Description

Background

Grocery Outlet (GO) is an extreme value retailer, with a focus on grocery.  The business was founded in 1946 has been profitable every year since its founding.  The company offers a treasure-hunt shopping experience for name brand products priced at 40-70% discounts to conventional retailers’ prices.  About 50% of the products sold are opportunistic products (typically excess inventory from CPG companies) sold at these large discounts.  The other 50% of products sold are staples (e.g. milk, sugar) that cannot be sourced opportunistically; these products are sold at or below pricing at conventional supermarkets.  Importantly, the staples products round out GO’s product offering, enabling the store to be a one-stop-shop for consumers’ grocery needs.

There are two key structural differentiators to GO’s business model.  These are summarized in the company’s slogan: “Out chain the locals, out local the chains.”  First, the company buys centrally (as a larger chain would buy).  The company has a central purchasing team that maintains supplier relationships and aligns purchasing with demand trends.  This team wants to be the “escape valve” to CPG companies for their excess inventory.  GO offers a non-disruptive, brand-protected sales channel for this excess inventory.  There are clear economies of scale to centralizing this procurement function, which differentiates GO from local competitors.  Second, stores are locally managed by “Independent Operators” – these IOs are entrepreneurs who handle merchandising, inventory management and store employees.  In return, GO splits its gross profit (at each respective store) with that store’s IO.  This model is an extreme decentralization of responsibility that enhances entrepreneurial spirit and local market knowledge.  It also creates a variable cost structure (to GO) for store operations.

There are ~400 total stores, with the majority existing in California, Oregon and Washington.  The company also has a foothold in Pennsylvania, which originated through an acquisition (of Amelia’s).  

Key company attributes

1. Consistent and strong same-store-sales growth

GO’s strong customer value proposition and unique operating model have led to excellent long-term same-store-sales performance.  The company has had positive SSS for 17 consecutive years, with average SSS of ~5.5% throughout that period.  

2. Store growth potential

In addition to the performance of existing stores, the company has benefitted from consistent expansion of its store footprint.  The company’s store count has increased ~10% per year for many years.  GO still has significant potential for future store growth.  The company estimates that it could open an additional ~1,500 “in-market and neighboring state” locations, and up to ~4,800 stores nationally.  GO management’s long-term store growth target is 10%, which as stated above is consistent with its historical performance.

3. Model stability

The two-sided strength of central purchasing and IO local management model is time tested.  GM% has been incredibly stable over time (at 30-31%), as has been the company’s EBITDA margin (at ~6.5% for the past seven years).  The company closes very few stores every year, which is another indicator of the success of the model.

4. Goldilocks profit levels

GO’s profit margins (~3.5% GAAP EBIT margin) are admittedly underwhelming compared to the market in general.  Grocery is a competitive category, and customer price sensitivity is high.  However, recall the Jeff Bezos adage: “Your margin is my opportunity.”  GO’s margins leave little room for competitors to undercut the company’s pricing to customers.  This company is genuinely offering consumers very good value (management consistently price compares to ensure that the company has better pricing than conventional and discount grocers).

Even at the modest margin levels at which GO operates, the company generates acceptable returns on capital.  I estimate after-tax returns of low teens (aside from 2020, where the company over-earned due to COVID-related pantry loading) on tangible invested capital.  (There is significant goodwill on GO’s balance sheet, but this is a legacy of its buyout by Hellman & Friedman (in 2014) as opposed to baggage from previous GO acquisitions.)  While GO’s returns on capital are not off-the-charts positive, I believe that they are sustainable, and they support the competitive durability of GO’s value proposition.  Management’s stated returns on new store investments are higher (>20% after-tax) than the company’s overall average.

5. Counter-cyclical

GO is counter-cyclical, which makes intuitive sense.  Consumers care most about access to extreme value when they need the savings.  SSS in 2008 and 2009 were 12.3% and 14.7%, respectively.  I like the defensiveness of this attribute; the company has grown consistently and does especially well when other retailers are under the most pressure.

