Description

Greencore (GNC):  GNC is a dominant player in the fresh food-to-go (“FTG”) segment primarily servicing grocery and convenience stores in the United Kingdom with private label sandwiches, salads, sushi, chilled ready-meals, fresh sauces, etc.  These are grab-and-go items consumed during “need-led” moments such as lunch, snack or a quick evening meal[1].  As you can imagine, pandemic-induced mobility restrictions severely impacted the FTG category. With a 4.9x debt to EBITDA at the trough, and as a proactive measure to bolster liquidity, GNC raised £90mm in the fall of 2020.  The combination of uncertainty around a recovery, leverage and newly issued shares left GNC trading at 7.1x F2022E EBITDA, a valuation too punitive given our view on business quality, liquidity and normalized post-pandemic earnings power.

We think GNC has a wider, deeper moat than is appreciated at first glance.  Manufacturing and distribution of small quantities of highly perishable fresh food across an entire country is difficult and expensive.  Most items have a two-day shelf life, so GNC has 400 vans delivering to 11,000 outlets daily and has spent >£300 million on logistics over the last several years.  The complexity and capital intensity have resulted in industry that has consolidated to three main players, GNC, Bakkavor and Samworth.  Within that group, GNC maintains #1 or #2 share in most categories, including >65% share of sandwiches and 80% of ready cooking sauces in the UK retail channel4.  Management has been deliberate about adding complementary offerings such as salads and sushi where GNC can run the same “playbook” of gaining market share organically and by consolidating the industry.  Category dominance, re-investment into the business and product offering and outstanding customer service have allowed GNC to maintain multi-decade relationships with the large retailers and play a greater role in driving the success of various categories.  With GNC a “partner” of sorts, many retailers have shifted from dual-sourcing to using GNC as the sole-supplier of various FTG categories, a position rarely earned by grocery vendors.  This entrenchment leads to sticky, long-term contracts with over 96% of GNC sandwich volumes under 3–5-year supply agreements.  

We think GNC will exit the pandemic with higher market share and stronger earnings power.  Covid-19 was no doubt disruptive to GNC’s business, but it was devastating to GNC’s #3 competitor Adelie.  Bought by private equity in 2015, Adelie entered the pandemic with significant debt and negative EBITDA.  As volumes crumbled, so did Adelie’s liquidity and profitability, forcing it into administration by the summer of 2020.  GNC and #2 player Samworth were clear beneficiaries, with GNC gaining key contracts worth ~£120mm in pre-Covid revenues, roughly 12% of GNC’s 2019 FTG revenues.  Adelie served coffee shops/bakeries in addition to gas stations and supermarkets, so we acknowledge that return to pre-Covid revenues may never be likely.  However, whatever revenues do stick we think should be absorbed with minimal increase in GNC fixed costs, allowing for a very attractive flow-through to profitability.  Adelie’s collapse removes what our research suggests was at times an irrational player, and further cements the duopoly between GNC and Samworth.  We believe it is in both companies’ best interests to remain rational as any material share shift between the players would only result due to pricing which would in turn create latent capacity that would aggressively be backfilled by more economically destructive share shifts – a proverbial downward spiral.  Instead, a rational duopoly should effectively improve pricing power across the entire market.  We also expect GNC to be a beneficiary in salads and ready meals where our research points to GNC winning share/shelf space from weaker, underinvested players and potentially consolidating the market to ultimately operate in a duopoly with Bakkavor. 

We believe FTG will continue to be a growth industry.  Prior to the pandemic, GNC’s FTG sales grew at a CAGR of 17% from FY11 to FY19, and GNC’s FTG business and the overall UK FTG market grew through the great financial crisis. Significant shelter-in-place restrictions were the equivalent of a 100-year flood type event with GNC reporting FTG revenues down 53% in the third quarter of 2020, recovering to -23% in the fourth quarter and -21% in the first quarter of 2021.  Our crystal ball is a little foggy as to how quickly or to what degree vs. 2019 employees will return to offices, but according to GNC estimates, less than 30% of GNC FTG revenues come from lunch with the majority comprised of breakfast, snacking, and evening meals.  So even with a hybrid remote/in-office schedule for the average employee, significant permanent impairment to core volumes is unlikely.  Additionally, industry research suggests industry growth of 3-4% in a normalized environment driven by high-single-digit/low-double-digit sales growth in emerging categories such as salads and sushi and low-single digit growth in sandwiches. 

Our base case assumes GNC does not get back to pre-Covid volumes in its base FTG segment, but when you layer on market share gains mentioned above and the potential shift of demand from shuddered foodservice establishments to grocery stores, GNC can grow revenues mid-to-high single digits over the next few years.  In its most recent report, GNC indicated that May FTG revenues were only 11% below 2019 levels, and we believe this performance will continue to improve as the economy reopens. 

The biggest risks include inflation, customer concentration and product quality issues.  While inflation is a risk in the current environment, more than 50% of GNC’s contracts pass-through food inflation, and a unique insight from our primary research suggests GNC can innovatively pass-through labor inflation by more frequently “refreshing” the product lineup at slightly higher prices (i.e., £5 winter squash salad becomes a £6 summer harvest salad).  Manufacturing automation could also be a mitigant, but it is in early stages, so we are conservatively assuming operating profit margins never return to 2019 levels. 

Customer concentration is a risk.  CoOp is GNC’s largest customer at ~20% of revenues and Marks & Spencer comprise another ~15%.  The “Big 4” UK grocers, Sainsbury, Tesco, Asda and Morrisons, combined account for another 40% of GNC’s revenue.  GNC’s sole-supplier status/embeddedness with many of the grocers makes the loss of a large customer as unlikely, and as far as we can tell, GNC has not lost a material contract in its core UK FTG categories.  While share within categories may shift, the consolidated industry structure and capital intensity of the business should prevent any major disruptions among the rational large players.  Instead, we think a more likely outcome involves share shift from the smaller, less-well-capitalized players to the likes of GNC. 

Already strong market share that increased in 2020; a rational and growing industry; long-term relationships and predictability of volumes/economics underpin steady 20-30%+ returns on invested capital, a setup we believe highlights GNC’s value within its ecosystem and supports our view on its exemplary business quality.  Management’s long-term goals, including mid-single digit organic revenue growth, high-single digit adjusted earnings per share growth, and half of adjusted EBITDA converting to free cash flow, seem very achievable.  Free cash flow, which we estimate in aggregate over the next three years will equal ~30% of GNC’s market value, is only used to pay down debt in our model instead of purchasing one of the several highly accretive transactions we believe are available in the market today. 

Our price target in our base case is GBP2.30 which assumes the business will trade at 8x 2023E EBITDA and all of the cash flow will be used to pay down debt. That implies ~70% upside from today's price. The stock took a hard hit after the company announced their H1 results which we think was a combination of a some people hoping/expecting for a more pronounced recovery in FTG volumes given some commentary from other UK food retail companies and a large shareholder got very sloppy liquidating their position.  

Catalyst

We think that management has given conservative "guidance" for the 2nd half of F2021 so that could be a catalyst. But we expect the business to really shine as we get into F2022 and we to start to see the benefits of the new business wins, some relief from non-exceptional COVID costs (right now all workers have to arrive earlier to testing and putting on personal protective equipment) and potentially some nice margin tailwinds from their automation program.

Consensus has come down significantly since the latest quarter so we think it is a good set up for a beat and raise relative to current analyst estimates.