Description

Grocery Outlet (GO) is an extreme value grocery retailer offering a broad range of brand-name consumables and fresh products at ~40%-70% discount. Similar to TJ Maxx and Marshalls, GO offers a treasure hunt experience of grocery items. They offer these deep discounts with no membership fees or large purchases. 

The Company was founded by Jim Read in 1946. GO accelerated its new store openings under the 3^rd generation of the Read family in 2006 (from 128 stores). Since then, GO has grown to over 430 stores in 6 states, mostly on the west coast. A typical GO store is ~14k sq. ft. (vs Whole Foods at ~ 39k sq. ft.) and carries only ~5,000 items at a time based on local preferences. Most of these stores are conveniently located in neighborhoods and are managed by local Independent Operators (IO). IOs are franchisees like owners of a GO store.

Walmart (now ~11k stores) started off by making purchases in large volume to negotiate the lowest price possible; passing that benefit to the consumers, and generating high sales volumes and rapid inventory turnover. Costco (~800 stores) offered similar value to its paying members by applying the same concept of low-cost on a very limited selection of bulk goods. Both companies created an empire around offering better value to their customer.  While it is no Walmart or Costco, GO is in the process of building its business with its own version of extreme value offerings to consumers and opening new stores. Below are the key reasons why I like GO:

1. Unique Business Model: Centralized purchasing and localized selling.

• How They Buy: GO opportunistically buys brand-name goods at a steep discount from its suppliers when there are order cancelations, overproduction, packaging changes, shorter “sell-by” dates, excess seasonal inventory, etc. The company has long-standing relationships with well-known, household brands and emerging brands that offer such buying opportunities – GO is usually their first call. This is because GO is one of the few buyers that can handle large volumes, is trusted to protect the brands, and has the distribution center to execute at a large scale. 
• How They Sell: Grocery Outlet stores are locally managed by independent operators (similar to a Chick-Fil-A franchise model). These IOs are experienced managers who want to build their own stores, gain independence, and aim to make more money. The IOs are responsible for the entire day-to-day operations of the store, including ordering, managing inventory, marketing locally, and directly hiring/training their employees. Like most franchises, IOs cover the store operating expenses, are responsible for selecting the merchandise that makes it to their shelves, and ultimately aim to maximize and enjoy the profits.

The company is responsible for investing in the stores, securing the lease, and providing (as consignment) all the merchandise inventory required for the store. They add value by using a centralized sourcing and distribution model and decades-long relationships with suppliers to constantly access an ever-changing assortment of products that they can put on the local store shelves.

In this relationship, once the store is open, GO splits the store’s gross profit in half (50%) with the IO.  A mature store should generate over $2M of gross profit, of which $1M goes to the IO and $1M goes to GO.  This $1M of gross profit should cover the store's operating cost, employee wages, benefits, etc. and the remaining amount will be the IOs profit. The other $1M of gross profit covers GO’s rent and local marketing spend - the remaining amount is contribution profit to the parent company.

Illustrative Example: Say Coca-Cola had 1 million seasonal bottles of soda with Santa Claus on the packaging in January – most traditional retailers would not take this product/packaging. So, instead of discarding 1 million bottles, Coca-Cola will sell thm to GO for $0.20 per bottle. GO will then mark it up to make ~30% gross profit and sell it for $0.30 per bottle. The GO consumer saves 70% (vs paying $1 per bottle at say Walmart); The IO and GO split the $0.10 of profit per bottle; and Coca-Cola earns $200k for its excess inventory. GO repeats this process with +85,000 items from its +1,600 suppliers throughout its 400 stores.  And growing…

2. Competitive Advantage:  GO has a unique competitive advantage that should get better over time.

• Sourcing Advantages: The ability to purchase at low prices is essential to a discount retailer. If you are a large consumer packaged goods (CPG) company with excess inventory, you would want a buyer who can take large volumes, pay you on time, and be able to sell your products in a way that does not tarnish your brand (i.e., before the “sell-by” date, etc.) GO is one of the few large buyers that can offer the above – as such, GO is one of the first calls that CPG suppliers make when they need to sell excess inventory. This ability and relationship should get stronger as GO executes its expansion plan, making it very difficult for a newcomer to access the same level and variety of merchandise at a steep discount.
• Selling Advantage: By working with entrepreneurial local IOs, the company offers a more localized product at each store. There is a strong alignment of interest with the local IOs to maximize gross profit dollars which results in attractive returns for the IOs. GO has a very selective IO recruiting program – they receive +20k leads annually and roughly ~70 are selected for the training program – even fewer actually get to operate a store. This pipeline supports access to higher-quality operators and future store opening plans.

3. Attractive Unit Economics:

• A typical GO store costs ~$2M, all in (including inventory, store buildout, and pre-opening expenses). A mature store (by ~year 4) generates ~$6.5 to 7M of revenue with a stable ~30% gross margin (~$2M gross profit). GO shares half of the gross profit with the IO; pays rent (~$225k-$300k per store) and some advertising - the remaining is its profit contribution. The average store should contribute over ~$600k per year. An attractive pretax ~30% return on a $2M investment.

• Over the past 17 years, same-store sales growth has averaged +5% (in line with Costco) and has enjoyed a stable ~30% margin. 2020/21 was an anomaly – unusually high growth followed by a decline. These stores tend to do even better in difficult economic environments (SSS growth was 12% and 14% in 2008/09), and ~7.5% YTD in 2022.

4. Long Runway for Growth: 

• Since 2015, the company grew from 237 stores to 430 stores while also more than doubling its EBITDA from $100M to ~$215M in LTM 2022 – a ~10% CAGR. They are currently in only 6 states.

• GO believes that they can open an additional 1,500 stores in and near their current markets. Longer-term, they should be able to open over 4,500 stores nationally (~10x more stores). Given the attractive returns these stores generate, a disciplined capital allocation towards opening more stores makes sense.
  • Aldi – with a similar business has ~2,000 stores across 37 states mostly in the eastern half of the US.  For context, there are ~2,800 Kroger’s and ~11k Walmart stores.
• Going forward, GO plans to keep a ~10% new store opening cadence. This should translate to ~40 new stores next year and +$80M of re-investment opportunities for several years. The cash flow generation from the existing stores and its healthy balance sheet should be sufficient to fund future store growth.

5. Valuation:  GO trades at a sensible valuation due to a fear of inflation and online grocery threats. GO currently trades at ~$28.50 per share and has ~100m shares outstanding.

• With ~430 stores today generating +$215M of LTM EBITDA, the stock is trading at ~$3B enterprise value or roughly ~14x EV/EBITDA. Given the potential returns profile for future stores' economics and the long runway to reinvest capital, I think this is a reasonable valuation.
• With a combination of ~10% new store growth, and ~2-3% SSS growth, coupled with some potential operating leverage, I expect earnings to continue to grow at an average of ~10%-15% (low-teens) going forward.  At this cadence, by the end of 2026, GO should have ~630 stores generating ~$5B in sales and ~$325-350M of EBITDA.  With a stable multiple, I expect GO to compound capital at ~mid-to-high-teens over the next ~5 years.

Key Risk to Consider:

• Limited ability to source attractive inventory at a larger scale
• Increased competition from the likes of Aldi as they overlap geographic presence 
• Ability to replicate success in new markets and regions

Catalyst

• Continued execution of current stores
• Disciplined expansion of stores in current and new markets