Grocery Outlet Holding Corp. (GO) Earnings Call Transcript & Summary

Hello, everyone. I hope you're doing well. Thanks for being with us at the Morgan Stanley Virtual Consumer Retail Conference. It is my pleasure to welcome the management team of Grocery Outlet, represented by Eric Lindberg, CEO; RJ Sheedy, President; and Charles Bracher, CFO. I have a quick disclosure I have to read, and then I will get right into the Q&A. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. Thank you for being here with us. I think this is Grocery Outlet's inaugural visit virtually, maybe it will be in person. Maybe a quick intro. This is one of the growthiest companies that we cover in our space, one of the growthiest in retail, about a 10% unit growth story, consistent sales growth, extremely consistent gross margin with a hybrid format, hybrid, meaning it's kind of a quasi franchise, but not really the independent operator model with a lot of legs to grow in the, call it, close out grocery market. And this business model has it perfected and now is expanding across the rest of the country.

So with that, maybe I'll start by asking a question that's been topical over the last couple of quarters, how to think of food at home in relation to your business model? It looks like COVID really hasn't had a material step change on your business. You can disagree with that. How come, is it the nature of the shop? And how do we think about that, whereas the rest of the industry seems to have had some benefit?

Yes. Thanks, Simeon. Appreciate being invited. Good to be here with you guys today. I just want to make sure, remind people that the updates we'll give today will be really talking about the trends that were part of the Q3 call. I want to make sure people don't construe anything or any comments as something more specific to mid-quarter updates. But to your question, yes, we actually believe we benefited from food at home trend, with our primary customers, we've seen quite an uptick in our basket size that's remained elevated, started at the beginning of pandemic and has remained elevated. However, to that is we have had experienced some terrific consolidation with the non-primary customers. We would say those are the casual customers that come in to see if we have check-in time to time, treated more as a treasure hunt. We've got a long history of 75 years. It tells us that value will ultimately win the day. So we're confident in that. we think what we offer in terms of value ultimately wins because people will migrate back to it. I think it temporarily had been a little bit dislocated and probably distant from that. In the meantime, you heard us say on the call, we've been leaning in on a couple of new initiatives. I'd say, one, expanding the assortment really to attract on the customer that is looking for more convenience through sort of added SKUs. And then secondarily, I think really our effort to sort of expand and broaden their reach through the e-commerce platform, which we're in test on. So Yes. Look, I think we have benefited a bit from the food at home, but maybe not as much as others.

Is it possible that stimulus basically made customers trade up and away from close out. And we've seen some similarity across some of the value-oriented change that we cover. And would it now be then the right time to see that migration trickle back into the value-oriented retailers?

Yes. I would say, for sure, people have a lack of spending on a lot of categories. I think they made up some of their disposable and so we're able to apply that to food at home, food away from home and things closer to home. And I think there is a logic now combination of stimulus. I think people will start dipping into that savings, they have built up from last year or 2. And I think, ultimately, look, our money is all going a little less far because of inflation. So I think as that starts to hit people getting through the holidays, I think there's going to be a real pivot to value. And we've been saying it's transitory. You just can't really pick it in terms of timing, but it certainly feels like there's a lot of headwind that's translated over to tailwind for us.

And I think you answered it similarly on the last call, the market is trying to snip out this trough in terms of sales or the desale. And I think the way you guided Q4 implies that we stabilize. And this is the beginning of an inflection. And I remember there was a lot of people said that on the call, and you were hesitant to officially call that out. But can you talk about that dynamic and...

Yes. Look, we were -- exactly as you described it, is how we said it. We were really pleased by sort of momentum going into Q3, October being flat was sort of a build up on that 2-year, call it, stabilization and inflection certainly what it felt like to us. The caution was, really, if we were sitting on the call looking at November and December, if you recall last year, there was sort of a deepening into the pandemic. There was sort of the variant case load went up and sort of people retreated back. So we had a really strong, from a comp perspective, November, December last year. And those are numbers that we get a comp sort of from the call on to the balance of Q4. And so we were a little bit more cautious perhaps or conservative, but I would say that we're feeling good about Q4, feeling good about that October number and certainly look positive about the stability of the business on going forward and look different to build on that going into Q1 and next year.

