Chit Chat Stocks - 2 Small-Cap Grocery Stocks with Big Upside Potential (GO, SFM)

Episode Date: October 16, 2024

On this episode of Chit Chat Stocks, Ryan analyzes two grocery stocks he believes to have a lot of upside potential. But will he be purchasing shares? We discuss: (04:27) Exploring Grocer 1: Business Model and Growth (07:21) Grocer 1: Historical Performance and Management Changes (10:16) Financial Metrics and Stock Performance (13:27) Valuation and Future Projections for Grocer 1 (16:18) Introduction to Grocer 2: Business Model and Market Position (19:17) Resilience and Competitive Advantage (22:19) Franchise Model and Supply Chain Strategy (36:30) Market Position and Sourcing Strategy (44:51) Growth Ambitions and Management Insights (54:01) Valuation and Investment Considerations (59:48 Risks and Future Outlook ***************************************************** Subscribe to our YouTube channel: https://www.youtube.com/@ChitChatStocks  Follow us on Twitter/X: ⁠https://twitter.com/chitchatstocks  Follow us on Substack: ⁠https://chitchatstocks.substack.com/  ********************************************************************* Sign-up for a bond account at Public.com/chitchatstocks  A Bond Account is a self-directed brokerage account with Public Investing, member FINRA/SIPC. Deposits into this account are used to purchase 10 investment-grade and high-yield bonds. As of 9/26/24, the average, annualized yield to worst (YTW) across the Bond Account is greater than 6%. A bond’s yield is a function of its market price, which can fluctuate; therefore, a bond’s YTW is not “locked in” until the bond is purchased, and your yield at time of purchase may be different from the yield shown here. The “locked in” YTW is not guaranteed; you may receive less than the YTW of the bonds in the Bond Account if you sell any of the bonds before maturity or if the issuer defaults on the bond. Public Investing charges a markup on each bond trade. See our Fee Schedule. Bond Accounts are not recommendations of individual bonds or default allocations. The bonds in the Bond Account have not been selected based on your needs or risk profile. See https://public.com/disclosures/bond-account to learn more. ********************************************************************* FinChat.io is The Complete Stock Research Platform for fundamental investors. With its beautiful design and institutional-quality data, FinChat is incredibly powerful and easy to use. Use our LINK and get 15% off any premium plan: ⁠finchat.io/chitchat  ********************************************************************* Sign up for YellowBrick Investing to track the best investing pitches across the internet: joinyellowbrick.com/chitchat ********************************************************************* Disclosure: Chit Chat Stocks hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Stocks. Before we get into this episode, we want to talk about our friends at Public. Heads up, folks. Interest rates are falling, but you can still lock in a 6% or higher yield with a bond account at Public.com. That's a pretty big deal because when rates drop, so can the interest you earn on your investment. A bond account allows you to lock in a 6% or higher yield with a diversified portfolio of high-yield and investment-grade corporate bonds. So while other people are watching their returns shrink, you can sit back with regular interest payments, but you might want to act fast because your yield is not locked in until you invest. The good news, it only takes a couple of minutes to sign up at public.com, lock in a 6% or higher yield with a bond account only at public.com forward slash chitchat stocks.

welcome to chit chat stocks on this show host ryan henderson and brett shaffer analyze businesses and riff on the world of investing as a quick reminder chit chat stocks is a ccm media group podcast anything discussed on chit chat stocks by ryan brett or any other podcast guest is not formal advice or recommendation now please enjoy this episode welcome in this is the chit chat stocks podcast my name is brett schaefer and joined as always by ryan henderson ryan had a little vacation over in europe so we're glad to have him back after two weeks we're going to be releasing this one on wednesday morning and we'll have ryan back on the power hours for the foreseeable future as we'll have some guests coming in from

time to time. We can't do these every week. We got to go on vacation sometime. But let's get back to the topic for today. We're talking two small cap grocery stocks, and Ryan has done the research on this one. So I'm going to be leading the episode. Ryan's going to go through these business models, what interests him about them, and then we're going to conclude with whether he is buying the stock, whether he likes these companies, what makes him attracted or not to them. And we think it'll be a fantastic research episode. We hope you will learn along with us. Two housekeeping items before we get going here. One, there will be notes, charts, graphics in the newsletter, which is free and you can subscribe to in the show notes or on the Chit Chat Stocks

Substack page. That's included free along with all these episodes. And if you enjoyed this episode, if you found value on it, give us a review on Spotify or Apple Podcasts. That's the best way to support the show. So Ryan, we haven't spoiled the companies yet. We're going to go through one of them and then we'll go through the other on the second half of the episode. Two small cap grocery stocks with large upside potential. I think that's going to be our working title. What's your first one? And why are you interested in this space? Yeah, the first, well, I'm interested in the space because it's easy to understand for starters. So it's not too complicated. The blueprint for success in grocery is pretty straightforward.

There's different ways that you can succeed. And we're going to talk about how one of the companies has done it a little differently. But I mean, it's pretty simple. Build new stores. Those stores grow every year. You squeak out a decent margin and you can generate some decent returns on capital. And it's something people always need. So it's easy to understand. I like looking at these. The first one we're going to talk about is one that both of us have followed for quite a long time. And it's probably one of the, it might be the best investment we've ever made. And it's Sprouts Farmer's Market. we're going to talk i'm going to kind of revisit this and talk about some of our past research why it worked out how it succeeded how it succeeded and then the second company i won't spoil it yet but i'm recently researching this one for the first time and i believe it might be

able to follow a similar growth blueprint to what sprouts has done so maybe it can uh maybe the stock could potentially follow similar returns. We'll talk about that in a bit, but let's start with Sprouts. I know we're supposed to do a little Q&A format here. So do you want to butt in and ask the questions? Yeah. And I should say we have owned Sprouts in the past as a full disclosure, but unfortunately, if you look at the stock chart, we haven't appreciated all the gains. I think it's a lesson in never selling and how multiple expansion can continue for a long time, But it's a different topic. What is this business model? For anyone that hasn't followed this company before, how are they unique and why have they carved out a little niche in the grocery

