Should Investors Take a Bite out of Greggs?

The Greggs (GRG) share price took a downturn on results but then bounced sharply on above average share trading volume. I assume that the results did not generate enough selling to accommodate buyers, presumably looking for good near-term dividend income. The shares appear to go XD of a 21.2p ordinary dividend on the 20th of May. The shares are attractive for their strong cash generation and high net asset value. The earnings due to the total absence of balance sheet debt may be judged of good quality at a time when such quality is important.   

The results for the year to January 2nd 2016

First, the top line showed the attraction of sales in money terms rising 5.2% to an annual total of just over £835 million. As a demonstration that the company is seeing rising demand from existing customers, reported like-for-like sales rose 4.7%, meaning that more than 90% of increased sales came from existing shops and cafes etc. and not from new outlets – although there were some of those as the management closed some and opened others (something that is an ongoing aspect of the Greggs way of business).

Profit before tax (excluding exceptional items) also increased by an attractive 4.7% despite a strong rise in capital expenditure last year (no doubt due to the substantial shop and cafe refurbishment undertaken last year).

Most tellingly, there was also a magnificent hike in dividends. The final ordinary dividend was raised a whopping 31.5% from 16p the year before to 21.2p this time. In consequence, the annual dividend was increased from 22p for the previous year to 28.6p. We are also informed that there was an extra £21.2 million for distribution as a special dividend, which, according to my rapid arithmetic, looks like being worth an extra 1.9% or so. The accounts show a figure of £44 million paid pout in dividends last year, contrasting with the £20 million shown as being distributed the year before. In short, the company appears to have paid out in dividends, of one kind or another, an amount equivalent to 4% the equity’s current market capitalisation of £1,100 million.

The management’s current dividend policy is summed up as follows:

“During 2015 the Board carried out a review of the appropriate capital structure of the Group, including consultation with some shareholders on different options for returning surplus capital.  Given the leasehold nature of the shop portfolio the Board concluded that it is not currently appropriate to take on structural debt and intends to maintain a net cash position.

In 2015 the Group paid its first special dividend of 20.0p per share (a total of £20.2 million), in addition to ordinary dividends paid in the year totalling 23.4p per share.  Our Finance Director, Richard Hutton, outlines the expected application of the distribution policy in more detail in the financial review.”

Trading

The company last year undertook an important redesigning of its shop premises to bring them up to date and fully competitive in appearance with the likes of Costa and Cafe Nero. In my judgement, and to judge from last year’s sales figures, that has been pretty effective. You will recall that previously Greggs’ outlets had a slightly tatty appearance and were decked out in the rather cold colours of blue and white: that is no longer the case. They have now caught up with the rest of the competition and are now painted in more contemporary warm colours.

Capital expenditure and investment

During the course of the year 202 shops and 25 premises were given this design makeover. At the end of the year Greggs had just under 1,700 trading outlets. The company states that it plans to invest £100 million over five years on its manufacturing and distribution resources. Last year, the company recorded £72 million of capital expenditure; more than half the £48 million they had expended the previous year. Last year combined capital expenditure and what they describe as “investment” totalled £125 million, in contrast to £101 million a year earlier.

Cash flow   

Despite and no doubt because of the aforementioned investment and capital spend, operating cash flow also rose significantly. Operating cash has risen in each and every year over the last three years. In 2012 it had shrunk to £46 million. Last year it had increased to £104 million after an annual rise in operating cash of more than 7%. Thus, operating cash last year covered the total dividend payout of £44 million 2.3 times. Cash and near cash in the balance sheet on January 2^nd was a near matching and very tidy £43 million. I add that the company has reviewed its capital needs and judges there to be more than enough cash generated by the business to justify the special dividend distribution (mentioned earlier) and to rule out any need to take on debt. Remarkably and unusually, Greggs manages to run its business without any borrowings. Even at theses low rates, it has decided not to take on debt to flatter earnings.

Margins and returns

In that connection, it is instructive to note that Greggs had a gross margin of over 63% last year, an operating margin of 8.75% and a bottom line net margin   of slightly under 6.9%. Its total return on assets was over 15% and its return on investment was 21%, which without the gearing of debt turned into a 22% return on equity. It is a picture of remarkable financial rectitude, adding greatly to the quality of Greggs’ earnings.

Assets and earnings per share

The company, without borrowings, employed total assets valued at £384 million – worth, on my estimation, about 380p a share. These assets are commanded by ordinary shareholder equity of £266 million, worth, on my estimate, somewhere in the region of 263p a share, representing nearly a quarter of the share price of 1,090p, last seen. That of course transforms the price to earnings ratio if you subtract that amount from the share price, to establish more precisely what it is an investor is paying for the actual earnings per share.

What next?

It is self evident that the company is being driven in part by investment in its shop and cafe outlets, manufacturing and the range of product offers for a changing market. Clearly, it is meeting with earnings success, to the benefit of cash flow and hence dividends.

Looking at the market consensus estimates, the market appears to be assuming a 5% decline in earnings this year and a 7% increase in earnings next year. It is worth noting that at this stage last year, the market was clearly underestimating earnings progress. Consequently, Greggs shares at a share price of 1,090p last seen, are valuing estimated earnings per share of 59p at 18.5 times, which does not look particularly cheap, either in relation to other shares in the market or in relation in the traditional priced to earnings ratio yardstick. However, subtracting the shareholder assets of 263p (see above) reduces the earnings valuation from 18.5 times to 14 times.

On the conventional method of valuing earnings (without acknowledging the value assets attributable to ordinary shareholders) Greggs’ shares sell at 17.3 times earnings estimated for next year of 62.8p, which is pretty close to the now historic price to earnings multiple of 17.5 times for last year. Adjust the ratio once again for the aforementioned net asset figure, and next year’s strict valuation of earnings falls to 13.1 times.

In conditions of uncertainty leading to rising domestic interest rates to defend the exchange rate for the pound sterling, the shares have the fundamental advantage of no gearing and no cost of borrowing. Naturally, it would still be subject in trading terms to any deterioration in macroeconomic conditions in the UK, because it is exclusively a UK company with not currency or overseas trading advantage to offset such an outcome.