Description

Summary

Grocery Outlet is a leading extreme value retailer, well-positioned in the US discount grocery market. The company’s unique business model, which includes a network of independent operators and a differentiated buying strategy, allows it to offer significant savings on high-quality, name-brand products. Grocery Outlet has meaningful whitespace for geographic expansion, with visibility to 10+ years of strong store growth ahead. Grocery Outlet’s experienced management team under the strong leadership of CEO RJ Sheedy is well-equipped to capitalize on these growth opportunities. At 8x 2024 EBITDA and 19x 2024 P/E (adj. for one-time systems conversion costs), the stock is attractively priced for a company with an excellent competitive position and likely continued double digit growth over the next 5 years. The risk of the investment is also limited due to the highly stable nature of the company’s financials and its counter-cyclical model.

Company History

• 1946: Jim Read founds Cannery Sales in San Francisco. He bought government surplus food products and sold them in previously vacant stores throughout San Francisco. Model ultimately changed to selling closeout, factory second, and discounted products
• 1973: The first Independent Operator Agreement is signed in Redmond, Oregon
• 1982: Peter and Steven Read assume leadership of the company
• 1987: Company is renamed Grocery Outlet
• 1995: Grocery Outlet opens its 100th store
• 2001: Grocery Outlet acquires inventories of failed Internet companies Webvan and Wine.com
• 2006: MacGregor Read and Eric Lindberg become Co-CEOs, ushering in the third generation of family leadership
• 2009: Berkshire Partners LLP acquires a majority interest in Grocery Outlet Inc.
• 2011: Grocery Outlet acquires grocery store chain Amelia’s and expands to East Coast
• 2012: Grocery Outlet expands into Southern California
• 2014: Hellman & Friedman acquires Grocery Outlet
• 2018: Board of Directors appointed Eric Lindberg to Chief Executive Officer and MacGregor Read to Vice Chairman
• 2019: Grocery Outlet launches its initial public offering
• 2021-22: Launched eCommerce capabilities in partnership with Instacart, DoorDash, and Uber
• 2023: RJ Sheedy assumed the role of President & CEO

Business Overview

Grocery Outlet is a retail grocery chain that operates primarily in the United States, known for its distinctive business model of offering deeply discounted, high-quality groceries. The company partners with suppliers to purchase excess inventory, closeouts, and overruns at significantly reduced prices. This approach allows Grocery Outlet to pass substantial savings on to its customers. Unlike traditional grocery stores that focus on maintaining consistent inventory, Grocery Outlet's stock varies frequently, providing a treasure-hunt shopping experience for customers looking for bargains on brand-name products.

Grocery Outlet’s flexible buying model enables them to offer quality, name-brand products at substantially lower prices than the competition. They source name-brand consumables and fresh products opportunistically through a large, centralized purchasing team that leverages long-standing and actively managed supplier relationships to acquire merchandise at significant discounts. The savings relative to traditional food retail can be quite dramatic – the company targets 40% average discounts to prices seen at mainline grocers, and 20% relative to what is seen at other discounters. Grocery Outlet also sources everyday staple products to complement the opportunistic offerings. Each store offers a curated and frequently-changing assortment of items, creating a "buy now" sense of urgency that promotes return visits and fosters customer loyalty.

The opportunistic buying model can lead to some shockingly-good values, especially in an era where high inflation has left consumers stretched:

At the store level, the company operates on a franchise model, with each store independently owned and operated by local entrepreneurs. This decentralized approach fosters a strong sense of community involvement and personalized customer service. Franchisees, known as independent operators (“IOs”), benefit from the flexibility to tailor their stores to the needs and preferences of their local markets, while also receiving support from Grocery Outlet's corporate headquarters in areas such as procurement, marketing, and operational training. Unlike a store manager of a traditional retailer, IOs are independent businesses and are responsible for store operations, including ordering, merchandising and managing inventory, marketing locally and directly hiring, training and employing their store workers. IOs initially contribute capital to establish their business and share store-level gross profits with the parent company. This model has been a key factor in the company's growth and success, enabling it to expand rapidly across various regions. Becoming an IO can also be a quite lucrative opportunity for the local entrepreneur – as the company shared in 2023, the annual net income of an average mature store operator exceeds $250,000, meaningfully more than they would be making as the manager of a competing store.

The 4-wall economic model of Grocery Outlet stores is very attractive. The stores average 14,000 square feet of selling space, are easy to navigate, and focused on the highest-selling SKUs. The average net cash investment in a new store is $2.5mm, including store buildout, inventory, and cash pre-opening expenses. There is a multi-year ramp in the maturity of the store, with sales increasing from $5.5mm during the first year and reaching maturity in 4 years. In that time period, the initial store costs are paid back, and the store reaches an average cash-on-cash return of 30%+. This high return and predictable economic model has provided attractive returns across many different geographies, and gives the company visibility into multiple years forward of attractive and profitable growth.

There is enormous whitespace nationally for Grocery Outlet’s concept. The company’s long-term strategic goal is to expand the store base by approximately 10% annually by penetrating existing and contiguous regions. Grocery Outlet also believes there is market potential to establish 4,800 stores across the United States. This would represent roughly 10x the current store footprint. 

