Description

a.     The “elevator pitch” in 30 seconds

          i.          Greencore is a leading manufacturer of private label convenience food in the UK and the US

1.     The company makes “food to go” for large food retailers in the UK and the US: food that is to be consumed immediately (or within the coming days), e.g. sandwiches, sushi, wraps, as well as, to a lesser extent, chilled ready meals, etc. The products are sold to retailers, who then sell them to consumers under the retailers’ own branding (or, in the US, to CPG companies, who then sell on to retailers)

2.     I estimate FY 2017E (Sep-31 year end) revenues of c. £2.6bn, growing at a c. +7% CAGR. Greencore should deliver a FY 2017E EBITDA margin of c. 9%, a FY 2017E operating profit margin of c. 7%, with profits growing at c. +15 to 20% to FY 2020E as a result of margin expansion in the US businesses. Cash conversion on a normalised basis should be c. 80 to 90% of NOPLAT to uFCF or NI to eFCF, and the company should deliver a stable post-tax return on capital of c. 11 to 13% over the next few years

3.     The company trades c. $12m ADTV, has a market cap. of c. £1.7bn and an EV of c. £2.2bn. It is listed and headquartered in the UK

         ii.          The business is more ‘moaty’ than I first expected

1.     Evidenced by (a) multi-decade customer relationships, (b) very long customer contracts (typically over five years in length), (c) tremendous market share gain in recent years (from outstanding customer service / product offerings), and (d) customers moving away from dual-sourcing to appointing Greencore as their sole supplier

2.     This translates into a (very) stable c. 11 to 13% post-tax returns on invested capital

       iii.          The company has done very well in the UK (its core market), but its US expansion has been slower than hoped for. Greencore recently made a large US acquisition (Peacock), which should help kick-start the existing US business

       iv.          Over the next few years, revenue should continue to grow at mid to high single digits and the US business should go from c. 0% EBIT margin to c. 7% (in line with the Group EBIT margin), which should lead to high double digit profit and FCF growth to FY 2020E

         v.          We think Greencore is mispriced because the market is under-appreciating Greencore’s growth potential as well as the stability of its long duration contracts and entrenched customer relationships. If the company can deliver on market expectations, this misperception should correct over the coming quarters

1.     Investors got too bullish, too fast, on the US growth potential, bidding up the share price in FY 2015. Since then, investors’ enthusiasm has waned, resulting in gentle share price pressure through 2016, even as the UK business has performed exceptionally well

2.     Furthermore the Q4 FY 2016 / Q1 FY 2017 acquisition of Peacock (involving a large rights issue) created a technical entry point, with c. 40% more equity coming to market

3.     Lastly, some investor concerns in the last month re. a major US customer acquiring one of Greencore’s quasi-peers in the US has created an attractive entry point, pressuring the share price. We think the market is over-reacting to headlines, rather than doing diligent research into the nature of Greencore’s positive customer relationships and long-term contracts (the contract with the aforementioned customer has at least five years left to run). If anything, the deal could be positive for Greencore’s share price: Greencore trades at 8x EV/EBITDA and the quasi-peer transaction is at c. 13x. Could Greencore be put ‘in play’? With an EV of c. £2.3bn, it’s certainly digestible for large food producers or private equity groups

4.     In summary, we think Greencore is currently mispriced for non-fundamental, temporary reasons, that should correct over the coming quarters. In the meantime, you own a well-run business growing intrinsic value at c. 10 to 15% p.a.

       vi.          We think that c. 10x FY 2018E P/E, 7% uFCF FY 2018E yield, 8% eFCF yield is too cheap for a stable business with this sort of profit growth potential, thus providing a substantial margin of safety and sizeable discount to intrinsic value

      vii.          We estimate at least c. 40 to 60% upside to fair value over the next couple of years, triangulated via various methodologies

b.     Summary of the business

          i.          Greencore is a leading manufacturer of private label convenience food in the UK (and is expanding in the US)

