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Is Grocery Outlet a Buy?

By Rich Duprey – Nov 5, 2020 at 11:15AM

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The deep-discount supermarket has been on a tear while building out its footprint.

With Grocery Outlet (GO -2.33%) scheduled to report third-quarter earnings next week, should investors put their money into the deep-discount supermarket chain's stock or would they be better off waiting?

The grocery store has an expansion mindset and an enviable track record of sales growth. Coupled with a business model that seems primed to capitalize on current market conditions, it makes for an intriguing possibility so let's take a look at whether investors should get in the express checkout lane.

Grocery Outlet storefront

Image source: Grocery Outlet.

Pennies on the dollar

Grocery Outlet is uniquely positioned between dollar stores chains like Dollar General and Dollar Tree and discount grocers such as Walmart or even Aldi and Lidl. It's a no-frills shopping experience in a small-format store offering consumers what management deems a treasure hunt atmosphere akin to being "the T.J. Maxx for food."

At the end of June, the supermarket chain had 362 stores in six states, 15 more than it started the year, and it remains on track to open 30 to 32 stores for all of 2020 with no closures. The long-term goal is to have 4,800 stores in operation, and while that is likely just an aspirational goal because it would take decades to achieve at its current rate of growth, it does hint at plenty of growth potential ahead.

Also, the narrow base of states it now calls home means it can continue marching across the country, too.

Racking up sales

The controlled growth strategy, though, has ensured it can manage sales expansion. The deep discounter has notched 16 consecutive years of positive same-store sales. Comps jumped over 17% in the first quarter and another 16% in the second, showing how well its able to compete alongside the dollar store chains. In comparison, Dollar General's comps jumped almost 19% last quarter, while even struggling Dollar Tree was up over 7%.

Obviously, Grocery Outlet benefited from the coronavirus pandemic, but the supermarket is holding its own as its value proposition resonates with consumers, suggesting it will add another year of comps growth this year as well.

A gaping hole in its strategy

Arguably, one of the biggest risks facing Grocery Outlet at the moment is its failure to have a presence in the online grocery shopping market. Because it is a deep discounter operating on very thin profit margins, it may be difficult to make the expenditures necessary to build an e-commerce platform, particularly as building out stores imposes a large financial burden. But that might be a shortsighted view.

Online grocery sales are expected to reach 21.5% of total U.S. grocery sales by 2025, according to the market researchers at Mercatus, hitting $250 billion.

Sales are forecast to grow from $35.4 billion last year to $106 billion this year, spurred on by the COVID-19 outbreak. And having seen the benefits of online shopping, particularly as supermarkets have expanded their curbside order collection options, Grocery Outlet may be putting itself at a disadvantage.

Aldi offers online ordering and delivery, as does Lidl, and Walmart is the leader in the space. With Amazon.com making a big push of its own in both online grocery sales and in physical stores, Grocery Outlet risks falling too far behind the competition to ever make up the lost ground.

The price of growth

Grocery Outlet's stock is not cheap, either. It goes for 66 times trailing earnings and 42 times next year's estimates, and with analysts forecasting long-term earnings growth of just 5.5%, it lags behind the likes of Walmart and the largest supermarket pure play, Kroger.

The deep discounter also trades at a substantial premium to the free cash flow it produces, making the stock a hard one to recommend at these levels.

There's a good growth story with Grocery Outlet as consumers appreciate the low price points, but not at any price. And because of the sky-high valuations in a low-margin industry, I can't recommend buying the supermarket's stock at this price.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Rich Duprey has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and recommends the following options: short January 2022 $1940 calls on Amazon and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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