Description

Greencore

Greencore has been written up a number of times on VIC. I recommend reading posts from OMC in 2017 and jared890 in 2012/2011 for further background. We thought it was appropriate to write up again given the fundamental change in the story. Greencore's financial year ends 9/30 and the company just reported financial results for FY18 on 12/4.

Summary: I recommend a long position in Greencore, a UK-based food manufacturer that supplies sandwiches, sushi, salads, and other convenience food primarily to UK grocery and convenience stores. Greencore recently divested their US-assets at a price that we think is attractive; however, shares reacted negatively to the announcement. As a result of the sale and the subsequent share price reaction, we believe the valuation for the remaining UK-based business is compelling at current prices. We think Greencore can more than double unlevered free cash flow through FY21 through a combination of organic growth, declining investment spend, and M&A potential, which you can buy today at less than 10x forward earnings. Our price target is 280p per share based on 15x FY21 unlevered FCF – ~2.50p share price and ~30p dividend for ~55% upside for an IRR of 28% through the end of FY20. We think this return is asymmetric and protected by Greencore’s strong balance sheet, stable end-market demand, consolidating competitive set, and upcoming capital return.

Background

Greencore’s stock has been an extremely controversial and poor performing over the last few years. The company’s expansion in America was the center of these problems, with many questioning management’s credibility and capability as the company struggled to generate an adequate return on capital in the US. Frustration boiled over in March 2018 when the company issued a profit warning, taking down earnings estimates by 7% because of low utilization of plants in the US. Investors took the announcement as an indictment of Greencore’s US strategy and shares fell 30% on the day and nearly 50% for the year to ~125p, which was ~8.5x ntm earnings. Shares bounced back to 180p over the last few months as results stabilized.

On October 15th, Greencore announced that it would sell their US assets to Hearthside, which operates a similar business model to the US business they acquired in 2016, Peacock, and is backed by Charlesbank, the private equity firm that sold Peacock to Greencore in 2016. The sale of the US was a complete ‘180’ from recent commentary from management that defended the acquisition and the company’s presence in the US. The US business was sold for $1,075mn (net proceeds of 802mn gbp), which was a 16.3x FY19 consensus US EBITA. The remaining UK business now trades (FY19 numbers) for 11x levered free cash flow, ~9x earnings, and ~9x EBITA, and will have 1.4x ND/FY19 EBITDA with a leverage target of 1.5-2.0x. We believe this opportunity exists for three reasons: 1) capital return has been an overhang for tax reasons and valuation optics; 2) Brexit-fears causing institutional investors to avoid the UK equity market; and 3) GNC’s valuation being anchored by Bakkavor, despite Bakkavor being illiquid, and controlled as well as having slower growth prospects, lower economic returns, and manufacturing assets that have a greater need for investment.

Investment Thesis

1. Divestment of US assets has refocused the company on the UK food market, where current management has a strong track record
2. Attractive returns are underpinned by a business model featuring complex distribution, high segment market share, embedded relationship in customers and high sales density
3. Greencore’s UK business has proven to be resilient and benefits from a number of long-term trends benefiting convenient and private label food consumption
4. Greencore is exiting an investment period and will be generating significant free cash flow that can be attractively redeployed through capex / M&A or returned to shareholders
5. Operating margin pressure from inflation will be offset by productivity, pricing, and cost rationalization initiatives

Investment Thesis

Refocused management is investing in UK, where they have a strong track record

• Management was distracted: US business had no synergies (no common customers, production process, suppliers, distribution, or geography) and was a distraction over the last few years
• Group CEO, Patrick Coveney was recently spending 50% of his time in the US, which means that he was spending far less than 50% in the UK given his group-level responsibilities
• Nearly all incremental investment went to the US over the past few years. The US had represented 95%+ of non-current asset growth since 2011, causing UK assets to grow at just ~1.5% per annum over this period
• US expansion was a mistake but not a deal-breaker: While the US expansion strategy clearly didn’t have the desired outcome, we think the sale of their US business debunks any empire-building reputation that may be placed on management
  • Management was willing to do the right thing for shareholders even though they would face criticism for ‘back pedaling’ on their strategy in the US and operate a smaller company in the future (i.e.,anti-empire building)
  • While the premium to invested capital was not above the company’s WACC, the sale at a premium indicates that management didn’t buy a lemon when it acquired Peacock and should mitigates criticism about capital allocation
• UK track record has been strong: Greencore’s UK results over the last seven years have shown management’s ability to deploy capital, resulting in steady growth, margin expansion, and improvement in returns.
  • Since 2011, Greencore has grown revenues and operating profits at a low-double-digit rate while increasing non-current assets by less than 2%, nearly doubling pre-tax RONCA.
  • Management accomplished this improvement through large, transformative acquisitions (Uniq), small, tuck-in deals (Sandwich Factory and Tasties), organic investment (Warrington), and divestitures of low-return assets (Cakes/Desserts).