Market misperceptions

I believe that GO is available at a discount to its intrinsic value for three main reasons: 1, lousy trends related to COVID; 2, fears of the online grocery threat to all offline grocers; 3, inflation worries.

1. GO was a beneficiary of COVID, as were many grocers.  There was well documented pantry loading.  As a consequence of the company’s extremely strong 2020 performance, the company is facing very difficult comps in 2021.  YTD SSS are negative, and 2021 is likely to be the company’s first negative SSS performance year in memory.  Two-year-stacked performance is solid, although unspectacular.  Beyond the difficult comps, GO is struggling with consumer behavior dynamics, which GO management attributes to continued stimulus funds, as well as trip consolidation.

My response: I view the poor SSS trends as transitory.  They will improve with the lapping of comps, and I also believe there is credibility to the idea that easy money policies have negatively impacted consumer demand for extreme value in grocery retail.

2. The “online threat” to offline grocers has been highlighted due to the rapid increase in grocery purchasing transacted online.  In 2019, ~4% of grocery spending was online; in 2020, due to COVID, that figure jumped to 10%.

My response: I view this as a red herring.  Off-price retailers like TJ Maxx, Marshalls and Burlington have been great stocks, despite <5% of revenue generated online.  These stocks put up excellent long-term performance, with almost no online presence, while apparel sales shifted to almost 50% online.  Share of grocery sales conducted online will likely continue to increase, but I think Grocery Outlet’s success is non-mutually exclusive from this trend.

3. Fear of inflation, and that this may result in margin pressure to GO.

My response: I believe that inflation worries are warranted.  However, I think this fear is over-stated in the case of GO.  This company is the largest buyer in its industry, and inflation will impact all retailers.  GO plays a relative game… they are targeting discounts to other retailers’ prices.

The value of GO

As stated earlier, there are some good value creation examples in the off-price retailer landscape (especially with the concepts that have had significant store growth).

The other check that I found compelling was a comparison to Costco.  Costco is rightfully viewed as a role model retailer.  I compared Costco’s US, ex-gas SSS vs. GO, from 2004 – 2020.  To my surprise, the stats were nearly identical.  The geometric means of same-store-sales over this time period were: GO 5.5%, COST 5.6%.  These companies also have nearly identical EBIT margins.  COST has the membership / subscription model, which is superior, but GO has significantly better store growth potential.

At about 19x my 2022 EPS estimate, GO trades at a discount to growth off-price retailers like BURL, FIVE and OLLI.  It also trades at a significant discount to COST.

As an additional sanity check, I ran the company’s current FCF yield, excluding the construction of new stores.  I think this figure is about 6%.

I view the company's forward PE and FCF yield (ex store growth capex) as acceptable, but not obviously cheap. Ultimately, my thesis is dependent on the company's store growth potential. I estimate that the average store generates pre-corporate, unlevered FCF of ~$480k.  At a 10% discount rate and 3% growth rate (vs. higher traditional same-store-sales), the existing 400 stores are worth about $2.7bn.  Each store is worth ~$6.8 million, which I view as a fairly conservative estimate given current market valuations.  Each store costs ~$2mm to build and launch; therefore there is significant value creation to the company from the store expansion operation.  I conservatively only value the NPV of 10 future years of store growth (in round numbers, another 600 stores, taking the company’s total to 1,000).  I think this is worth NPV of ~$1.5bn.  Note importantly that I burden the new store NPV with corporate costs (as I exclude those costs in the current store analysis above).  Based upon this math, the stock offers ~70% upside, close to ~$40.

Catalyst

Catalyst

The company already guided to Q3, and gave directional forward guidance for Q4 (stating that the two-year stacked comps should hold with current trends).  The company has traditionally been conservative in its guidance, and I view the risk of weaker-than-expected 2H 2021 performance as unlikely.

The positive catalysts are: 1, optically better performance (easing of comps) in 2022; 2, a sunset of stimulus benefits; 3 (less likely), potential stock buybacks (leverage is very comfortable at 1.5x EBITDA and the company is FCF positive, even after store growth investments).