1.     The company focuses on fresh sandwiches in the “food-to-go” market, chilled ready meals and some selected grocery products in the UK and in the US. Basically, Greencore focuses on food you can eat with little to no preparation. In the UK, sandwiches are the key products, with a more concentrated product portfolio. In the US, the company is focused on salad bags, sandwiches and breakfast sandwiches, preparing a wider variety of products

2.     At first glance, this seems like a potentially boring, low growth, and commoditised segment of the value chain. That was certainly my first thought. But as we did more research, we become increasingly impressed with the ‘moatiness’ of the business and the underlying growth prospects. It might not be sexy, but there is decent growth and strong barriers-to-entry protecting Greencore’s low double digit post-tax return on capital

3.     The UK business generates c. 55% of revenues and profits, with the remainder from the US. Of the US’s c. 45% of revenues, c. 3/4 of that (i.e. c. 30% of the Group) comes from Peacock, a recent (and substantial) acquisition

         ii.          The company has a strong market positions in the UK, and has been getting stronger over the last five years

1.     The company has done a super job of consolidating the market in the UK

a.     Over the last decade, it’s become the supplier of choice to many leading food-to-go retailers (e.g. Marks & Spencer) in the UK, and I’ve been increasingly impressed with business quality

2.     The UK food-to-go market is c. £2.5bn in size and is growing c. +4 to 5% p.a. I estimate the TAM to be c. £3.0bn

a.     Market-level growth is structural in nature and very stable: even during the great financial crisis, the UK food-to-go market grew every quarter

b.     As the concept of the nuclear family dissolves (more people living away from family), the cost efficiency of bulk purchasing and preparing of meals and sandwiches has fallen. This has led to a steady and consistent rise in the number of prepared meals and sandwiches purchased each year

3.     Greencore is no. 1 or no. 2 position in 8 out of 10 categories. Greencore is the clear market leader, with a c. 38% share of the UK food-to-go sandwich market (estimated to generate c. 55%+ of operating profit)

4.     The company has consistently outgrown the broader market’s growth by taking share over time, through (a) old-fashioned operational excellence and (b) by adding strategic value to customers via partnering on NPD (e.g. for M&S and its very popular food lines). I expect these trends to continue: none of our primary research checks with potential customers/peers, suppliers, etc., have given us anything but glowing praise for Greencore’s quality and operating momentum (or begrudging praise, in the case of competitors’ comments)

       iii.          In the UK, Greencore’s main customers are the largest food retailers

1.     They account for c. 2/3 of revenues, as well as 7-Eleven and Starbucks in the US (combined, those two come to c. 10% of Group revenue)

2.     Most of the contracts are long-term in nature (5Y+), providing a high degree of revenue stability

3.     At first, we were concerned re. relative negotiating power (the UK super markets are behemoths). In fact, we think Greencore’s consolidation of the market (partly inorganically, but much of it organically) is evidence of the high quality product offering that competitors cannot match, and shows how willing supermarkets are to move away from a dual-sourcing strategy for Greencore’s products to a sole-source strategy: a huge vote of confidence in Greencore

       iv.          In the US, Greencore recently bought Peacock, to supplement its existing US business

1.     The US accounts for c. 45% of Group revenues. In the US, customers often co-invest in PPE with Greencore (and Peacock, previously). This means margins are a little lower in the US than in the UK, but the returns on capital are approximately the same (low double digits, after tax), as the PPE invested by Greencore is lower than in the UK

