Stockwatch: Rapid growth, but at a price

Is Greggs overvalued, or its share price momentum signalling further upside? Last year, shares in this high street baker soared from 434p to 738p and are testing 1,000p after 2014 prelims showed profit before tax and exceptionals jumped 43% to £44.3 million on total sales up 5.5% to £804 million.

In response, the consensus pre-tax profit estimate for 2015 has risen by 8.5% to £62.6m and for 2016 by 10% to £68.1 million. Looking at raw earnings growth, however, the Company REFS table shows 2014 earnings as more like a jump in long-term context, with high single-digit percentage growth projected thereafter. It means the classic measure of growth stocks - the price/earnings to growth ratio - soars above 2 times, whereas investment value is normally deemed to exist below 1. Greggs will therefore be an interesting test of the PEG ratio: should you heed it irrespective of an attractive business?

A consumer marketing success story

Significantly driving 2014 gains is the company's revamping from pasty and sausage roll outlets to embrace the British coffee shop culture offering healthier sandwiches, breakfasts and quality coffee. A smoother blend launched a year ago has led to coffee sales of £1 million a week currently, and free-range omelette also porridge are about to be offered for breakfasts. It's possible to envisage Greggs opening up a new chapter in its 75-year history just as UK disposable income is improving. Average household incomes have rebounded to pre-recession levels helped by deflation in the grocery market, releasing more money for "food on the go."

But mind how this alleged £6 billion market is highly competitive with little freedom to price. Greggs has established itself with meal and sandwich deals among the cheapest and its new menus have helped in-store sales grow by 4.5% in 2014, accelerating to 6% in the final quarter.

This positions the group versus the likes of Pret A Manger albeit with its own specialties such as soups and steak-and-cheese rolls. 2015 initiatives include new fresh soups and a £2 offer for coffee and any savoury snack.

Last year, Greggs also benefited from relatively mild weather and 213 of its outlets being refurbished, although the overall shop count reduced to 1,650 as 71 were closed versus 50 opened. In 2015, some 80-100 new shops are expected to open and 60-80 be closed, the longer-term target being over 2,000 in the UK.

Share buybacks are a curious proposal

With net operational cash flow up 31.6% to £97.1 million versus a £52.9 million net cash outflow from investing activities, Greggs is the kind of business able to return meaningful amounts while also investing for growth. The 2014 cash flow statement further clarifies £19.6 million paid in dividends and £7.9 million spent buying back shares.  "The board has already identified that it has the capacity to return up to £10 million to shareholders in the first half of 2015 and will do so through a resumption of its share buyback programme."

However, the extent of rise in share price and P/E ratio versus expected growth rates, query whether this is appropriate than say a more significant expansion of the dividend. If the stock more than fully discounts prospects for the foreseeable future then buybacks would not be value-enhancing, however appealing to traders (possibly further boosting the price).

While the proposed 2014 dividend rises 12.8% to 22.0p, with twice earnings cover the prospective yield is only 2.5% - not enough to serve as a prop. Usually in such situations boards proceed with buybacks as enhancing EPS this way helps to achieve or beat targets. The board is quite a victim of its success and somewhat compromised now it has declared a near-term buyback agenda; but from a shareholders' perspective there is no point repurchasing richly valued stock.

Directors are running their equity positions

The three main executive directors own 181,300 shares between them, worth about £1.8m, and there is no sign of any selling. That would anyway look odd versus the buyback policy. Also a non-executive director has just bought 500 shares at 964p in line with a sense of anticipating further upside. The chairman sums it up thus: "Our focus on the food-on-the-go market has resulted in accelerated like-for-like sales growth which, combined with structural cost reductions, has improved the group's financial performance markedly. There is more to do but we have started out very well on a journey designed to deliver a sustainable business model for long-term capital growth."

From an operations' view, management appears to see plenty more scope in years ahead with no anxiety to be locking in gains. Assuming no sales now Greggs is out of its closed period on trading, this is a good sign. It still doesn't guarantee that at just over 1,000p the stock offers value.

Growth often comes with a hefty price tag

The situation illustrates a current theme I have iterated: how the macro context of weak growth and deflation weighs against cyclicals and big companies, while small-to-mid-caps sporting growth numbers and a good story see their stock priced richly. Such a trend towards a tiered stockmarket is worth bearing in mind for portfolio balance. But it is an inherently risky approach given the overall evidence on buying stocks with high P/E multiples is grim - and PEG ratio is high here too. This set of results has benefited from cost reductions, but without annual revenue growth nearer 10% than 5% the earnings growth trend will settle back somewhat.

Given a bout of wider market turbulence it's easily possible this kind of stock becomes priced more attractively - so prudent investors may prefer to wait than chase current momentum. And it's worth considering where else this applies.

For more information see greggs.co.uk.