sector? Yeah. So you mentioned it. We were shareholders starting in 2021. We ended up moving accounts and stuff. So we ended up discarding it eventually, but we've talked about them a number of times on the show. So for anyone who is not familiar, Sprouts is a health focused grocery chain with smaller sized stores. So around 27,000 square feet is their average store size. For reference, Walmart, Walmart Supercenter is north of 100,000 square feet. A Safeway or an Albertsons, something like that is more 60,000, 70,000. So it's a smaller box size, but they sell common grocery items that you'll find and they're located – the stores are located primarily throughout the western and southwestern united states they source locally

so a lot of relationships with local farmers and they sell 70 around 70 percent of their items they sell are attribute based so really primarily selling well maybe not primarily but a lot of them are dietary restrictions people that come in that are vegan or vegetarian or lactose intolerant whatever it is Good and free. Yeah, looking for vitamins and supplements, all that stuff for the health enthusiast. That's what they like to call it. I was forgetting another old term there.

They say health enthusiast, which I guess kind of – it's nice. For us health freaks out there, that's probably a better term. It's – yeah. Nice if it was. Yeah, basically they sell to people that really care about where their groceries come from and care about what's in it. Um, and I've got on the write-up that we'll have in the newsletter, I've got a picture of what the typical store layout looks like, but produce is kind of front and center. It's the thing they prioritize the most. Um, and it's like, like Brett said, not, not to, not degraded, but health freaks,

people that really care about their health are coming into the store. And so it's, it's a very different experience. I'd say, I think going to your typical grocery store, it's called Sprouts farmer's market and there's no big shelves or anything like that. It's very much a farmer's market type of feel where you can see everything throughout the store. So that hopefully gives some sense of what a store looks like. If you're around the Western United States or Southwest, I recommend at least checking one out if you're interested in the investment. But since they sell primarily to health enthusiasts, they really are not trying to be the low-cost provider. And this means that they're able to generate best-in-class

gross margins among grocery peers. So Brett's sharing a chart here, but they have around 38% gross margins. This is as of 2023, but last 12 months, it's bumped up to 38. Some of the other ones here, Walmart, 24%, Kroger, 23%, Ingalls Markets, 23%, Costco, 12%. So they really do have a lot of room to work with below the gross profit line. And it allows them to generate really high operating margins as well. So it's a very different business model than a lot of the discount grocers that you will see. I believe it has the highest gross margins among any publicly traded grocery company in the United States. That could be correct. And I think Whole Foods might have beat them

before that, because one of Sprouts' most interesting attributes is they go for almost, it's not everyday low prices, because as you can see there, you can get the actual same item at Costco or Walmart for much, much cheaper. But compared to Whole Foods and some of those Whole Foods competitors that are smaller and spread out around the country, they are significantly cheaper, which I think doesn't show that Sprouts is like a extreme discount retailer, but it shows that some of these other stores that go after the health enthusiasts are selling at, let's say, extremely high prices. And I also think looking at this chart, as an aside, it shows how incredible the Costco business model is that they can run 12% gross

margins and still generate positive profits. Yeah, that is, it's pretty outrageous. I mean, they are Costco. Costco gross margins are half of Walmart's and Walmart is a pretty low cost provider. So it's pretty astounding. It's the most efficient operation maybe in the world. And it's impressive what you can do when you focus on essentially one thing for 30 years. But back to the topic at hand, Sprouts Farmers Market, let's go through the history and management. What caused the stock to go through? I almost call it a giant U where it went public and then just went down for 10 years and now it's rocketed up higher and it's hitting all-time highs. Yeah, it actually came out at a pretty steep IPO in terms of the valuation

and a lot of that was because of the unit growth. They'd been expanding store count rapidly so they got a decent valuation when they came public. But let's go through some of the older history and then we'll go through some of the more recent history that's led to the impressive stock price appreciation the first sprout store was opened in 2002 in chandler arizona over the first decade of operations the business grew slowly but in 2012 they merged with henry's which actually was founded by the same family so i think it was like this family operation that henry's has been around for a while someone started sprouts and eventually 10 years into the Sprouts Life, they merged. And then a year later, they also bought Sunflower Farmer's Market

and rebranded all these stores to Sprouts Farmers, to the Sprouts banner. So I think like tripled Stork out really quickly, or it might not have been quite a triple, but they became a much bigger business in a matter of two years. A year later, Sprouts went public. So that's 2013. However, over I'd say the first five years of Sprouts being public, it was highlighted by rapid store expansion. That was the goal. They were growing unit count quite quickly, so much so that they were having a hard time really supporting their own growth. Margins were deteriorating. Gross margins were significantly lower. certain stores in some of the expansion markets lacked a nearby distribution center, which led to lower quality goods. And it doesn't seem like there was any sense of direction in terms of the target customer. They were pretty much going after whoever. I mean, they would send out coupons via paper coupons to everyone. And basically whoever cashed them in, they were happy

to have them. These are kind of the quote-unquote coupon clippers. Fast forward to 2019, they decided to replace the CEO and bring in Jack Sinclair. Sinclair had been the head of grocery at Walmart and did a really impressive job running that business. And when he stepped in, he seemed to be the one that really pushed the shift towards being a more health-focused brand. They shut down some of the underperforming stores. They added another distribution center, I believe it was in Colorado, and made sure that all stores were within 250 miles of a distribution center to ensure high quality produce. He also eliminated the mail coupons, which led to a bit of a hit on sales because there were a lot of customers that would come in and just redeem the

coupons. And then in hindsight, you can say that I think we're to the point now where we can officially say this transition has worked. People associate Sprouts with a health-focused grocery chain. It's not the coupon clipper store anymore. Prior to the transition, I thought this was going to be risky. I wasn't sure whether they were going to be able to really pivot in the eyes of consumers, but they seem to have done a pretty good job of that. Maybe that's the stock price speaking, but it seems like they've done a pretty good job there. Comp store sales are trending positively again. There was a drop after COVID and then there was also the drop from the coupon clippers. And then gross margins have gone from 29% in 2015 to 38% over the last 12 months.

