Should you buy shares in Greggs?

If there's something that most people remember from March's budget it's the 'pasty tax' - the government's plan to charge VAT on freshly baked food (apart from bread). For investors the proposal could be a big problem for one of our favourite food retailers, the bakery chain Greggs (LSE:GRG).

There's no doubt that the 'pasty tax' is a major headache for Greggs. Savouries account for around one third of its total sales. The company has said this morning that the tax could have "a material impact on our sales and profits". It's not difficult to see why. Having to increase the price of sausage rolls and pasties by 20% is not good for a business that already has to deal with cash strapped customers. The alternative, absorbing the cost itself, could do a lot of damage to profits.

The stock market knows this, and the shares are down sharply. Oriel Securities told its clients to sell the shares, saying they were only worth 400p. Many analysts seem to have taken the view that George Osborne will, in effect, decide whether Greggs' shares are worth buying or not.

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Given Greggs is under a cloud of uncertainty, a lot of investors may sit on the sidelines until the dust has cleared. The government's consultation period ends this Friday (18 May) with the changes due to come into effect this October. It may lead to a buyers' strike on the shares for the next few weeks, with worried sellers sending the shares lower. Some think this uncertainty presents investors with an opportunity. But we're no longer so sure.

Trading is holding up pretty well

Greggs revealed this morning that its like-for-like sales for the first 19 weeks of the year had declined by 1.8%. This is not too surprising. Most of us know that trading on the high street is tough - both Tesco and Morrisons' underlying sales are declining. What's interesting is that Greggs' like-for like sales have not got any worse they were down 1.8% for the first ten weeks of trading. Given that the weather during the last few weeks has been awful, this looks like quite a robust performance.

Total sales have increased by just 4.3% as new stores mature, but Greggs' alternative sales channels are showing promising signs. It looks as if Greggs' frozen sausage rolls have been a hit with Iceland customers, so much so that a further seven savoury products and one sweet product are now being sold. Given that Iceland is doing relatively well at the moment, it raises the question as to whether Greggs could develop a significant wholesaling business, particularly as it has its own bakery network.

Greggs like-for like sales growth (%)

One of the good things about Greggs' business model is that it has been moving away from the high street and focusing on places with more sustainable footfall. There has been a growing focus on transport interchanges such as train stations and airports, an idea that is now being rolled out to motorway service stations. Its first coffee shop in Newcastle upon Tyne has done well, and a second one in Middlesbrough has just opened.

But what about the impact of the pasty tax? The truth is that no one really knows. That said, it's difficult to see that Greggs, with its own chain of bakeries, will be at a competitive disadvantage to other bakery shops selling the same products.

The big uncertainty is whether higher selling prices will lead to more people making their own lunches or buying them in convenience supermarkets. Greggs' reputation for good value may mean that sales may not suffer that much.

Should you buy or avoid the shares?

So should you buy Greggs shares? Greggs faces lots of challenges, but it has not become a bad business on the back of a random government proposal. In fact, it still remains a very good one. We think that its gradual shift away from the high street will give it a more sustainable business model in the long-term.

Its finances also remain impeccable, and it has cash on its balance sheet. Yes, it rents all of its shops, but it is not tied into long-term rental agreements like some of its peers. Its fixed charge cover (the ability to pay rents and interest) is a comfortable 2.2 times. At 486p the shares trade on 11.7x forecast earnings, offering a yield of 4.3%.

For all these reasons I've been a fan of Greggs in the past. The trouble is that UK supermarkets Tesco, Sainsbury's and Morrisons are now cheaper and offer bigger dividends. So even though we like the Greggs business model, there's still scope for the shares to go lower unless George Osborne changes his mind. We'd therefore avoid the shares for now.