greggs did fare well before lockdown: it reported a 9.9 percent like for like sales decline in the week to 21 March 2020, just two days before the U.K. entered full lockdown and when weaker retailers like Laura Ashley had already entered administration citing the impact of COVID-19. However, it's hard to envisage a scenario where the workforce is going out to work as they did before the lockdown with the same frequency, so I think some sales impact is inevitable. If job losses are sustained in a post-lockdown economic downturn, that will also impact the number of lunches workers eat out of home, although given its highly competitive price point, Greggs could actually see some uplift from tightened consumer spending. It's worth noting, by the way, that the company has trialed selling its foods in frozen form through retail channels: an interesting idea, but not big enough to impact my thesis in this article.

On the supply side, there are also some storm clouds. The U.K. food ingredient supply chain has been tested by the lockdown and panic buying, although it has reacted well overall, there may be some price fluctuations as a result which could impact margins for bakeries. No sooner will public attention have eased off COVID-19 then it will start to turn once more to Brexit, which is scheduled for later this year and is already rearing its head in the news cycle once more. No matter what agreement is reached on trade with the EU, or Greggs' limited exposure to European suppliers, there will doubtless be concerns about price impacts on U.K. suppliers. This is something Greggs flagged previously (see this article), which I expect investors to worry about more as the reality of Brexit dawns. On the positive side, at the time of that article there was concern that Brexit could lead to higher labor costs, but given the unemployment in the U.K. as we emerge from lockdown, I think there will be affordable labor available in the U.K. regardless of Brexit.

There may be some more positive mitigating factors too, for example a review of business rates and also increasing retail vacancies give Greggs some more negotiating power with their landlords. Long term both these factors could be positive for the company, but I expect limited upside from them to be factored into the share price in the short term.

Conclusion

Greggs has carved out a strong, defensible position with a distinctive consumer proposition. In the long term I expect its success to continue. In the short to medium term (between now and mid 2021), I expect a stream of disappointing news to mean its share price doesn't gain substantially. As there are other companies I expect to do well coming out of lockdown, I don't think Greggs represents good value at this time.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Challenging trading environment in 2020 and start of 2021 will mean drip of disappointing news, limiting upside for the shares at today's prices