Grocery Outlet locations as of March 30, 2024:

You can see from the map of Grocery Outlet locations that the concept is currently very focused in California and the Pacific Northwest. Thus, there are large swathes of the country that could benefit from an offering like GO’s and will serve as expansion opportunities for years to come. The map above does not reflect Grocery Outlet’s recent acquisition of a 40-store chain based in Tennessee, North Carolina, Georgia, Alabama, Kentucky and Virginia. This acquisition will serve as the basis for GO to expand across the Southeast over the coming years. Overall, in 2024 the company is targeting an increase in stores of 58 to 62 for the year, a +13% growth y/y, very much in line with the company’s longer-term targets.

Grocery Outlet competes well and co-exists with a variety of other retail concepts. There is meaningful overlap with a variety of other retailers, but the company’s unique model continues to resonate. By geographic proximity, the retailers closest to Grocery Outlet are most often Dollar Tree, Albertsons/Safeway, and Walmart.

Some skeptics of the company have cast doubts about the company’s store growth target. In particular, they assert that the cohort of recently opened stores has been struggling, suggesting that the concept has limited capacity for new stores. In particular, the bears wave red flags around Grocery Outlet’s “Temporary Commission Adjustment Program” (TCAP), which provides a greater commission to participating IOs who require assistance in meeting their working capital needs for various reasons and functions as a loan from the company. The bears suggest that these programs are being increasingly utilized by struggling new stores. However, a look at the numbers shows that TCAP and other loans to independent operators are not at elevated levels currently. Whether you consider the loans on a gross or net of allowance basis, the programs are currently being utilized at a level consistent with GO’s history as a public company: 

In sum, Grocery Outlet’s business is differentiated, resonates with both consumers and potential franchisees, and should have attractive expansion opportunities for at least 10+ years. The company's unique combination of cost savings, community engagement, and sustainability has helped it carve out a niche in the competitive grocery market, attracting a loyal customer base and driving steady growth.

Management

RJ Sheedy has served as President and CEO of Grocery Outlet since January 2023. He has served as a director since January 2023. Previously, he served in a variety of increasingly important roles at the company, including as President (2019-2022), Chief Merchandise, Marketing & Strategy Officer (2014- 2018), and Vice President, Strategy (2012-2014). Before joining the company, RJ served in various roles at Staples Inc., an office supply company, from 2005 to 2012, most recently as their Vice President, Strategy. 

We believe that RJ has been a very important driver of Grocery Outlet’s growth over the past 10 years and is well suited to continue to roll out the concept nationally. Additionally, we believe the management team around RJ is top-notch, and that the board (including Eric Lindberg, former CEO and member of GO’s founding family) remains quite aligned and engaged. Note that the board members and executives of the company currently own ~5% of the shares outstanding.

Financials/Valuation

One of the hallmarks of Grocery Outlet’s business has been its consistent growth and profitability. Same store sales growth rates have been quite attractive over time, particularly in stressed economic periods like the 2008-2009 recession:

The strong comp sales performance, combined with new units and consistent EBITDA margins, has led to meaningful increases in revenue and EBITDA for the company over time:

Grocery Outlet currently trades at 9x 2024 EBITDA, which equates to 24x P/E. It is very important to note that profitability for 2024 has been weakened by the one-time costs of an ERP systems transition – management has stated that total expenses related to this are $33mm hitting in the first half of 2024. If we adjust for these costs, the look-through multiples are 8x EBITDA and 19x P/E. We expect that looking beyond 2024, Grocery Outlet will quickly regain the hits to margin it sustained through the systems transition. Additionally, the company will continue rolling out stores at a brisk pace, increasing store count +10% per year. Combined with healthy 3-4% comp growth, top line should compound at a double digit rate over our investment period. Putting it all together, we consider the current price very attractive for a company with a strong competitive position and attractive growth outlook for the next 10+ years. The company and its insiders certainly agree, with Grocery Outlet increasing its share repurchase activity in recent quarters and multiple board members purchasing shares recently.

Risks

• Inventory variability/sourcing model: Due to its reliance on excess and closeout inventory, Grocery Outlet faces the risk of inconsistent product availability, which can impact customer satisfaction and loyalty. The sourcing model may not scale at the same rate as the store base (though thus far the company has not runt into issues on this front).
• Supplier relationships: The business model depends heavily on obtaining surplus goods from suppliers. Any disruptions in supplier relationships or changes in supplier inventory levels could adversely affect stock availability and pricing.
• Macroeconomics: Grocery Outlet and other discount retailers have experienced weak periods of same store sales in particularly strong economic climates, as consumers may trade up to more luxe options. On the other hand, economic downturns would provide a source of upside for Grocery Outlet.
• Competitive pressure: The grocery retail sector is highly competitive, with major players like Walmart, Kroger, and Amazon posing threats. These competitors have greater resources and could undercut prices or improve service offerings. Grocery Outlet’s model is notably differentiated from all of these players, however.
• Geographic limits: Grocery Outlet’s model and brand recognition have been more concentrated in certain geographies, and the company could have a more difficult time expanding outside this footprint (though recent efforts on this front have performed well).
• Franchisee performance: The success of the franchise model depends on the performance of individual franchisees. Poor performance or financial difficulties faced by franchisees could impact the overall brand and financial health of the company.

Conclusion

Grocery Outlet is a high quality, well-managed, and well-positioned business. We believe that the current price is very inexpensive, that the forward growth outlook remains strong, and that an investment in Grocery Outlet is an attractive risk-reward looking forward over a 5-year period.

Catalyst

• Completion and lapping of ERP system implementation costs
• Continued store growth and execution