And somewhat unsurprisingly, just like me, there was a lot of skepticism around this time that they were going to be able to differentiate themselves and really become this health enthusiast brand. So at the time, Sprouts Farmers Market stock traded at an EV to EBITDA of six times. They had tons of cash on hand as well. So they've been buying back a lot of stock for quite a while. But at this time, they were plowing, I want to say like $200 million a year into stock buybacks. And it was doing a lot of work for them. The share count is down 35% over the last eight, nine years. And they were able to buy back a ton of stock around kind of from pre-COVID to today. And they actually, it might've been sort of like

just good fortune, but there was all the supply chain hiccups with COVID that stopped them from being able to really add, like grow their stores at the pace they wanted. So they weren't able to commit as much money to capital expenditures and new stores as they were hoping for. So instead, while those refrigerators were stuck on hold, they weren't able to get them. They were plowing any cashflow they had back into buybacks and it worked out really, really well for them. Maybe Brett can share this chart of the share count here. Yep. One second. I'll do it for the YouTube watchers. And for anyone that wants to check out that gross margin change. If you look at when they made that change of, as you mentioned,

the key part was the shift away from the coupon clippers to the everyday low price model. We're not going to have stuff on discounts, but it's going to be a reasonable price for you. That can be shown right in the gross margin chart because in 2019, it had been 34% for multiple years. And then in 2020 to today, it's been 37%. So they have 3% more in margin potential, whether they can have that flow through to the bottom line. And as you can see, if you look at their EBIT margin chart, it has for the most part. And I think that shows that the strategy did work. The key thing, I think the three things that mattered the most to make this a successful stock investment was the buyback that Ryan just mentioned. I'm sharing right here,

that share count what do we have here i think it's millions so 154 million in 26 2015 down to 100 million uh the last update so quite impressive and then the third the second thing was the fact that comp sales got hit and people were debating there was a huge debate over whether this was because of the giving up the coupon clippers or if that was just a narrative given out by management and that it was actually, well, traffic is down to the stores and it's not going to stabilize and people are losing faith in this brand. Turns out that it was probably mostly just the coupon clipper things because comp sales have recovered after the pandemic overhang.

There was a bit of a bull up effect. And then third is the profit margins that I mentioned there. So it's been a nice combination with all three things working out for them. You have the buyback, which is reducing shares outstanding. Margins are going up. now comp sales have recovered. That's not about engine to earnings growth. Yeah. I mean, long story short, a lot of things went right at a time when investors didn't think they would, which is a recipe for pretty good returns. So I want to go through the actual

numbers here and I'm going to go through Brett, your write-up from 2021. And at the end, you gave a summary on why we own the stock and you gave a bunch of assumptions. So I'm going to go through each one, see where they landed, and see why the stock has had such a great run over the last three to four years. So in July of 2021, Brett wrote a 17-page write-up on Sprouts at $24 per share. I will say we started buying this, I believe, around $20 a share. Who cares? We haven't owned it the whole time. Yeah. It's more of a lesson in how much money you can lose by selling too early, I would say. Hopefully, we'll take that lesson to heart over the long term, but continue with the notes. So here was his summary. He says,

summary of why we own the stock. Bullet point number one, 10% annual store growth with a long runway for reinvestment unencumbered by competition. Update, they've increased store count at 5% a year. So they really haven't met that target, but they've been able to... to store count has still grown at a decent clip. So I'd say kind of, I'll give you a half point for that one. Recovered margin profile in comp store sales growth, I'd say in recovering comp store sales, update operating margins have expanded from 5.5% to 6.1%. That is a ton for a grocer, by the way. And comp store sales growth has gone from negative 10% roughly when they were COVID to positive 7% this quarter. So check point for that one. Third one, smart initiatives and

marketing store formats and supply chain. A little tough to quantify this one, but the gross margins have expanded, as you mentioned, and the average store size is down 3%. So yeah, I'd say it seems to be working out on the new store formats. And then consistently dropping share count. Yep, update. Share count has dropped 5% a year since this write-up. And then high current and forward earnings, free cash flow yield. You had a whole section on how you thought valuation or multiple expansion was a possibility. And that's exactly what's happened. EBITDA, whatever metric you want to use, the valuation has tripled. So that has also led to the majority of the stock returns here. Long story short, Sprouts looked somewhat distressed a while back. You could say management

turnover. There was a lot of debt. Margins had deteriorated a little bit. Comp sales were looking rough. So that's what I say when I mean distressed. It wasn't really like they were going to go bankrupt. New management came in, changed the target customer from coupon clippers to health enthusiasts, the expanded margins, bought back stock and added new stores. Today, the stock is at $115 a share. So a 383% return over three years if you held. Lesson to us there. But what surprised you in terms of your estimates or your projections relative to what's happened? A little bit on the comp sales. I thought they were really, honestly, I was way too under. I was too pessimistic because I thought comp sales could get to 3%. And that was a reasonable assumption and that it would work really well in that case. And it probably still would have. But the 6.7%, I had no confidence that that could happen. And then the second one, I definitely underplayed how much they could drop share count at that

current level. They were highly cash generative, even as they started growing stores again, and that helped them a lot. Although now, so we'll get into the valuation today, they don't have as room to, you know, share counts can't go down when your valuation has gone up so much. And the third thing, which surprised me the most, and is the most frustrating thing, we said it three times already, is the multiple expansion has been, I wouldn't say crazy, but it's maybe getting close to the bottom of the crazy if that makes sense yeah it