How do you manage -- or how do you position your business with respect to pricing gaps versus other food retail? And how has that evolved over the last 12 months?

Yes. It's a good question, particularly given the -- just the massive amount of inflation that we've seen. But just orient people, really we measure the value proposition versus 2 big groups. So the discounters, 20% or better, the traditional is 40%. Then you break it into the categorization, we think about opportunistic really can have 40% to 70% savings. That's sort of a big number that we've already talked about. That's been very consistent. And more of the made-to-order products where the commodities can be closer to that 20% value savings. So a little bit lapsed. I'd say we have not changed the value proposition at all. We're very flexible in the model, and we are not leaders in terms of pricing, we're followers. So we're doing a lot of work every week on itemization price gap. We look at our basket is how we do it. And the buyers are looking to take advantage to try and keep that delta between us and the next year's competitor consistent, but it's given us an opportunity to price and change price and follow other as they take price up. I think everyone knows. I mean we're seeing it across every category, every item, every vendor that we deal with people are taking pricing. So we're just being very, very careful to continue to keep the gap that we have that we're known for in the industry with our customers, wide enough to make it very, very relevant.

And to follow on what you said, Eric, I think on the last call, you hinted that the competitiveness -- or there is a little bit more competitive intensity. And I think that dovetails with what you just said. That's a 6-month look back? Or that's -- was a 3-month look back?

Yes. No, no, go ahead and finish.

No. I mean, a food retailer today said they're starting to see inflationary pressure. That doesn't mean what they're doing on price, but cost inflation pressure starting to level off. I'm curious if that's a fair observation? Or are you're going to be a little further behind that curve given where you are in the sort of cycle of purchasing?

Yes. So go back to competitive, what we said -- what we've seen on the West Coast, we've seen some really aggressive pricing, particularly on features, front pages, promoted items, particularly in the South and the North, probably also in Northern California. We may be a bit of a microcosm for the rest of the country because I think we would look at the published data that we all see that we're still less competitive than 2019, but more competitive than 2020, when promotions really dropped off and people sort of didn't spend those dollars, both on the supply side or the retailer side. Things got pretty competitive around the holidays. I would say, looking back 3 months, they've sort of fallen through the summer. Very competitive. They've fallen off in the fall, pick up a little bit over the holidays. And certainly, we're seeing increased prices. I don't think we're seeing any tail off from suppliers passing on increased prices to Grocery Outlet. That's been pretty consistent, more than we've seen at any other point in history. But I think that's a natural follow-on to what you're seeing on the PPI coming through to the CPI. But maybe RJ can provide any more...

Inflation, in general, can you talk about how it plays through your business, both from the way you as corporate deals with inflationary pressure and then as the IO, as the operators deal with it?

Yes, I can take that one. So we do think we mitigate the risk of inflation, the impact of inflation in more so than most because of the model. So good questions, Simeon. On the buying side of the business, first course of action for us as we see some cost increases or potential cost increases is to move between suppliers, move between items, flex this muscle that we have that we're always across many suppliers in and out of items. And in that way, able to navigate more cleanly, some of these cost increases that are being passed along by suppliers or trying to be passed along by suppliers. Remember, we don't have longer-term volume commitments. We don't have rigid hierarchy of brands and items and structure in some of these things that you'd see. We don't slot in fees. We don't have ad shares, et cetera, that you would see in a more traditional retailers. So we're very, very flexible and fluent in how we're able to move between products to navigate that. And customers are used to new products popping up in the store all the time and it has the treasure, how do we appeal the model. So that's helped us quite a bit. So I'd say we've been more active there than in previous times because of inflation. Secondarily then, as Eric said, we're fast to follow and as retail prices have moved up elsewhere and we mark our value if it's 40% or 50%, we'll keep that delta intact, and we'll be able to follow those price increases up. And in situations such as these then that value is even more compelling, more important to consumers because everything is more expensive elsewhere. So it punches above its weight, so to speak, even though we're maintaining that same delta. And important to remember that we're pricing items every day. And so in that way, able to maintain, first and foremost, about value but then also delivering, Simeon, you mentioned at the start, the very consistent margins that we've been able to deliver over many, many years in the business. And so in terms of the operator consistency in gross margin and the healthy margins we've been able to deliver even in times like these help us and them because of the way that the commission dollars are split. If you're asking more specifically about labor and some other inflationary pressures on their P&L, labor sits there, supply sit there, some other things sit there. Our job is to support them in growing sales and helping them however we can to improve profitability. Of course, that's sales and margin and for the commission that they make. And then think about systems and the support that we provide that then make it easier for them to run the store. So whether it's technology enhancements to reduce labor hours or other information to help them better select items and support their customers. There's a long list of things that we've been focused on for a long time, and we lean in even more in times like these to help them manage some of those expense pressures and maintain the healthy bottom line.