2.     Major customers in the US include Starbucks, 7Eleven, Dole, Tyson and Kraft

3.     Greencore has been building out its footprint in the US for c. five years. The company has struggled a little to secure major contract wins, and its facilities are currently under-utilised and generating minimal profits. The management team are very confident in getting the US margins (excl. Peacock) to Group levels (c. 6 to 7% EBIT margins) by 2019E. Any new wins that are announced will be interpreted positively by the market. It is hard for an outsider to assess the timing of any new contract wins: Greencore appears to have a well-invested production footprint and a strong record, but most of these contracts are long-duration and don’t come up for tender often, so ‘cracking a new market’ is proving more slow-going than management initially expected a few years ago

         v.          Greencore’s strategy focuses on further expansion in related verticals/geographies

1.     Categories for growth include (a) in the food-to-go category, both in the UK (its home market) and the US (a major growth opportunity), (b) in related food-to-go products, (c) in alternative distribution channels (e.g. coffee shops, where it currently doesn’t have a presence), and (d) in longer-term in new geographic markets

c.     Key drivers of the investment thesis

          i.          Continued Group top-line growth of c. +7% p.a. to FY 2020E (broad-based growth, coming from the UK and the US)

         ii.          US margin expansion from c. 0% EBIT margin to c. 7% by FY 2019E, as production volumes ramp in new facilities from new contract wins in the US, driving annualised Group profit growth of c. 15 to 20% to FY 2020E

       iii.          Stable margins and ROIC in the UK business (in line with the past)

       iv.          Some multiple expansion towards the levels of peers, as investors begin to re-appreciate Greencore’s high quality, stable growth and margin profile

d.     Business quality:

          i.          Revenue growth: I think Greencore can grow Group revenue by c. +7% p.a. to FY 2020E

1.     The UK Sandwich business has been growing at c. +9 to 10% for the last few years, and new contract wins in 2H FY 2016A will kick in to revenue growth from FY 2017E. Greencore continues to take share in this segment and is performing very, very well. I estimate growth of c. +7% annualised to FY 2020E, but I think this may be slightly conservative: the company has demonstrated unexpected contract wins over the last few years

2.     The rest of the UK business (e.g. the Prepared Meals and Grocery sub-segments) is likely to grow at mid-single digits to FY 2020E. It’s a little less attractive than sandwiches (more commoditised, more fragmented)

3.     The US business should growth at closer to c. +10% annualised. Peacock has been growing profits at c. +10% over the last few years, whilst the existing Greencore US business (excl. Peacock) was growing at a similar rate

4.     The existing US business (excl. Peacock) has significant additional capacity, providing huge revenue and profit growth potential if Greencore can sign up major customers. This has been a key management focus for the last two years, but the company has yet to secure more ‘big wins’. This has (justifiably) concerned some investors (contributing to the share price decline in FY 2016). It provides both an opportunity for upside and a risk factor to be monitored

5.     Most of this growth is from unit volume growth, with unit pricing rising in line with inflation. Per unit pricing has been pretty stable over time. The sandwich and food-to-go markets are pretty acyclical, so most growth will be stable, secular unit volume growth of mid-single digits over time, complemented by share gains and expansion into less-well penetrated customer sub-segments (e.g. coffee shops, etc.)  

         ii.          Greencore’s ‘moat’ is wider than I first expected (particularly in the UK)

1.     I was initially sceptical of sustainable competitive advantage in the business. How hard can it be to make sandwiches!?

2.     But… Greencore is the UK’s no. 1 producer, making nine million units a week. It is the largest purchaser of prawns in the world. Greencore’s moat is multi-faceted: there are customer-related competitive advantages, production-related competitive advantages, and economies of scale all combining to offer a decent moat and stable post-tax returns on invested capital in the low teens

3.     The industry in the UK is very concentrated, with all other competitors ceding share to Greencore over the last few years. The no. 3 and no. 4 competitors are highly geared and privately owned; they do not have the financial capacity to invest in new contract wins in the way Greencore does. I expect them to continue to be marginalised and could even become an acquisition target for Greencore in the future. The no. 2 competitor has been bought be private equity in the last year and has lost key customers to Greencore in this time. As such, the UK industry structure is very stable