it when the stock was at like 50 60 a share i thought man you know it's gotten pretty expensive but this is part of what if you read the book the hundred baggers or hundred baggers um can't remember the author's name right now but it's a great book he talks about kind of the formula for finding a hundred baggers. And one of the big ones is that it helps to start at a really cheap multiple because multiple expansion can really drive returns in a huge way. And we've seen that in this case, like we're going to talk about the valuation today and it isn't crazy, but you can look back now and you can say it was crazy in a good way. Three years ago, six times earnings for a cash generative business that can grow is, you know, that that's pretty

crazy. I agree. I agree. So we've been alluding to it. What's the valuation look like today? Is it still attractive? What are some of the numbers look like? Yeah, obviously it's more expensive today than it was a few years ago. So it's easy to feel like the returns are in the past, but that's not the right way to invest. We want to look at the potential returns today relative to our opportunity costs. And it is really hard. I personally have a problem with this where if I've invested in something, maybe I sell, and then it does even better after I sell, it just feels wrong to buy back in. But you've got to look at this without any sort of subjectivity here and just, is it a good opportunity today based on your target assumption? So I'm going to go through their targets and just value it based off that.

So they are projecting 10% annual unit growth, low single-digit comp store sales growth, flat profit margins, and a lower cost required to build their stores, so potentially higher ROIC. Let's just say – I think, to be honest, the 10% store growth is a little optimistic, but let's just take it at face value. Let's say they hit all these targets. 10% growth, low single-digit comps, let's call it 3%, maybe 13% annual revenue growth over the next five years. They would be earning $13 billion in revenue and just under $800 million in earnings before interest and taxes. I'll do different multiples here. If they trade at an EV to EBIT of 20 times in year five, you would get a 4% annual return. If they traded at 25 times, you'd get an 8% annual return. Unfortunately, I think the assumptions here are pretty optimistic.

Maybe they can surprise the upside on comp sales, but 10% unit growth, I would be surprised if they did a whole lot better than that and probably, frankly, are going to grow a little slower. but even with those optimistic assumptions you're getting less than a 10% IRR I'm not sure I really like the risk reward here yeah that makes complete sense to me I think the the way you would have to be optimistic on the stock going forward is if you thought comp stores sales comp comp growth whatever whatever we're going to call it same store sales growth is not in kind of that two to three percent range or maybe just slightly above inflation that we are thinking and they go into that 5%, 7%, 8% range for multiple years. Because if that happens, you're going to get

operating leverage as well. So that could lead to you trading at, if you're an EV that you bid of 20, that could lead to a 10% return. But I'm not sure I would have confidence in that because this isn't this isn't trader joe's this isn't costco they could be these brands that they could end up being these brands in like 20 years but i wouldn't say they have the certainty of brand durability certainty of customer loyalty certainty of company culture because they've really started changing the company culture when singular came in five years ago and i don't think like those companies deserve high multiples but i don't think sprouts giving that uncertainty around the durability of this brand i don't know if they deserve a high multiple today what are they

trading at today like 30 30 times 35 times someone yeah ev to ebit is 30 times so basically i think multiple compression is a big risk here the i think if if it were we titled this episode two stocks, two grocery stocks with high upside potential. So I will say if they were to surprise to the upside and really be a multi-bagger from here, I think it would be because they lean more, they do become more of a Trader Joe's like brand. They really start to resonate with health enthusiasts. Right now, I think 21% of sales comes from their private label brand. If that starts to increase as well. EBIT margins will likely increase with it. So yeah, if they really become the go-to brand for health enthusiasts, I think that probably bodes well for operating

leverage as well as unit growth. I agree. I agree. And yeah, we can't put that in a podcast title, but it's almost like Sprouts Farmer's Market had a ton of upside potential and it wasn't guaranteed to work. I will say that. I did not have 100% conviction. You shouldn't have 100% conviction on anything. We got nervous from time to time

after a couple of few bad quarters, but they had a lot of upside back then. And the tease on this episode is that the second stock could potentially have the same upside as Sprouts. and why we're looking at it. We haven't sent the company's name yet, Ryan, because we want people to listen to the full episode, although I know they can't skip around. So what is the second company, and what is their business model, and why does it interest you?

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for stock research on small and micro cap ideas and think you can as well. Try it for yourself. Simply go to joinyellowbrick.com slash chitchat and search a company or ticker you're interested in. You are bound to find a great report on just about any company, that's joinyellowbrick.com slash chitchat. Listen up, folks.

Time could be running out to lock in a 6% or higher yield at public.com. But you can lock in a 6% or higher yield with a bond account, but your yield isn't locked in until the time of purchase. So you might want to act fast. Lock in a 6% or higher yield with a diversified portfolio of high-yield and investment-grade corporate bonds only at public.com forward slash chitchat stocks. The second company is Grocery Outlet Bargain Market.

Grocery Outlet has a $1.6 billion market cap, so much smaller than Sprouts. And while the growth blueprint might look similar, they operate a very different model from that of Sprouts. So Grocery Outlet is a leading extreme value retailer with just over 500 stores located primarily throughout the West Coast of the United States. They've got some stores in the Northeast and they just made an acquisition, which I'll talk about in a bit, which gave them a store base in Tennessee and Virginia and Georgia and stuff like

that. So to give some sense of what a typical store looks like, the stores are not that pretty, to be honest they uh like you go in there and you're not blown away it doesn't look like a whole foods there's not like any major tech savviness in terms of the checkout there's no almost dollar general-esque right yeah yeah exactly it looks like they you look like maybe you can look at the store and you can think oh you know what i might find a bargain here because uh it everything's kind of displayed and like i don't know it's just not just not very pretty Um, but they have small stores, 14,000 square feet of selling space. So even a little smaller than a Sprouts farmer's market, it's actually like not that much bigger

than the average convenience store. Um, and the discounts are significant. Grocery Outlet targets 40% average discounts relative to the prices at standard grocery stores. And they offer that on normal name brand items. So it's not like you're getting the Trader Joe's, private label stuff, local farmers, local suppliers that you've never heard of before. It's name brand items. You're getting a lot of the big CPG brands.