2. Attractive, double-digit ROIC in the UK is underpinned by the company’s business model

• OMC does a great job describing the UK business in his write up in 2017, which can be read here: https://valueinvestorsclub.com/idea/Greencore/140270#description
• We believe that Greencore’s mid-teens returns on capital in the UK can be sustained due to the company’s high relative market share in key categories, long-term customer relationships, and an increasing mix of higher-value activities with customers
• High Local Market Share: Greencore has been able to grow market share and establish leading position in key categories in the UK and Ireland. Current management has been deliberate about selecting product categories where Greencore can generate attractive returns while disposing of lower value business lines
• Greencore is #1 or #2 across the categories in which it operates
• In the company’s core sandwich business, Greencore has 60%+ market share in the grocery channel in the UK, which it increased from ~35% market share in 2011
• Greencore also has a cooking sauce business in which the company has sustained ~80% market share
• Increasing Value-add Activities: Greencore is increasing differentiated services within its customer base through direct distribution, new product development, and merchandising/ ordering
• Distribution: Greencore has taken on distribution responsibilities outside of Greencore’s food to go products for some of its customers
  • While Greencore receives a lower-margin pick fee for distribution, we believe the real value for Greencore comes from increased switching costs
  • Since 2014, volume through its direct to store distribution network has more than doubled from 120mn to 240mn+ units
• New Product Development: Greencore serves as a category captain and leads new product development efforts in the category for customers, increasing switching costs
• Ordering / Demand: In some cases, Greencore has taken over merchandising, assortment, and ordering functions. We believe these additional activities increase switching costs and drive some scale benefits in production and distribution
• Long-term Customer Relationships: Greencore has long-term customer relationships in the UK, most of which have spanned decades
  • These relationships are cemented by long-term contracts: ~90% of Greencore’s UK sandwich revenue is under contract for at least the next three years, which has increased from 23% in 2012 and 58% in 2015 

3. Greencore operates in attractive categories that benefit from changes to consumer behavior that should sustain market growth in the mid-single-digits

• Greencore operates in growing categories in the UK food to go market. Greencore’s primary end-market, Sandwiches, has been growing at a mid-single-digit rate, and other categories such as Sushi and Salads have been growing low-double digits
• Category and Channel Expansion Opportunity: Greencore has grown sales by an 11% CAGR over the last six years. Food-to-Go sales have grown even faster in recent periods, growing 17% p.a. from H1 2015 to H1 2018. We see scope for continued growth above market through expansion into other day parts, e.g. breakfast and ready meals as well as other channels c-store and coffee shops
  • Greencore’s direct to store distribution improves its ability to serve customers that require daily deliveries and have a large number of sites e.g. coffee shops and convenience stores
• Strong Value Proposition for Customers: Fresh and prepared foods and Food to Go are attractive categories for Greencore’s customers, which has expanded Greencore’s shelf space. Both provide customers with better than average margins, and an opportunity to differentiate their brand with a private label offering
• Resilient Demand: Greencore’s core categories have shown resiliency in challenging economic periods. Greencore’s food to go business and the food to go market comped positively throughout the financial crisis

4. Step up in free cash flow generation and under-levered balance sheet creates a substantial capital allocation opportunity for M&A or further shareholder returns