4.     Most of Greencore’s customers have been with Greencore for decades. Greencore has not lost any customers in recent years and, instead, has been steadily picking up new customers from competitors. Many customers now sole-source from Greencore, rather than dual-source, as in the past, an indication of their trust in Greencore (and of Greencore’s relative leverage vs. customers)

5.     Many of our primary research checks indicate that these contracts are the incumbents’ to lose, and are very hard to poach. Given Greencore’s reputation for superb customer service, this is an excellent source of customer stickiness

6.     The logistics of getting a perishable and fragile product across a country on time are very complex and require a certain level of (a) production capacity, and (b) distribution capacity. Both of which are capital intensive, and lead to economies of scale for the largest producers (i.e. Greencore)

7.     Price is clearly an important criteria for customers. But so too are other factors. (a) Ability to produce consistently in very high volumes (meaning only a handful of competitors can compete for the large national contracts). (b) The ability to distribute millions of products a week (again, meaning only a few of competitors can compete). (c) Excellent food safety standards (if a health scare was to occur it would be very problematic for the customers, so long records of operational excellence from suppliers are key. Greencore is industry-leading here). (d) New product development skills are surprisingly important: most of the growth in the sector is from higher-end products and Greencore has been at the vanguard of this wave, working with its high-end customers from market research and product design (yes, we’re still taking about sandwiches!) to production and distribution. Greencore’s value added is therefore quite a bit higher than most competitors, which ultimately leads to slightly higher margins and better asset turns than competitors

8.     The market in the UK is pretty much immune to technological disruption or new market entrance, and I expect the industry structure to remain fairly steady, with Greencore probably taking a bit more share over the coming years

       iii.          The financial profile: the Group operating profit margin of c. 7.0% is likely to expand a little (c. 70 to 80 bps) by FY 2020E

1.     The UK business should be pretty stable, at c. 8.0%, in line with the past

a.     Revenues and margins in the UK business are very stable on an underlying basis. Any margin volatility, which is limited, comes from new major production contracts ramping up (there is a slight increase in start-up costs in the first few months of new contract wins)

b.     In this sense, and without wanting to sound too sanguine, margin volatility is normally an indication of new revenue coming online, i.e. a good thing…! (Even so, the market can be a little myopic re. quarterly/semi-annual profit numbers)

c.      When there is raw material inflation, Greencore has done a good job of passing that on to customers in the past. I feel comfortable on this front, fundamentally (though the market does occasionally get worried about it)

d.     Operating leverage is low, with mainly variable costs (raw materials, labour, etc.)

2.     The US business, excl. Peacock, is currently just break even. Major capacity coming online means asset turns are low. Management are highly confident of ramping to c. 6 or  7% EBIT margins by FY 2019E

3.     Cash conversion is pretty good; there is some one-off “start up” capex from new plant openings at the moment, but otherwise, on a steady-state basis, the business has low maintenance capex requirements

       iv.          Current leverage is c. 2.2x ND/EBITDA. Given the stability of the business, this seems fine to me

1.     The company is likely to de-gear towards c. 1.5x ND/EBITDA and return excess cash to shareholders after that

2.     I think the company can return c. 11 to 13% of the market cap. per annum from 2019E onwards (and c. 6% in 2018E)

         v.          Capital allocation at the company has been pretty good. I don’t expect that to change

1.     Organic investment in new production facilities has been done in conjunction with customers and at good (high double digit) post-tax returns on capital