And this deep discount treasure hunt style experience is very resilient regardless of economic conditions. So aside from lapping COVID when they had negative comps, because every grocer had negative comps following COVID, they have reported positive comp store sales growth every year for the last 20 years. And in 2008 and 2009, great financial crisis, they delivered two of their best years ever, 12.3% comp sales and 14.7% comp sales. So this is resilient. It's a very durable business. If times get tough, low prices never goes out of favor. And in tough times, people look for them or trade down even more so. So the two things you're trying to say here with this chart and what it shows is first, in the great financial crisis, they saw an increase in comp sales.

So they are counter-cyclical, which makes logical sense given their business model with that extreme discounting. And then second, during COVID and then after when we had this high inflation period, they were able to pass on that and still maintain that discount. And they didn't lose customers, given that they had that wide gap versus, say, a Walmart or a Kroger or something that's going to have that, say, standard grocery price. Yeah, 100%. All right. So the question is, Ryan, and people are going to be looking at this like, well, if they sell stuff 40% less than Walmart, how do they not have negative 40% gross margins, given that Walmart has pretty slim margins themselves? Why can they sell things at such a cheap cost? What is this unique business model?

Yeah, this is kind of the logical question you ask when you see it. And I recommend if there's a grocery outlet near you, just go in and just look at some of the prices and you'll be like, how are they possibly making money here? Because you can get whatever, like hummus trays that you'd get at $3 at Safeway for a dollar there or whatever. And it's just very cheap. So I asked this. I just put this into Google. And on their website, they have a step-by-step playbook for how they are able to get items at such low cost. So it says, step one, when a brand has excess inventory from packaging changes or

manufacturing overruns, they call us. Step two, we buy these excess products for pennies on the dollar, passing the savings on to you. Step three, each local store owner chooses products from our inventory that their customers will love the most, personalizing each store selection to its local community. And step four, we move the products into our stores and onto our shelves where customers can come back week after week looking for new finds new brands new and exciting ways to save so if you're a cpg brand and something's whatever gone out of favor maybe there was a packaging change maybe something went wrong on that batch of inventory you're not recently this happened to quaker oats with they had uh salmonella scare right yeah so there was some scare around

that they've had too much inventory they're going to go to grocery outlet yeah and i'm it's not saying that the items with salmonella won't won't end up at the grocery outlet but there yes if there's something that goes wrong with the product whatever it is you can't sell it to anyone like you know you're going to have to mark this down but at least you want to get some salvage value so you sell it to grocery outlet or whoever the deep discount retailer is so to kind of break things down a little further grocery outlet operates a franchise model at the store level so each store is independently owned and operated by local entrepreneurs they found that this works out well as it allows the ios or independent operators to order the inventory that's best

suited for their community so maybe whatever some item that works well in washington might not work well in arizona um and it's the ios would be best suited to know that they also probably have relationships in their community that help them. They might know a lot of the customers personally. It just helps to have local entrepreneurs running the stores. Importantly, these IOs contribute some initial capital to help get the store set up. So you are the franchisee, you're paying for inventory, staffing, et cetera, to get the stores up and running. But Grocery Outlet is responsible for funding the build-out of its store footprint, not the IOs. So Grocery Outlet is still capital intensive. They then collect a 50% share on the store level gross profits. So if gross profits

across all their stores came down, it's not like you get this super high margin franchise revenue where you get a chunk no matter what happens to the franchisee. You're very much tied with the franchisee at the hip. The supply chain side of things, on the other hand, is run entirely at the corporate level. So they have a dedicated team responsible for finding excess inventory, closeouts, overruns from suppliers all over the world. They bring these products into their distribution centers. I couldn't find an exact count on the distribution centers, but it looks like it's about seven to 10 distribution centers across the country. And then the store operators can go order from the grocery outlet inventory. So does that kind of all make sense in terms of

the corporate process. Yeah, it makes complete sense. They want that scale at the corporate level so they can negotiate with these suppliers and say, hey, we're the big player. Do you want contract with us? We'll take this inventory off your hands. Interestingly though, according to an interview with a former Grocery Outlet executive, Grocery Outlet already acquires roughly 30% of all closeout CPG inventory nationally. So they're probably the biggest buyer already of this discounted inventory and i'm going to talk about this in a second but that might lead it's not like if you're walmart you can always just order more from the cpg brands but if you're grocery outlet there's kind of a limited supply in terms of inventory like

brands aren't hoping to grow their their like bad inventory or their overruns or anything like that So the sourcing model is very important for this kind of business. So the fact that they already have 30% market share, according to that one person, I guess it's not a guaranteed number, but if it is very high, there might be a limit on, and I hate using this word, the total addressable market. But in this case, that might not be a real concern. Yeah. And I would take it with a grain of salt because obviously it's one person.

And whenever you – first of all, the former CEO of Sprouts went on and did some expert call and talked about how the business was going to collapse. That was prior to Sprouts absolutely ripping. So former executives don't always give the best interviews. But the – They're not always right. That's probably because why they're former executives. Exactly. But yes, it's important.

I mean, they're a big buyer of this closeout inventory. All right. So we know what the business model is. It's fairly easy to understand. They have a niche. Someone like Walmart or Kroger is not going to step into that because their business model is almost always in a reaction to how these other players are doing it. So someone else is not going to copy them exactly.

But I want to know what management is saying. What are their ambitions? and do you think they have reasonable assumptions for their plans over the next few years? So according to their latest investor presentation, Grocery Outlet is targeting 10% annual store growth over the long term, which kind of feels like every small retailer just says that, like we're targeting 10%, you know, nice round number, double digits gives people something to be hopeful for.