• Pro Forma for the completed deal, Greencore has net leverage of 1.4x which is below target levels of 1.5x to 2.0x, i.e. potential for use of 50-125mn
• Exiting Investment Period Will Drive FCF: Greencore is exiting investment period where capex was 2x normal levels. Strategic capex has already started to step down in H2 in 2018, driving total capex in FY 18 to 61.6mn vs. 97.5mn in FY 17. Total capex will step down to ~40mn in FY19
• As a result, we see EBITDA-capex increasing ~2.75x from FY17 to FY19, resulting in ~90mn+ in LFCF and ~80mn in UFCF in FY19 on a fully-taxed basis assuming 10mn in exceptionals
• If the company were to take leverage to the high end of their target range by the end of FY19, Greencore could repurchase ~15% of shares outstanding in addition to the proposed tender, or complete a deal at 6-8x EBITDA that would increase Greencore’s EBITDA by 20%+
• Greencore’s CFO guided to ~40mn in UK capex starting in FY19 and stated that the group has enough capacity to support MSD growth through 2023
• Large Adjacent Market for M&A: Despite Greencore’s high market share in Sandwiches, Greencore has significant opportunities to expanded into adjacent categories the UK fresh and prepared foods market through M&A and organic investment
• Greencore’s strengths in distribution, sourcing, new product development and existing customer relationships create an attractive platform for acquisitions
• OC&C consultants identified 115 UK companies between 80-500mn in revenue in their 2016 report, which we believe fit the profile that Greencore will target. Aggregate sales for these companies are between 80-500mn in revenue are 22.5bn
  • Within the family-owned and PE segment there were 9.8bn of sales across 56 companies for companies above 80mn GBP in revenue
• Smaller or overleveraged companies that are less equipped to endure financial pressure from Brexit may create attractive opportunities for acquisition or organic share gain
• We believe Greencore has a proven track record performing acquisitions of this size in the UK and will prudently deploy investor capital
• Premium Brand Holdings has proven the success of an acquisitive model in the North American market. PBH typically executes deals at 6.5x EBITDA

5. Operating profit pressure from inflation will be offset by productivity, pricing, category management, and cost rationalization initiatives

• Inflation Impact: Greencore faces inflation in both materials and labor, which inflated by 3% and 4% respectively in FY18. If inflation accelerates, Greencore may be unable to recover inflation from customers which would pressure operating profit
  • Labor: Labor is 25% of Greencore’s cost of sales or 17% of total revenues. Labor inflation was 4% or ~10mn in FY18 . Management expects labor inflation to be slightly higher than 4% next year
    • On Greencore’s most recent earnings call, the company highlighted benefits of productivity initiatives, which drove a 15-20% improvement in units per hour per worker
    • Conversations with competitors indicate that the open book model makes it easier to recover labor inflation
  • Materials: Raw materials are 75% of COGS or 51% of revenues. The company experienced 3% material inflation or 23mn in FY18
    • The company has a variety of pricing and other mechanisms to offset raw material inflation with customers. Conversations with competitors confirm that raw material inflation is typically mechanically passed to consumers
    • Greencore has a history of successfully passing through raw material inflation. In FY11, Greencore experienced a 50mn headwind from input cost inflation on a revenue base of ~730mn in the company’s convenience food division, which was successfully mitigated
• Improving Utilization: Greencore has excess capacity at facilities in the UK that support MSD revenue growth through FY23. Absorbing this capacity will benefit margins and profitability
• Category Management: Greencore exited its 125mn cakes and desserts business, which was zero margin, through the sale of a facility in February and the closure of another in June. These facility closures benefitted margins in the back half of the year, but had a limited impact on results due to the timing of the closures. Greencore has announced the closure of its facility in Kiveton to consolidate long-life ready meal production to a single facility, which impacts 15-20mn of low/no margin revenue, but has a limited impact on profitability
• Cost Rationalization: Greencore announced a productivity program focused on removing 15mn of gross costs from their UK business. Greencore believes it can capture 50% of the gross savings. We suspect that there are more opportunities to run leaner through productivity
• Consolidating Competitive Landscape: Within Greencore’s core sandwich category, there is only one core competitor, Samworth Brothers in the grocery channel. Samworth – recently acquired 2 Sister’s facility to grow its share of Tesco’s sandwich business. The consolidated competitive set limits alternatives for customers and should lower competition and pricing pressure within the industry

