Grocery Outlet Holding Stock: Poor SSS Growth Outlook For The Near-Term (NASDAQ:GO)

Images By Tang Ming Tung Investment overview I wrote about Grocery Outlet Holding (NASDAQ:GO) previously (29 May 2024) with a sell rating as I was very uncertain about how same-store-sales [SSS] performance was going to be and that the business may miss FY24 guidance. Fast-forward to today, and the share price has gone down as I had expected. I continue to be negative about GO, as I expect SSS growth to be poor in the near term, given that the trade-down motion is over and the industry is getting more competitive. 2Q24 earnings (announced on 6th August) GO reported 2Q24 net sales of $1.128 billion, representing 11.7% y/y growth, driven by 2.9% SSS growth. Gross profit grew at a lesser rate, by 6.9%, to $349.2 million (implying a 30.9% gross margin, which was a 140bps step down from 2Q23). The lower gross margin offset the positive impact from the lower expense ratio, resulting in the EBIT margin being compressed 80bps from 3.9% in 2Q23 to 3.1% in 2Q24. The high tax rate (32.5% in 2Q24 vs. 30.7% in 2Q23) caused net margin to compress as well, resulting in a net income y/y decline of 17% from $24.1 million to $20 million. SSS to continue facing headwinds May Investing Ideas In the 2Q24 quarter, GO SSS growth came in at low-single-digit percentage (2.9%), and notably, this was supported by lower pricing (-2.1% contribution), which attracted consumer traffic (5.1% contribution). The previous bull case for GO was that it benefited from the trade-down movement as inflation was high, and that has driven SSS growth to an elevated level. However, I believe the macro environment is no longer in a favorable setup for GO, and therefore, SSS growth will continue to slowdown from here. Two macro-indicators shaped my view: (1) On a year-to-date basis, food at home inflation is up only about 1% (unlike the past year that saw massive inflation); (2) real wage growth is about 4 to 5% on a year-to-date basis, which means consumers are increasingly being able to afford relatively more groceries (vs. last year). With this view in mind, I believe consumers will not be as keen as they were to purposely trade down, and this would mean traffic loss for GO. Indeed, management noted traffic slowed in June, and that trend continued into 3Q24, and they have guided 3Q24 SSS growth to be ~1.5%, signifying another quarter of deceleration. The bigger implication from this guide is that GO is either: Not seeing improved productivity in the new stores, and/or GO-matured stores are losing share because new stores should see higher SSS growth because of the productivity ramp-up (the maturing phase). Either way, I don’t think this is a positive situation for shareholders. Competitive environment to drive down margins With the trade-down motion over, GO is now competing against incumbents on a level field, and this is a very bad situation for GO as competitors are stepping up on promotions. In the 2Q24 earnings call, GO’s management noted increasing promotional pressure throughout the quarter and into July from key competitors. Comments from peers are also creating a promotional environment. For instance, Kroger gave hints in their 1Q25 earnings call on how they view promotions in this environment. On a broader level, other consumer goods companies are also leaning on promotions to attract demand. The promotional activity, we did notice an increased activity from May, June, into July. Competitors have been more aggressive with promotions to turn some of their negative customer count and volume around. Company 2Q24 earnings We are identifying new supply sources using more effective promotions and improving product mix, which is contributing to further margin improvements. Kroger 1Q24 earnings The problem for GO is that it is relatively subscale compared to other grocery incumbents. Given that economies of scale are a major competitive advantage in the grocery industry (strong bargaining power to drive down the cost of goods sold), I don’t see how GO can outcompete large peers in terms of pricing. To give a sense of things, GO LTM revenue is ~$4.2 billion, whereas Kroger (KR) has $150 billion in revenue, Walmart has $665 billion, Costco Wholesale has $253 billion, and Albertsons Cos has ~$80 billion. Moreover, these peers have way more presence (footprint) vs. GO; better supplier relationships to fund promotions (like Kroger is doing); and more alternative sources of funding (i.e., advertising revenue, Costco’s membership revenue, etc.) to support more aggressive promotions. As such, I think GO is stuck between choosing to protect SSS growth or its margins. If it chooses to compete aggressively by reducing prices, margins will collapse (they are already declining). Whereas, if it chooses to protect margins (by not reducing prices), SSS growth will fall. Valuation Bloomberg If GO is to report poor SSS growth as I expected over the next few quarters, I believe valuation is going to see more pressure. Over the past 12 months, GO’s forward PE ratio has already seen massive derating from ~27x to ~18x today, and I do think there is a lot of room for valuation to fall if the market starts to value GO like a mature grocery player. For reference, KR is being valued at ~12x and Albertsons Cos (ACI) is being valued at ~9x. Risk Inflation could surge again, and we may see another round of trade-down motion that will benefit GO. GO may also execute better than I expected regarding the UGO acquisition, giving them a strong anchor point (in route) to further expand in the region (i.e., open more stores). This may help offset the negative pressure from poor SSS growth. Conclusion I give a sell rating for GO as the trade down motion is largely over and the demand environment is getting more promotional. I expect SSS growth to continue slowing down from here, and even if management decides to protect SSS growth, its profit margins are at risk given its smaller scale relative to large incumbents. Moreover, the valuation has plenty of room to fall, especially considering the potential for continued earnings pressure.

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