Thanks for that. I mean I'll come back to the IOs in a little bit. I'm going to jump maybe backwards. I overlooked one of the questions I wanted to ask about the past 12 to 24 months. If you look at the mix of product that's coming from every day versus WOW! or versus opportunistic, sorry, if I don't have the definitions, how has that evolved? And then thinking about the seasoning of a store, a new store in a market, you'll get a customer who probably treasure hunts you and then figures out, "Hey, I love this product, and I slowly fill the basket and either I convert to a regular or I stay as a regular -- occasional shopper, if that makes sense." Has that path evolved at all during COVID? And how has that changed?

Yes. So first part of your question, what we've seen over the past 2 years is, 2020, there was a bit of a shift to everyday products, and that was driven by demand. So where we saw some of the larger demand spikes those were in categories that were a little bit heavier every day. And so these are low single-digit percentage shifts, right, that we saw back in 2020. So not tremendous, but a little bit there. That has since reverted back this year, again, as a result of demand more than anything else. But on the whole over the -- think about over the past few years, still maintaining that relative 50-50 split between opportunistic and every day, which is been a nice balance for us for a longer period of time. So that's the answer to the first part of your question. The second part of your question, yes, for customers, what does the mix look like and what is the adoption and future customer type look like. What I would say is the past couple of years, we continue to see, as we look at new customers coming into the store, we continue to see a very healthy mix, if you will, across the very broad customer base that we have. And because our model is unique, they fall into different shopping patterns based on their needs. And so we have some where we serve very well as a primary store, right? A majority of their dollars spent will be with us, and those are customers that will over-index on value, right, in the treasure hunt and what we offer and they make that work, and we, of course, offer the full shop. You can get everything that you need across all departments in our store. On Flipp side, you have customers again because of needs and behaviors. We're always going to be a more of a tertiary or secondary store. They shop us first, they find what they like, the more impulse, treasure hunt shopper and then they carry on with the other stores that they shop at. We don't try to be all things to all people. We think it's really, really good that we represent a unique offering in the market. And then as a result, we don't have this objective that we're a primary serve for everyone because it's just not what who are and what we offer. The last part of my answer, just in some of the dynamics that we've seen as far as customer count goes, in basket, yes, we've seen an elevated basket. There's been a consolidated shop. A little bit more of a headwind on the treasure hunt or the secondary or tertiary shopper because of a lean into convenience for them, the need or the excitement maybe around saving money isn't quite as strong as it was before, and maybe they've shifted a little bit more to e-commerce, that type of customer, right? So back to some of the earlier comments. But we think those are transitory, you ultimately turn in our favor and then further enhance some of these initiatives that we've been pursuing this past year that set us up really well.

Something that Eric mentioned was the expansion of the assortment. Can you talk about, I guess, where -- what parts of the store or what categories were you not as full in? And is there any difference in how you're buying the product, meaning in the end result on the margin of this or it's available items that you just weren't purchasing before?