But they believe they have potential for 4,800 stores in total. That's their long-run potential. Keep in mind, they're at 500 stores today. So that's about a 10x on their current store base. If you look at their historical results, the 10% target doesn't actually seem to be too far-fetched. They've grown store count at about 9.7% since 2015. However, this number is slightly inflated as last year they acquired a company called United Grocery Outlet for $62 million in cash. And that gave them an additional 40 stores. So if you strip that out, it's maybe more like 8% or 9%. But it gave them 40 stores and a distribution center in Tennessee, North Carolina, Georgia, basically the Southeast. And they also run a similar buying strategy to Grocery Outlet. So they're buying out a lot of this closeout inventory.

So in theory, it's not like they have to rework the whole business. It should be a decent strategic fit here. And I would say if they're able to get store formats like this in bulk, do it if it's at a reasonable price. Because we're going to talk about this here in a second. but one of the hardest, one of the biggest barriers to get in there is like, it takes time to build out a lot of stores in different places and locate, you know, and locate spots that'll have a lot of customers. So if you know a place already has it and you can buy them at bulk for the same price, I think it's a good idea, but here's where I get a little concerned about them

hitting this target. So two things, the first one, this being a massive buyer, the CPG closeouts, But if they 10X their – let's say that 30% of nationals close out inventory figure is right. If they 10X their store count, there won't be enough inventory to support that. So they'll either have to adjust their buying strategy, maybe reduce the discounts that they offer, or I don't know. Or maybe they're misleading investors on their total potential store base. But the other one here – Right, so you're saying that – Sorry, yeah.

Go ahead. They were saying that, or you're saying, that they might want to change the model and have some stuff that they buy on a standard method. I think that could potentially work, but it also might ruin the customer value proposition. Because if someone goes into a store and sees that it's the same price as somewhere else, well, then you don't have that guarantee that when you go to a grocery outlet, you're getting that extreme discount, which is the whole reason for visiting the store. yeah they already do some buying of like normal products like everyday staples that people would want toilet paper or whatever that where it's not at like extreme discounts and you're not getting crazy price but you go in and you get a good price on five or six items that you'd always get and then you find like a couple that have like huge huge discounts so um maybe it just skews

more towards that over time not really sure but yeah you wouldn't want to lose that customer value proposition. But the big one for me is that their independent operators are only allowed to own and operate one store. So generally speaking, I'm all right with this because it means the IOs have to focus exclusively all their efforts on one store. None of those stores are falling by the wayside or deteriorating. It's good for quality assurance and then likely margins as well because they got to make a living off of one store and not just like can't just do five stores at once but if you're trying to grow store count 10 by 10 a year that means you'll be adding right now 50 new stores every year so you'll have to recruit 50 new ios to meet that target which is not easy to do

you got to recruit them train them it's just it seems even though they've been able to do it like the bigger they get, the harder it is to hit that 10% store count threshold because the talent pool for independent operators that want to do this isn't that big. You have that much more people that you have to train. It's not like someone already knows how to do it and they can add two or three new stores next year or whatever. If you're telling them to only own and operate one store, it's kind of a barrier to the growth rate on a regular basis. right so there could be some quality control issues as we hit this next scale of the business if they want to hit that 10 growth and that's probably a big thing

leading into the valuation which speaking of let's hit the next section we're combining the economics of the business how the income statement works and we're going to lead to ryan's assumption and what he is thinking are fairly reasonable estimates for the next few years here and how that plays into our valuation work and whether the stock looks cheap. Finchat.io is the complete stock research platform for fundamental investors. They have all the standard financial data on more than 100,000 stocks globally. But beyond that, they have company-specific segment and KPI data on 1,800 stocks. Want to see NVIDIA's data center revenue? Finchat's got it. Like to track Spotify's premium subscribers? They've got that too.

and they just added ETFs to the platform as well. The breadth of FinChat's data is truly one of a kind. We use FinChat every day, and I've personally been using the AI Copilot more and more to summarize earnings calls and conference transcripts. To get 15% off any paid plan, go to FinChat.io slash chitchat. That is FinChat.io slash chitchat. To get 15% off any paid plan today, the link is in the show notes. Yeah. So on average, over the last 10 years, Grocery Outlet has generated 31% gross margins

and 3% operating margins. Free cash flow conversion is not very good as they are responsible for building out their new stores. So they tend to be... If they're building out all the new stores, CapEx is high. But if they, let's say, put the brakes on building out new stores, free cashflow margins would be super elevated. So it's typically with grocers that are in kind of high growth mode or even any retailers that are in high growth mode, you're really valuating them on an operating income or net income basis. They do have a little bit of debt though on a term loan that's due in 2028 or something like that. So there's some interest expense as well. So I'd probably just use, and what I've chosen to use here is net income as

the preferred metric to value them on. Over the last 12 months, net income is a little understated as they had a costly one-time ERP system transition, enterprise resource planning system transition for anyone who doesn't know the acronym, but it makes margins look a little worse than they should be moving forward. So if you add back that $33 million system transition that they had, the costs associated with it, grocery outlet is trading at a price to earnings of around 19 times. So not crazy attractive, but let's get into some assumptions and see where we get. So I think the following are realistic targets. Keep in mind for Sprouts, I just took the targets at face value, didn't really change them at all. I'm changing these to something that I think is a

little more realistic. 7% annual store count growth. They've beat that over the last 10 years, even if you strip out the acquisitions and maybe they can find more acquisitions over the next 10 years. So maybe they beat this, but 7% I think is fair. 3% comp store sales growth for grocery outlet. This is kind of a little dependent on like the economic environment. Like if times get really tough, maybe this is higher. If inflation is really high and maybe comp store sales are higher or whatever. But 3% I think is, they have averaged higher than that over the last 20 years. So I think they can continue to do so. And then long run net margins of 2%, which is about in line with where they've been over the last three years. Although it recently dropped as we talked

about with the system transition. So if that happens, they'd be earning around $134 million in net income in five years. We don't really do, or I don't really do super elaborate models for these episodes. So let's use the old slap a multiple approach on it. I do think this is a recession resilient business. That's pretty clear.

