GO - Grocery Outlet Holding: Unit Growth And SSS Growth To Continue Driving Growth

2023-12-14 06:37:34 ET

Summary

• Grocery Outlet Holding reported strong 3Q23 performance with $1 billion in revenue and 6.4% same-store sales growth.
• The system transition issue impacted SSS growth by 150 bps, but I don't see this as a structural impairment to the Company's business.
• GO aims for long-term annual store growth of 10% which means that my 10% growth assumption can be easily met.

Summary

Following my coverage of Grocery Outlet Holding ( GO ), I recommended a buy rating due to my expectation that GO can continue its growth pace given the strong 2Q23 performance. I was also encouraged by management's forward-looking statements about growth in the near term. This post is to provide an update on my thoughts on the business and stock. I reiterate my buy rating for GO, as I expect its growth performance to track well or even beat my 10% growth assumption over the next 2 years. The system transition headwind is a mistake, but it does not mean that GO business model is structurally impaired. Future units growth strategy also bodes well for GO, which I expect to drive margin expansion.

Investment thesis

3Q23 was another strong quarter for GO, as it reported $1 billion in revenue and EPS of $0.31. Revenue performance was driven by 6.4% same-store-sales [SSS] growth, which marked an improvement of 820 bps on a 3-year stack basis (normalizing COVID-period impact). SSS growth performance could have been higher if management addressed the transition issues properly, which impacted SSS by 150 bps. Adjusting for the 150 bps, SSS growth would've been 7.9%, and 3-year stack SSS growth would have accelerated by nearly 10 percentage points. That aside, on a positive note, gross margin improved to 31.4%, ahead of management guidance of 31.3%. The improvement in gross margin was due to organic drivers such as healthy deal flow and a favorable buying environment. Adjusting for the system transition issue, gross margin would've improved by another 50bps to 31.9%.

I remained positive about GO's ability to perform against my FY23 expectation of 10% growth over the next 2 years. As mentioned, a normalized SSS growth would be 8%. Importantly, the growth driver for SSS was primarily traffic (8.6% growth). Both the number of new customers and the number of trips made by existing customers increased, according to management. This suggests that the trade-down movement is still ongoing and as long as the macro environment remains tough, I expect this trend to continue for the longer term. Regarding the negative pricing headwind, the primary cause was in-stock issues arising from the switch to a new ordering and inventory management system. As discussed above, the system transition headwind is 150bps, without these, pricing will be flattish. Nonetheless, because of this hiccup, 4Q23 SSS is expected to be weak at 2%, indicating that FY23 is likely going to track lower than my expected 11% growth. While I agree that this was a bad execution mistake, I don't think this represents anything structural defect in the business. With improved warehouse inventory levels and system flow, management is already anticipating a sequential improvement throughout 4Q. As such, so long as GO fixes this, and does not repeat the mistake again, the business should be back to normalized SSS growth in FY24.

Coupled with SSS growth, GO new store growth is also tracking according to plan. During the call, management announced that they will be opening 27 new stores in FY23, with an additional 13 stores expected to open in 4Q, for a total of 468 locations by year's end. In my opinion, for management to give this guide in November, it suggests that everything is on track and there are no visible headwinds that could delay these growth expectations. Moreover, management reiterated their long-term annual store growth target of 10%. 10%, along with positive SSS growth, would mean that GO can easily beat my 10% growth expectations.

Regarding margins, management is now guiding to a 4Q23 gross margin of 30%, which is a 10bps y/y decline, largely due to seasonality and the 150 bps of impact of the system transition. This also impacted the FY23 gross margin guidance, which is now guided by 31.3%. Putting aside the system transition impact, I believe 3Q23 results show that margins can continue to improve, and I expect them to continue expanding over the next few years. Specifically, management has indicated that there is still a strong pipeline of closeout opportunities, spanning various categories and suppliers, with support from evolving consumer preferences and increased innovation. This ties back to my point on the weak macro environment sustaining this trade-down trend. GO will continue to be in a good position to take advantage of closeout opportunities as it has the traffic to support its large procurement volume. I also like that GO is not using too much promotion to drive SSS growth. This can be seen from the flattish pricing change in 3Q23 (adjusted for the system transition headwind). We should not forget that the upcoming store unit growth plan will focus on clustering in order to leverage GO's supply chain and brand awareness. Revenue from these new units is going to flow into the P&L at higher incremental margins, which should drive margins up as well. As such, as we move past 4Q23, the FY24 margin should go back to the path of expansion.

The closeout market remains strong, and our growing size and scale provide increasing access to products. We remain highly selective with our opportunistic purchases, and we continue to buy only the best deals that are presented to us. 3Q23 earnings results call

Valuation

My target price for GO based on my model is $39.88, a minor reduction from my previous target price of $44 as I adjusted my FY23 estimates modestly downwards to reflect the system transition impact. While management reiterated their guidance for $3.95 billion in sales, I am taking a more conservative approach. I did the same for earnings margin, where I revised from 2.7% to 2.6% as the system transition is going to take a full quarter to resolve. Post FY23, my assumptions are the same: that growth can easily grow at 10% a year (10+% store unit growth + positive SSS growth), and that margin will expand due to better operating leverage.

The one major revision that I made was to assume that GO will trade at 26x forward PE instead of 29x (my previous estimate). One of my concerns is that the trade-down impact might end earlier than expected as US inflation rates are tapering fast. So fast that the Fed is signaling a rate cut in CY24 . When I compare GO against peers like Sprout Farmers, Kroger, Natural Grocers, and Albertsons Cos, GO is trading at a very high premium already, even at 26x. As such, to be conservative, I am assuming the multiples remain at this level (the low end of GO's historical trading range).

Risk

As I mentioned in the valuation section, if inflation were to taper back to 2%, the trade-down impact that GO has been enjoying might end soon. This does not mean that GO is going to be structurally impaired. It just means that the growth in the near term might be impacted as consumers revert back to their previous purchasing habits. The slowdown in growth could hurt growth expectations, thereby driving valuations down.

Conclusion

Overall, my recommendation for GO is a buy rating. Despite a system transition hiccup impacting recent SSS figures, 3Q23 showcased strong performance with $1 billion in revenue and 6.4% SSS growth. I believe the positive traffic growth indicates the continuous trend of trade-down, and with management's reiteration of store unit growth, GO should be able to grow 10% over the next 2 years. Additionally, future unit growth strategy should drive operating leverage.

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