2.     Clearly the Peacock acquisition, which involved a 40% rights issue to fund it, is a huge investment of capital. From our detailed checks (including speaking to many Peacock customers who directly worked with Peacock), the strategic logic is sensible, the price is sensible, and Greencore have done significant diligence (almost a year of discussions with the seller, including meeting the management of all of Peacock’s major customers)

       vi.          Earnings quality is good; I see no issues there, even given recent M&A, etc. All very transparent/sensible…

      vii.          FX exposure is largely hedged on a transactional basis

1.     This is done via hedging agreements and purchasing contracts with suppliers and with customers

2.     It’s made possible by Greencore’s high visibility into a non-cyclical product where supplies are purchased relatively shortly in advance of being turned into ‘inventory’ and sold to customers, meaning NWC and margin risks from FX and raw material price fluctuations are relatively controllable

    viii.          Sell-side momentum is marginally positive, with slight upgrades in recent months

e.     Management quality:

          i.          The management team is pretty strong, with deep industry knowledge and a great record over the last five years or so

1.     I have gotten to know the management for a year before investing, allowing me to dispassionately assess their capital allocation abilities and strategic and operational acumen

2.     The CEO and CFO have been with the company for the better part of a decade, and seem to be appropriately focused on mid-term shareholder value creation (rather than massaging semi-annual results to please the market)

3.     Management’s financial interests are fairly well aligned with those of shareholders (a fairly standard UK mid-cap compensation package. Nothing too exciting, good or bad…)

4.     They have always been transparent and candid in my discussions (and in conference calls). The CEO has probably been too bullish on the rate of growth in the US business (pre-Peacock) when speaking to investors in 2014/15, but I believe his commentary these days is suitable grounded. I may be ‘drinking the kool aid’, though…!

5.     There are no other major stakeholders of note (unions, major shareholders, regulators, etc.)

f.      Assessing the mispricing (Mr Market’s misunderstanding):

          i.          Information flow has been somewhat disrupted by the Peacock acquisition, potentially confusing some investors

1.     The acquisition involved a 40% rights issue, which created some technical pressure on the stock (a lot of new volume to be absorbed by the market)

2.     We are still to see fully consolidated results, which might be causing confusion for some investors. This will change at the 1H 2017E results in late May

         ii.          Greencore has no direct peers, which can cause some confusion for investors

       iii.          Limited investor awareness/understanding. The company has had no IR until this month

1.     I think that hiring an IR manager will improve investor awareness and understanding over the coming quarters

2.     A CMD in the US in June should also be helpful (c. 30 to 40% of the shareholder register  is US-based)

       iv.          Investors got too bullish, too fast, on the US growth potential, bidding up the share price in FY 2015

1.     Since then, investors’ enthusiasm has waned, resulting in gentle share price pressure in 2016, even as the UK business has performed exceptionally well

         v.          We think that investor concerns in the last month re. a major US customer acquiring one of Greencore’s quasi-peers in the US are superficially concerning, but fundamentally a non-issue

1.     We think the market is over-reacting to headlines, rather than doing diligent research into the nature of Greencore’s positive customer relationships and long-term contracts

2.     The contract with the aforementioned customer has at least five years left to run and the product Greencore produces is one of the customers most successful and critical product lines. Management sounded very sanguine about the news when we spoke with them a week ago

4.     If anything, the deal could be positive for Greencore’s share price: Greencore trades at 8x EV/EBITDA and the quasi-peer transaction is at c. 13x. Could Greencore be put ‘in play’? With an EV of c. £2.3bn, it’s certainly digestible for large food producers or private equity groups

       vi.          Our FY 2018E and FY 2019E profit estimates are c. 10 to 15% ahead of consensus

1.     I am aware that this is punchy. I have gone over the build-up in detail with management, on multiple occasions, to get comfort in our estimates, and believe the sell-side is being conservative and that management is trying hard to ‘under promise, over deliver’ through 2017E

g.     Risk assessment (identifying potential land mines):

          i.          Our profit estimates for FY 2018/19E are c. +10 to 15% ahead of consensus. We might be too bullish

1.     Missing these compresses the potential returns, though there is still substantial upside even on consensus estimates

2.     I’ve done a lot of cross-checking with management in laborious detail to get comfortable with our forecasts, but you never know until the company reports… I think the sell-side are being a little light on US profits in 2018E onwards