And one that should translate well into new states because I think people love low prices everywhere. So I don't think a mid teens earning in multiple is like unrealistic. I think this deserves to trade at 15 times, roughly. Right now, it's at 20 times. I don't think 15 times is too optimistic. So let's assume it trades at 15 times in year five.

You've got basically a low to mid single-digit annual return, if that's the case. 20 times, you're getting probably a high single-digit 10% return, maybe. um but what i would say is that margins could be higher like it it's really hard to tell with some of these grocery stores where margins are so thin because if they beat by half a percentage point it's you know a 40 increase in their margins so um that's where i think there's probably the most variability but i guess i'll leave things with you for now yeah and what do you think? So historically, you said this margin is not that much different. Sorry, I have to sneeze. So for anyone looking at me, I try to think, well, try not to sneeze at the same time.

All right. Margin expansion. So net income historically has been close to 2% or lower, and that's worse than Walmart, I believe, and at Costco levels. So what do you think is happening here? Do they just have to maintain these extremely low prices? Because when they show the gross margin here, it's stated at 30%. So there must be some cost here, I guess. And I haven't looked into it. I'm sure management has talked about this at some point. The labor aspect might be the thing that is working against them, where wages have gone up a lot. And if those are growing at three, four or 5% a year, you got to hit comp sales about the same level to maintain your margins. And hey, I don't know if they can beat that. But if they do,

i guess you could see margins expand to three four percent because look at that gross margin level it's not like costco where you're starting at such an extremely low level on the unit economics perspective that your operating margin is not going to be that high regardless of how big you get or how strong your comp sales are so is there is there anything you see that makes you optimistic that this margin expansion could happen yeah i mean like if if they are able that's probably not where i see the most upside coming from but i think it's possible that they could beat it the difficulty is that they just don't really have that high of like auvs like their stores don't generate that much in sales and if you're a grocery store you have

to employ a certain amount of people. So they have a lot of operating expenses. So margins are probably going to be pretty thin. And I don't really see a world in which they... If times... If the economy

goes into a recession and more people trade down, AUVs will be much higher at the store level. People will go there more. And margins will probably look pretty good. COVID, net margins were 3.4% So twice what they are today.

So it's possible. But I would feel more safe – like I'm not going to write that into like a thesis if I'm investing in it because 2% seems way more realistic. And if they're adding a bunch of new stores, if anything, the AUVs are probably going to be lower to start. Like the AUVs on the new stores aren't going to be as high as the ones that have been around for 20 years. Yeah. And if they keep growing at 10%, yeah, that's not going to be something that happens in the near term as they slow down that store account growth. Other question that could impact returns, buybacks. Share count going up, share count going down. Could it have a big impact on the investment? Yeah. I haven't even looked. Honestly, I probably should have.

That's all right. We can look live. I'll do this live in real time. Yeah. That's why we got the beautiful cloud-based platform right in your browser. Get a lot of advertisement out there. Total shares outstanding have not gone down. I don't think it's really a part of their strategy at the moment. It's not a part of the plan. Yeah. The cat-backs build out. And I think they've only been public for a few years now, if I'm not mistaken. Yeah. I want to say it was a 2019 IPO.

So not a big thesis there. Yeah. And they're not in capital returns mode from a dividend perspective either. So you really got to hope they're going to have a good ROIC, good reinvestment runway. And it seems to me the key here is the comp sales. Yeah. Okay. And the store growth.

Like this is something with Sprouts, I don't think they're going to be able to grow stores. like it a sprouts concept might not be as popular in missouri or it might not be as popular in ohio but low super low everyday prices i think is can be popular everywhere now right are they going to be able to sustain that on this on the sourcing side of things i don't know i i would say that's kind of across the bridge when we get their situation because it's they seem fine keep They've been able to keep their discounts quite steep, even at this size. So I think if there's anywhere that they can surprise to the upside, it would be that they have way more stores than people think in like 10 years. Yeah, I could see that happening.

And it seems like the thesis rests on margins stay all right because they're going to be low because of their customer value proposition. But you've got to think that revenue has a chance to 3, 4, 5x over the long term. All right. What should we talk? Oh, wait. No. We got one more section here. What could go wrong?

What are you looking at as a downside for grocery outlets? I think the outcome for a grocery outlet investment pretty much comes down to kind of one big risk, which is either A, they're unable to grow new stores at the rate they want, or B, they open new stores aggressively, but the new stores don't perform as well. So here's a quote from a short report I read on the company. It says, Our diligence suggests grocery outlets' recent IO, independent operated cohorts, have struggled to make an acceptable ROI on their stores. There is evidence that grocery outlet system-wide AUVs are becoming increasingly bifurcated between legacy core markets and the new markets, where legacy market AUVs remain healthy while newer store AUVs are increasingly challenged. Basically, all this is to say they did some channel checks and they think that the new stores aren't doing so well. If that is the case, margins are going to deteriorate a little bit and – Well, there's not much room.

Yeah, it could get unprofitable. Yeah, if they grow too fast, there could be – it could be a really big issue. I think it's easy to turn that off. Like you can stop growing store count too quickly and say, hey, we need to shut some of these down or whatever, but – or replace the independent operators. And I don't think it's the end of the world. So it just seems like the expectations are kind of high for this business at the moment at 19 times earnings. So like 19 times normalized earnings. I don't know.