Financials

• We believe Greencore will grow underlying revenues mid-single digits and grow operating profit high-single digits by maintaining adjusted margins of 7.4% through FY21 as corporate overhead is reduced, productivity initiatives take shape, capacity gets absorbed, and inflation is passed to customers
  • Greencore’s FY18 included additional corporate allocation due to the sale of the US division late in the year
• Management has explicitly stated that current capacity is adequate for mid-single digit growth through FY23, so we see scope for limited strategic capex through FY21, which drives our rationale for capex below 50mn through the forecasted period
  Over the next 2 years, we expect Greencore to deploy at least 100mn through M&A and take advantage of low multiples in the UK, purchasing a company for ~6.5x EBITDA, which are typical acquisition multiples for Premium Brand Holdings in North America
• In our downside case, we model EBITA margins compressing below 2010-2012 average of ~6% for GNC’s convenience food division due to labor inflation and pricing headwinds

Valuation

• Greencore’s UK stub trades implied at 7.0x UK EBITDA, which is a 2.0x+ turn to US private label food, and fresh convenience food manufacturers
• Greencore’s valuation appears to be an outlier on FCF or EBITDA-capex when considering that Greencore is exiting an investment period with growth being supported by capacity absorption

Return Potential

• We believe Greencore will generate a 55% return in our base case when the market values Greencore at 15x FY21 UFCF, which is equivalent to 9.5x EBITDA and 12.1x earnings

• Additionally, we think an investment in Greencore has downside protection through stable demand for food to go, a strong balance sheet, and long term contracts as well as the upcoming tender offer, which will likely be done at a premium

Risk

1. Brexit – The UK’s decision to exit the EU will impact labor and raw materials availability and inflation, both of which are important inputs for Greencore. If the company is unable to pass these costs onwards, then Greencore could see its margins squeezed.
   1. We believe that pressure on availability can actually catalyze demand for more outsourcing if customers are facing similar labor shortages.
   2. Greencore has the scale and balance sheet to invest in better automation, procurement, recruiting, and supply chains, where smaller competitors lack this capability
   3. Higher labor costs impact both Greencore and Food to Go competitors, including in-sourcing, limiting negotiating power for customers
   4. 80% of raw materials and packaging cost of sales are procured locally
   5. Food to Go items don’t have a fixed assortment, which allows Greencore to alter its menu to avoid raw materials with rapidly rising costs
   6. Brexit has the potential to lower asset prices and potentially impact Greencore’s competitors, which may create attractive M&A opportunities
2. Customer Concentration – Greencore’s customer base is primarily large UK grocers. Greencore supplies these customers, predominantly through sole-source agreements. Losing one of these customers would be meaningful to revenues and profits
1. Customer relationships have spanned decades and Greencore is deeply embedded in customers operations through new product development, distribution and other activities
2. Capacity is tight in the UK and capacity growth for Samworths has been through the acquisition of existing, utilized facilities rather than new builds as well as distribution
3. 90% of Greencore UK sandwich sales are in contracts for at least 3+ years  with the average sandwich deal length now 4.4 years, increasing from 2 years in H1
3. Customer consolidation – The UK grocery consolidated further as Sainsbury acquired ASDA in a recent M&A deal, which could cause pricing pressure
1. We believe that grocer consolidation is unlikely to lower pricing for Greencore and other fresh food manufacturers. The category is very attractive for grocers as it drives traffic, creates an opportunity to distinguish the brand, and is higher margin than the rest of the business. The industry already operates on an open book model, so Sainsbury and ASDA know Greencore’s costs
2. Additionally both Sainsbury and ASDA saw the rationale of consolidating spend under a sole supplier, so we don’t think they will elect to multi-source in the future.
3. Finally, sandwich manufacturing is consolidating as well. Samworth Brothers recently acquired 2 Sister’s sandwich manufacturing facility, leaving Greencore and Samworths as the primary scaled sandwich manufacturers

Catalyst

• Brexit vote on 12/11
• Greencore announces pricing of tender offer
• Greencore reports FY19 results above forecast and proves cash generation capability after years of muted cash generation caused by strategic capex investment cycle and cash exceptional
• Management provides more details for investors into UK expansion strategy
• The company begins executing its capital allocation plan – repurchasing shares in addition to the tender offer or performing accretive M&A