GO - Grocery Outlet Holding: Bullish On The Growth Momentum So Far

2023-04-06 11:48:45 ET

Summary

• GO's 4Q SSS was driven by an increase in traffic and ticket size, which is indicative of the company's strong growth momentum and competitive position.
• GO's differentiated operating model with flexible sourcing is expected to result in relatively stable gross margins over time.
• GO has a long runway for unit growth and a healthy pipeline of sites for the next 36 months.

Overview

As I have mentioned before , the current environment is an alignment of stars for Grocery Outlet Holding ( GO ), in which it stands to benefit from raising prices and capturing share from traditional grocers. The recent 4Q22 performance have reinforced my bullish view. GO's 4Q SSS of 15.1% was nearly 300bps above the consensus estimate of 12.2%, and it was driven by an increase in both traffic and tickets as customers continued to respond positively to the business value proposition of offering deep value. GO also provided guidance for FY23, with revenues that were in line with expectations. Despite the recent stock trade down, which I attribute to a market selloff, I maintain my buy rating because I think the thesis is being proven correct.

SSS

The 15.1% 4Q SSS was driven by a 10% increase in traffic and a 4.6% increase in ticket size. This is so impressive that the stacked two-year SSS growth of 13.7% is the highest in the past 8 quarters. This, in my opinion, is indicative of GO's strong growth momentum and competitive standing in the market. The 4Q22 quarter saw an overall uptick in traffic throughout the quarter, and management noted that the trend carried over into 1Q23. However, I would like to highlight the fact that this year SSS should begin to moderate as GO lap the impact of inflation. Elsewhere, East Coast locations continue to outperform the rest of the chain on a comparable basis, helped by the rising profile of the company's brands in the region. Management highlighted the fact that new customers come from a wide range of demographics, with some having slightly higher incomes, and that existing customers are taking more trips and contributing more financially. These are, in my opinion, crucial indicators of GO's success and growth.

Gross margins

Despite solid sales and service, gross margin fell to 30.2% in 4Q22, down 70 bps y/y due to rising input costs. With the holiday season behind us and with the help of disinflation, I anticipate an increase in gross margin for 1Q23. The optimistic shopper climate should lend further support, especially given the reasonableness of promotions in most sectors of the market. Despite these challenges, I expect GO's differentiated operating model with flexible sourcing to result in relatively stable gross margins over time. If we look at GO historical performance, gross margin has consistently maintained around low 30%, which I believe speaks well of its ability to sustain margins.

Long-term growth

While I expected GO to make the most of the current environment to drive even more store growth, I was a bit disappointed to hear that the company would only be guiding 6% store growth in FY23 due to ongoing supply chain and permitting delays. On the other hand, I think this may just be a matter of timing, as it makes sense to be more cautious in the short-term given that no one can predict the future of the macro environment. I think it's crucial that management is still positive about resuming annual growth of 10% starting in 2H23, with 47 stores planned for FY24. GO also has a long runway for unit growth and a healthy pipeline of sites for the next 36 months.

Guidance

GO provided FY23 guidance that was in line with the consensus on the top line but lower than expected on the bottom line after adjusting for non-cash rent and the provision for accounts receivable reserves. Guidance for FY23 included net sales between $3.85 and $3.90 billion, SSS between 4.5 and 5.5%, and adjusted EPS between $0.94-0.99. As for 1Q23, SSS of 10% and a 30.6% gross margin were guided.

Bear case

I believe the primary bear case for GO would be its valuation, which is trading at 27x forward PE. This is not an easy valuation to swallow in the current market. I believe the bear case narrative would go something like this:

1. While GO has shown strong momentum, the peak is likely over, and growth will begin to moderate from here on out.
2. The decline in growth may be sharper than expected, given the huge benefits from inflation.
3. This sharp drop may force investors to re-evaluate their expectations, causing valuations to re-rate downwards.
4. If the decline is so severe that near-term revenue growth is reduced to single digits, GO valuation could be reduced to the high teens. (which is at least 8x from the current 27x). In that scenario, I believe a high-teens PE would be the floor because it still has better growth potential than other grocery peers (Natural Grocers, Sprouts Farmers, Krogers, and Albertsons) trading in the low-teens PE.

Conclusion

GO recent 4Q22 performance has reinforced the bullish view on the company. The 15.1% 4Q SSS, driven by an increase in both traffic and tickets, is indicative of GO's strong growth momentum and competitive standing in the market. Despite the challenges of rising input costs affecting gross margins, I believe GO's differentiated operating model with flexible sourcing will result in relatively stable gross margins over time. While there may be a bear case for GO's high valuation, I maintain my buy rating as I believe the company has a long runway for unit growth and a healthy pipeline of sites for the next 36 months.

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