Yes. So the most recent add of these 200 items that we mentioned on our last call, I'd say not so category specific, more at the item level. There was a -- have your representation for some more ethnic items entrees, introduced some more Hispanic items with the assortment. We're always looking to enhance the notch offering, the natural, organic, specialty, healthy specialty cheeses. We added a few there. So just more specific item-based opportunities that performed well in our store. We've grown those categories over time, and we saw an opportunity here to lean further still into those. And I would describe it, Simeon, as continued evolution of the assortment, looking back over 10, 20, even close to 30 years where we broadened our appeal, we've become more convenient to customers, right, for the basket and then that leads to the trip. And so this is just a continued evolution of that. And then as far as the margin profile of the items go, these have been more or mostly everyday items. So to be able to offer those more consistently from a convenience standpoint. And we've said before that on average, every day can be a little bit lower margin, opportunistic, a little bit higher. But remember, we've been evolving this assortment from majority opportunistic to now this nice 50-50 blend. And over that time period, have maintained still very consistent margins. So and then that, again, speaks to just the ability for us to flex pricing and manage margin and ultimately deliver value to customers and drive sales. This is about driving growth. and then able to maintain consistent margins and deliver a pretty consistent profit dollar growth as well. So we think about this most recent addition as well as future that will follow with -- following that same pattern.

Thank you for that. Next topic is the closeout pipeline. It's sort of a black hole for us on our side, and we really only get a good update when we speak to you. So this is a great opportunity. Can you talk about the overall flow? I don't know if it's percentage of deals that you're seeing or how much what percentage of deals are you buying? What percentage is push-pull, any sense to give a state of the union?

Yes, it's good. We're really encouraged by the pipeline, and we have been over the past couple of years. And it's not without a lot of effort and great work by the team here, right? It's not something that comes easy. We work really hard at it. And for us, it's all about the partnerships that we have with suppliers, Simeon. These go back, for the largest ones, decades, their strategic partnerships. We're a solutions provider to them. And we work really, really hard to be a preferred retailer for them, and we are. And that's a constant conversation and dialogue and how do we help them further still. And so we continue to find those opportunities as we engage in those conversations. We're -- more specifically to some of what you asked, we're still a low and a mid-teens share player in the space. If you were to look at the total amount of opportunistic or secondary product available at any given time period, so still plenty of room for us to grow in terms of gaining share. We have and we plan to, so long as we keep listening and partnering with our suppliers, we expect to. And then in addition to that, the pie continues to grow. It continues to grow because companies are still innovating. Supply chain disruption never goes away. And in fact, I don't know, what we've experienced this past year or past 2 years, I think in recent history has never been greater. And so that all of that has and will continue to yield more opportunistic product, along with just normal reasons why these products exist, packaging changes, exclusive lines, fragmentation within the industry, fresh, the list goes on. So we think we're positioned really well. We think we do it better than anyone in the consumable space, and we continue to stay close with our supplier partners for again, how we can always be a better partner to them and then in turn, help them with their inventory challenges and then deliver the value in the treasure hunt to consumers.

I want to ask about traffic, but we talked about the supply of closeout. So I'm going to jump over it for a second is -- are you -- first of all, you still don't really have competitors doing what you're doing. And then as you start to expand, are you excited? Meaning there's as much of this capacity or close out supply in every pocket of this country as there are in the markets in which you operate, meaning there's plenty of supply and you're just there to absorb it.

Yes. There's plenty of supply. We've said before and continue to believe. We could triple our store count before we're bumping up against any constraints from a supply standpoint at the 50-50 split that we are today. And then, of course, there's plenty of opportunity for us still as we think about everyday opportunities, private label, product development, other opportunities with suppliers. So I feel really good about that. And none of that has changed in the past couple of years or even more recently. And then as far as competitors go, yes, there are other people that -- other companies that buy opportunistic product. It is a -- it has been and continues to be a very fragmented marketplace, if you will, for access to this type of product. So scale really helps us. The -- we're a closed system, really helps our suppliers care really, first and foremost, about brand protection, their items, brands are represented in a great enjoyable store and they are. And the operator model is a big, big part of that. So that's certainly unique to us and then all the other attributes by which we buy. So it's not that it's just there and no one else is looking at it or trying to buy it. I mean that certainly exists. But again, it's about what's important to suppliers and being the best partner that we can. And that's something that we continue to work really, really hard at. And we're always open to feedback. We're always asking them, how can we be better? And that's where we make our investments. That's where we spend our time, and that allows this model to work really well.

