Is Grocery Outlet Stock a Buy?

After starting out as a discount military surplus store in 1946, Grocery Outlet Holdings (NASDAQ: GO) has grown to encompass 355 grocery stores today. The company went public on June 19, 2019, at $22 per share, so it's been a market beater during its first year on the stock market.

After a year of the stock doing so well, now seems like an appropriate time to dive deep into the Grocery Outlet company and assess its chances to continue to beat the market. 

Two women shop in a Grocery Outlet location.

Image source: Grocery Outlet.

How Grocery Outlet is different

Grocery Outlet is always on the lookout for a good deal. By constantly sourcing cheap inventory, it's able to pass the savings on to consumers.

However, none of Grocery Outlet's locations are company-owned, and it doesn't franchise. Rather, each location is owned and operated by an independent contractor. In most cases, these contractors borrow money from Grocery Outlet to get started. Once operational, they choose what to stock. They just have to purchase their supply from Grocery Outlet's inventory.

Grocery Outlet pays these independent operators a commission for their work, and shares in the gross profit.

This makes Grocery Outlet's financials a little tricky. For example, in the first quarter of 2020, net sales for Grocery Outlet were $760.3 million. However, its independent operator sales were $745.5 million. In other words, the operators purchased more from Grocery Outlet than they sold during the quarter.

This structure does present regulatory risk for Grocery Outlet. Regulators could decide these independent contractors are actually employees of the company, causing a massive restructuring. However, the unusual structure also has benefits. Grocery Outlet attracts operators who likely have an entrepreneurial spirit and are willing to work hard to succeed. 

Three stacks of coins in a row are topped with the letters I, P, and O.

Image source: Getty Images.

Promising metrics at its IPO

Grocery Outlet looked promising at the time of its initial public offering (IPO). With brick-and-mortar chains, I assess three things first: comparable-sales growth, unit growth (opening new locations), and profitability. Regarding the first two factors, the company had recorded positive comparable sales for 15 consecutive years, and it had ambitious plans to grow to a 4,800-location empire. 

Profitability was a different story. Grocery stores have thin profit margins in general, but Grocery Outlet's are exceptionally skinny. The company's net profit margin was 1%, 0.7%, and 0.6% in 2017, 2018, and 2019, respectively. Share-based compensation contributed to declining profitability in the last two years, and it's reasonable to expect that cost to diminish in coming years. So maybe it's poised to improve.

However, the starting point is low. Big-time competitor Kroger had a net-profit margin of 1.5%, 2.6%, and 1.6% over the last three years, easily outpacing Grocery Outlet. It may not be fair to compare the two chains, since Kroger has other businesses such as e-commerce pharmacy Vitacost. However, the point still stands that Grocery Outlet needs improving profits to be a good long-term investment.

Overdelivering since its IPO

In Grocery Outlet's first quarter as a public company, it gave guidance for 2019. It expected net sales of $2.50 billion to $2.53 billion, comparable-sales growth of 3% to 4%, and non-GAAP earnings per share (EPS) of $0.68 to $0.71. 

Grocery Outlet beat all three of these projections. It reported full-year net sales of $2.56 billion, up 11.9% year over year. Its comparable sales grew 5.2% for its 16th consecutive year of growth. And non-GAAP EPS came in at $0.79.

When full-year 2019 results were reported, the coronavirus pandemic was already getting out of control. Therefore, Grocery Outlet did what most companies have done: It didn't issue guidance. However, results have remained positive. Q1 net sales surged 25% higher, driven by astounding comp-sales growth of 17.4%. This outsized quarterly performance gives management confidence it can grow new stores by at least 10% this year -- its long-term annual goal.

When companies go public, it takes time for management to establish a track record with investors. So far, Grocery Outlet is building a good one; it's over-delivering on its promises.

A dice displays the words buy, hold, and sell next to a stack of hundred dollar bills.

Image source: Getty Images.

Is it a buy?

Give Grocery Outlet credit. It's doing what it said it would do. It's expanding and becoming more popular -- as evidenced by the comp-sales growth. There's a lot to like, but its thin profit margins keep me from calling this stock a buy. It already trades around 40 times forward earnings estimates, which is pricey even for an expanding chain. 

Some might point to Grocery Outlet's Q1 as proof of improving profits. Quarterly net income increased a whopping 235% to $12.6 million. While this data point is technically true, if you dig deeper you'll see operating income actually fell 22%. The improvement to profitability came from fewer interest expenses than last year.

In summary, Grocery Outlet is a good public company and an up-and-coming grocery chain. But until it can improve the bottom line, I don't think it will beat the market long term.

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Jon Quast has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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