Given Greggs’ long track record of strong cash generation and the success of the 2013 strategic plan to date, it seems reasonable to look beyond the short-term impacts of input cost rises and government-imposed cost increases to the benefits expected from the current investment programmes. Employing a DCF model to do precisely that, we generate a valuation of 1,226p per share.
We did not change our estimates following the Q416 trading update in January 2017 but noted potential upside of £1-2m in our FY16 PBT estimate of £77.2m. Greggs outperformed this expectation, delivering pre-exceptional FY16 PBT of £80.3m. After £5.2m of exceptional charges relating to the restructuring of the supply chain, statutory PBT was £75.1m (FY15: £73.0m). Despite a sharp increase in investment, net cash increased modestly to £46m from £42.9m.
Greggs has been warning for some time that it would face margin pressures in FY17e. The decline in sterling’s value and increases in underlying commodity prices are negative for gross margins. The National Living Wage and Apprenticeship Levy add to expenses. However, Greggs expects to be a beneficiary of rates revaluation. Nevertheless, although we have edged up our FY17 estimates to reflect the stronger-than-expected performance in FY16, we project little growth in earnings this year.
Based on the low growth that we model in FY17e, Greggs’ PEG ratio in that year is 7.1, which, one could argue, makes the shares appear expensive. We view that as too short-term an assessment, especially given Greggs’ long track record of profit growth. When one looks beyond the near-term margin pressures and the investment peak of the next two years, there is potential for Greggs to return to its traditional strong net cash generation. That will fuel further growth and special dividends. It also underpins our DCF valuation of 1,226p per share.