So maybe we'll stick on the store target because you mentioned how many you expect to have over time. Anything -- any updated thoughts on that store count target, your path, your pace, your geographic expansion? How do you approach that?

Yes. So I kind of start off top and say really early innings. We finished the quarter at 407 stores. We think there's a lot of room in terms of leg space. We like the number, 10%. It's aggressive. It's sort of top of the mark in terms of competitors. It's what we've built the infrastructure about around. We've put a lot into sort of thinking about scaling and making sure we can keep up with the investments that we know are necessary to sort of stamp that out. We know that what's unique about GO is this ability to be a small format, down to 10,000 is our smallest up to 20,000, 25,000, but we're very comfortable getting a very relevant mix into that small format. And then the fact that it's very transportable. It works in urban, it works in rural, it works in between. We've never seen it not work in a location. So we get really excited about taking this model from the West Coast to our next jumping off line, which is Mid-Atlantic, which we think is a nice opportunity, about 150 to 200 stores. And then thinking out beyond 5 years from there, where do you go from Mid-Atlantic? You can go back into Ohio Valley through Pittsburgh, you can go to the Northeast, you should go to the Southeast. There's lots of opportunities and ultimately, dreaming, big dreams, right, Simeon, you think about the country, there's not a town we don't think could accommodate a Grocery Outlet ultimately in the future. So we're very early, really excited about what we see out in front of us, and we're going to continue to sort of stamp out a disciplined 10% growth that we talked about.

Thanks for that. I'm going to jump around a little. I was going to talk about mid-Atlantic expansion, but you touched on it. I think maybe one on -- and it's not a constraint, but we probably should talk about the IO and the model, the health, the state of their union, the pipeline that you're building, how they've coped with COVID, how their P&L is looking? There's a lot of topics there, but I think it's a potential constraint. But I'd love to hear how you think about it, give a thorough state of the union, yes?

Yes, you bet. I'll start with state of union. We've just come off of a great 10-city stop. We split the team into 2 and went north and south and [indiscernible] and talked to all the operators we got in front of about 400 operators and small groups and just dedicated to half a day to talking listing, ship sharing, really getting with them around how they're doing, and they're doing great. They're very resilient. They're entrepreneurs, they're optimists. It's been a really tough but satisfactory, both financially and just sort of made it through the last 18 months. Financially, 2020 was a great year for us. It's been more of an average year for them in 2021. I'd say they're tired, but they're very optimistic about the future. The labor constraint has been challenging for them. They've dealt with it. I think we're starting to see some reshoots and people coming back into the workforce which feels very good. And then, look, I think they feel ultimately really, really supported by Grocery Outlet and demonstrated again by everything we've done to lean into them. The partnership need into -- some of the investment we can make that covers the broad spectrum of store. It is not that something that you sort of say, hey, financially, we're going to deal with you more of a transactional basis. But look, we're going to invest in things that we think we'll keep for 5 and 10 years that will help them with efficiency, help them with scale, help them with sort of dealing with more transactions, more effectively. So -- They're feeling great. I'll transition now to sort of pipeline of IO. That continues to be really strong. We saw some really interesting people come out of the woodwork to restaurants last year when they were really pinched and traditional grocery retail, we probably saw that diminish a little bit. I think that's starting to come back. Ultimately, what attracts the operator pool is the opportunity to be independent to control their own destiny, to work with the umbrella of Grocery Outlet doing a lot of the [ hard lifting ] and allow them to be in front of their customer, in front of their community and doing what they love to do, which is merchandise and sell. And that proposition is incredibly strong today. We've got record numbers of people coming in to the top of the funnel. We've got some better tools to sort of get them through training to make sure they're really ready to take on a store, and we're really happy with the pool of candidates, both from quantity and quality that we see.