3.     (NB: my estimates for FY 2017E include Peacock for Q1, for comparability purposes, whereas the business was not consolidated until Q2. Hence my FY 2017E estimates will appear a little high vs. consensus due to the extra quarter of Peacock revenues and profits, but this is purely a apples-to-oranges comparison issue for 2017E only)

         ii.          There is execution risk re. the large Peacock acquisition

1.     M&A is always tricky. The management spend almost a year in negotiations with the seller and, during this time, met all major customers before the deal was consummated, giving us increased comfort that the management are not rushing into anything foolishly. But, the risk is always there. The news re. a major customer (Tyson) acquiring a quasi-peer of Greencore (AdvancePierre) is an example of potential risks here

       iii.          The company has guided for 2017E profits to be 2H weighted; if there is 1H weakness, it might spook traders

1.     There’s a risk I am too sanguine here. There are justified reasons (new production facilities ramping in the UK, the Peacock acquisition coming through), so I am fine to give the (good) management team the benefit of the doubt. But I may be underestimating the seasonality of profits and ‘what’s in the price’, meaning upcoming results (end of May) might be volatile. I’m fine to take that bet here, but it’s worth flagging as a risk

       iv.          Customer concentration risk

1.     Some of Greencore’s customers account for c. 5 to 10% of Group profits. Whilst contracts are multi-year in nature (the average customer contract’s remaining life is over five years), clearly any contract losses would be a blow to profits (and suggestive that something might be amiss in Greencore’s product offering / customer service quality). I think this is more of a risk in the US, where Greencore’s excellence is less proven and less differentiated

2.     Kraft, as a customer, is potentially going to negotiate harder with suppliers, after the merger with Heinz. This would be marginally negative for Greencore

         v.          A major US customer (Tyson) announced the proposed acquisition of one of Greencore’s quasi-peers in the US (AdvancedPierre), raising concerns the customer might cut Greencore’s contract (c. 10% of Group revenues)

1.     As mentioned, we think the market is over-reacting to headlines, rather than doing diligent research into the nature of Greencore’s positive customer relationships and long-term contracts

2.     The contract with Tyson has at least five years left to run and the product Greencore produces is one of the customers most successful and critical product lines (Jimmy Dean breakfast sandwiches). Obviously, there are break clauses in the contracts, etc.

3.     Tyson and Peacock have successfully worked together for over a decade. I’ve spoken to people at Tyson familiar with the Peacock relationship and it all sounded very amiable/positive. I’ve not detected and specific issues from any primary research calls

4.     Furthermore, apparently Greencore is in talks with Tyson to extend and expand production agreements. Greencore management sounded very sanguine when we spoke to them after the Tyson and AdvancedPierre news broke

5.     So it’s clearly a risk factor, given the revenue concentration issues, but we think one that is likely to be a ‘storm in a teacup’. Clearly, we could be wrong…!

       vi.          Raw material inflation is a minor risk, in my view

1.     Greencore has done an excellent job in the past of passing on raw material inflation to customers. I think this is a non-issue, fundamentally, though can often be a cause for sentiment to wobble if the issue is hitting the sector news

h.     Margin of safety and potential returns assessment:

          i.          Over the next few years, revenue should continue to grow at mid to high single digits and the US business should go from c. 0% EBIT margin to c. 7% (the Group EBIT margin), leading to high double digit profit and FCF growth to FY 2020E

         ii.          As such, I think that c. 10x FY 2018E P/E, 7% uFCF FY 2018E yield, 8% eFCF yield is too cheap for a stable business with this sort of profit growth potential, providing a substantial margin of safety / discount to intrinsic value

1.     See below for (a) current trading valuation as per my estimates and (b) my views on fair value / upside in a ‘base case’ scenario

       iii.          We estimate at least c. 40 to 60% upside to fair value over the next couple of years, triangulated via various methodologies

Catalyst

See above