Please ensure Javascript is enabled for purposes of website accessibility

Grocery Outlet Gets a Post-IPO Bump, but How Good Is It Really?

By Nicholas Rossolillo - Updated Jun 26, 2019 at 8:14AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The concept is proven, but the current valuation is quite pricey.

West Coast discount supermarket Grocery Outlet (GO 0.79%) recently completed its initial public offering (IPO) and soared as much as 40% above its starting price. The closeout and overstock business model has been a successful one in the last decade as bargain shoppers continue to flock to the treasure-hunt-style experience, so it's no surprise that investors piled into the new stock as well. But Grocery Outlet has a lot to prove, and the current valuation is assuming quick runaway success. I'm not sure the rosy outlook is warranted quite yet.

A unique model for the world of groceries

The Grocery Outlet chain operates as a franchisor, with each store independently and locally owned and operated. Corporate takes care of purchasing, which allows its franchisees to sell goods typically 40% to 70% off a typical grocery retailer. The resulting shopping experience is a revolving door of mystery inventory, similar to what one would expect from TJX Companies' TJ Maxx or Ross Stores.

Sounds great. However, because Grocery Outlet is a franchisor, it needs to somehow pay its partners. Specifically, it shares 50% of gross profit on a per-location basis with store owners. These independent operators are responsible for staffing, local advertising, and other day-to-day operating expenses. But because each store is independently owned, there could be high variability in each location's actual performance -- a risk the company calls out in its prospectus.

The learning curve for new Grocery Outlet openings shows up in the numbers. From the beginning of 2015 to the end of 2018, the company grew its store count by an annual growth rate of 10.1%. Over that same period, comparable-store sales (a combination of foot traffic and average customer ticket size) increased 4.2% a year. All else being equal, that should equate to 14.3%-a-year revenue growth. However, total revenue and adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) was up an average of only 12% and 12.4% a year, respectively. That implies that, while well-established stores are doing well, new store openings underperform the average. With Grocery Outlet planning on expanding new locations at about a 10%-a-year rate going forward (based on an end-of-2018 store count of 316), there is a possibility that these plans drag down results in the short term. With the stock trading at 145 times trailing-12-month earnings, I'm not sure past performance warrants such a high valuation.

A man and a woman hugging inside a Grocery Outlet store.

Image source: Grocery Outlet.

Great bargains = slim margins

Appealing to bargain hunters can be a profitable model, but doing so in the grocery business is different than retail. Add to that the fact that Grocery Outlet is a franchisor and shares gross profit with its franchisees, and it all adds up to pretty slim margins. This is another reason to eye the stock's lofty premium with some skepticism.





Q1 2019

Adjusted net income

$33.8 million

$48.7 million

$49.3 million

$9.95 million

Adjusted net income margin





Data source: Grocery Outlet.

Granted, shifting the bulk of operating expenses onto franchisees can mean Grocery Outlet investors get to enjoy the most profitable aspect of the business and leverage earnings in the years to come as new stores open up. However, even when "adjusting" net profits by backing out interest and tax expenses in the above chart, Grocery Outlet's margins are slim. Over the last 12 months, off-price retailers TJX Companies' and Ross Stores' profit margins of 7.7% and 10.5%, respectively, far surpass the grocery chain's performance.

Too much debt?

Perhaps things will look sunnier when Grocery Outlet reports on its second quarter of 2019. After all, the company has said it is using the estimated $346 million in proceeds from its IPO to pay off a term loan. That should help reduce interest expense, which totaled $6.0 million in 2018 and $1.4 million in the first quarter of 2019.

However, even after using up its stock proceeds to reduce liabilities, this grocery chain still carries substantial debt. Listed at $873 million pre-IPO, Grocery Outlet says its total debt will be $513 million going forward. That is a hefty sum considering cash on the books totals just $19.4 million. Thus, interest expense will continue to weigh down the bottom line for some time.

One could argue that Grocery Outlet doesn't need cash to expand as the onus lies with prospective franchisees to pay up-front opening costs. However, the chain offers financing to help new store owners get up and running (which means more debt). Plus, the fact remains that this discount grocery chain is priced high for the modest expansion the company expects to pull off in the immediate future. After a hot IPO, investors should tread lightly.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Grocery Outlet Holding Corp. Stock Quote
Grocery Outlet Holding Corp.
$38.50 (0.79%) $0.30

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/27/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.