Can I ask about turnover? Was it different, same during the COVID period?

Lower in '20, higher in '21, not higher than sort of that high single digits that we've seen historically. Obviously, the number goes up, but as a percentage, it's been pretty steady.

Great. We have 5 minutes. There are no questions on the webcast as of now. I'll ask about e-commerce. I think it's obvious what the rationale has been, but how big could this be for your business? I would think your treasure hunt and therefore, you're the antithesis of what I would want from e-commerce. I'd rather go to your store and see what you have. But how can you execute it and make it as profitable as what you would have an in-store purchase?

Yes, hard to say how big it can be. It's part of what we're hoping to learn here from the pilot. But certainly, the penetration that it is for the industry, is something that we're optimistic about. We think it can be a nice new channel for us and a way to attract or acquire customers that might not otherwise come into the store. I think you're right, Simeon, to mention the treasure hunt. And this is something that we will -- that's still ahead of us. But how do we represent that online or how do we recreate that online. I'd say this just initial entry or pilot in partnership with Instacart is just more conventional in nature. It's got the full shop on there. And of course, it's showing tremendous value. We think, though, an opportunity on top of that is to bring the excitement of walking up and down every aisle that you feel and you see when you turn the corner, and oh, my gosh, I can't believe they have that item or that brand at that price, and I'm going to stock up on a call and tell my friends about it. That emotional reaction that customers have, which drives loyalty, we think that's a real opportunity for us online. So in that way, then you'll get the best of both. The first piece of it is you're just offering tremendous value to the e-commerce shopper where hasn't really been offered before. I mean customers are paying a lot of money to shop online, and they've really enjoyed the convenience, especially these past couple of years, that's been important. And now with value, we think, can drive some nice incremental business for us. And then if we can crack the nut on representing the treasure hunt as well just makes it even more. So we'll -- as we move through -- we're only weeks in. As we move through more time, I mean this pilot period, we'll have a more informed view on what we think the upside potential is. But so far, so good. We're pleased with operationally how it's gone.

Thank you. Two minutes. I have one, and we do have one from the audience, so few questions. From the audience, going forward with the 10% unit growth, how should we think about the mix between CA/West Coast and [indiscernible] Mid-Atlantic. My question, part 2, the buyback. I get the rationale, I guess, what's the time frame in which you expect to use it?

Yes. I'll hit the first one quickly. Good blend of existing store expansion sort of existing geography and then moving into new markets. We have a blended underwriting model, which I think you've heard us talk about. So no change from that but just a good way of new stores and existing storage.

And then with respect to the buyback, yes, we -- for us in the conversations around capital allocation with the Board, I think the starting point has always been continued focus on investing in growth. We love the returns we get there. And we think that fundamentally is the greatest creation of shareholder value going forward. So as we evaluated the buyback, we like that it gives us one more tool in the capital allocation toolkit because of the fact that we can do everything we want to do to expand the store base of 10% per year, continue to reinvest in the fleet and build all the infrastructure that we need. But in addition to that, we've been able to generate over $100 million in excess cash over the past 12 months. So I think the buyback is another lever in addition to further deleveraging the balance sheet that we can use. But I think you'll see us be opportunistic in the way that we put that to work.

One more question just came in. So we got to do it under 60 seconds. The consumer has been flush. Are you seeing any signs of consumers starting to seek out merchandise value in their baskets? I think any signs of people are becoming more value or if there's any pressure on the consumer? The consumer was very strong with stimulus. I think it's, are you expecting to see what you kind of -- what do you think will play out?

I think -- yes, I can take -- I think we're all experiencing it as consumers. And I think you continue to read more and hear more about it. So -- And we think that looking forward will be a positive for us because we're offering the best value compared to anyone barned on. So yes, we think those tailwinds are still to come.

Great. Well, Eric, RJ, Charles, thank you very much for being here for your perspective. Have a great holiday season. Be well.

You, too. Likeweise.

Thanks, Simeon.. Thanks, everyone. Bye.