It doesn't seem that risky on the business model side of things. And that's kind of just the nature of grocery stores in general. Like once you have a grocery store in an established location, people are just going to go there. they're going to keep going there but yeah being the low-cost provider too it's not like there's going to be like sprouts theoretically you could say like whatever maybe less people become health enthusiasts or whatever and they're not able to get to their target market that doesn't really exist for grocery outlet maybe if if we get into an insane bull market maybe no one will care about deep discount retailing yeah this is what kathy wood is shorting when the ai super

utopia arrives correct yeah i guess all right well if everyone's rich they don't need this yeah exactly exactly well once the optimist bot starts doing this for everyone we'll be good uh what i'm curious about is the ipo valuation seemed absolutely absurd because i was looking at the stock it was down a lot i'm sure that's what caused you to have a little bit of interest to the multiple definitely compressed from a top line perspective but they were trading at 35 times ebitda 40 times ebitda now it's closer i mean it seems somewhat reasonable 17 to 20 times as you mentioned 19 times normalized pe what do you what do you think was going through people's minds like an insane growth concept or was that kind of a bubble period i think ipos are just that period

ipos were broken like they were just surprised if there were like of all the ipos between 2018 and 2022 spax included i would bet less than like five percent of them had positive returns after two years yeah a lot of multiple compression a lot of multiple compression and hey it could be cheaper here. But I guess we're going to lead into the last section going across both these stocks. And once you have anything else before we close up here. Yeah. Let me just add sort of the management situation. So RJ Sheedy, I think is his name. He's been in the business for a while at different roles. He became CEO last year and he seems fine. He seems like a good operator. The somewhat concerning thing here is that it's just been like pure insider sales,

one after the other for like since the ipo and there has not been any insider buys and then the there is i think a part of like the founding family owns like two two to four percent of the company i don't have it up right now but there is some incentive there from the original founding family to care about the stock price it's you know they have like i think 40 million dollars worth tied to tied into grocery outlet stock so there's at least some sort of incentive alignment there yeah all right so we got sprouts farmers market huge winner historically at least the last five years valuations crept up as we saw which might be putting it mildly but their business is maybe i would say firing on all cylinders at the moment it's doing quite well and there seems to be

a lot of momentum at the back, facing a lot of tailwinds. They've reversed some of their woes just remarkably over the last few years. Grocery outlet, going through a tiny bit of a rough patch maybe from the earnings perspective. But as Ryan mentioned, there could be some things where you're just kind of comping to that COVID margin, which is not normal. You also have that ERP thing. And it was a lot of just multiple compression from the IPO. So are you buying either of these stocks and which one would you which one entices you more at current prices so i'm not buying either one here i just don't love the current valuation on either one of them

but i if i had to buy one i'd probably lean more towards grocery outlet just seems like more durable concept there's not any they're gonna grow comp sales they're gonna have positive comp sales as long as like it's a normal environment for probably 10 years for the foreseeable future um and it's it's a little bit cheaper on a valuation basis so i'd probably take them but i would say sprouts probably has the biggest opportunity to outperform on the comp sales basis. Yeah, I agree. There is that right tail for them. And there seems to be a huge risk that Sprouts goes through a multiple compression because the last few quarters, comp sales have been fantastic, but it could revert back to 3%, 4%, and the stock will get hit a ton. Now,

maybe it's a buying opportunity then. But as Ryan mentioned, if the upside hits today, or excuse me, not today, over the next five years from your reasonable prediction of what the income statement can look like in five years, you can get maybe a single digit return on the stock, which I would say, why not buy some bonds for your portfolio? Some corporate bonds get 6%, 7% return. With grocery outlet, I was surprised at giving your assumptions how low the forward returns look. And we're at a stock price of $15 and 83 cents as of this writing. So let's just say $16. Given your assumptions, and maybe just do some back of the napkin math so it's not exact, what price interests you on Grocery Alley? Because it does look like you have fairly

high confidence that sales will be higher in five years. So at some level, there's a price that makes sense yeah i'd say if either of these traded around 10 times earnings i'd probably be up for it it's hard to imagine either one growing the top line any faster than like 10 to 12 percent um so 10 times earnings thinks you get a fairly reason fairly strong return i don't know what happened but it seems like maybe just during the giant tech bubble like no one liked grocery stocks because a whole bunch of the like grocery companies were trading at single digit earnings multiples and they were fine earnings yeah ingles markets even kroger a little bit right although they might have been slightly higher yeah i remember ingles markets

don't remember if kroger got that low but it just like it fell out of favor so if that ever happens again yeah i buy these in a heartbeat they're pretty they're pretty easy purchases to make the only question becomes like, what do margins look like? Because they can vary so quickly. Yep. And what does management do? Because you do have that capital expenditure risk where you had to reinvest into the business if you keep growing that store and they're pretty bad at it. Hey, well, that earnings you had, they just got destroyed. All right. That's going to close things out for us. Ryan, do you have anything on your radar for your next stock research episode? and if not, anything else listeners should be apprised of that's coming up.

I don't know what my next stock will be. So if anyone has any recommendations for things I could check out, feel free to shoot them over to me. We've got an earnings episode coming up. Earnings season is right around the corner, I believe. Yeah, basically starting this week. Yeah, the other thing is I've been thinking about just kind of, I listened to an interview with that Jason Hirschman guy, who's just an exceptional

investor. And I think we should do maybe like a portfolio type episode because I think my philosophy around concentration has changed a bit. So I'm, I'm, I'm officially a starter position guy. I know some people don't like that, but I, I'm totally fine with starter positions. there we go yeah that could be a four yeah that could be a phone a tease for the upcoming episodes if you didn't see i did a stock research report on celsius that people seem to enjoy although i did jinx it because i decided not to buy and the day it came out marked the near-term bottom for the last week and stocks of about 20 so that was unfortunate but i still think it was a good episode and hopefully people got enjoyment out of that one we're going to be having an interview

on, I won't say who the guest is yet, but they've been on before. We're going to be doing one on Evolution Gaming. I think they're just called Evolution now. And we're also going to be doing my next stock research report, which will be in a few weeks, if not maybe a month. And that'll be on StoneCo, which for anyone that didn't know, who joined the live Power Hours last week, we had Dave from Investing for Beginners. And he brought that stock because he has boots on the ground Connections and has been to Brazil. And the company has been doing decently well. And the stock trades at, I haven't done the full report here, but it looks like five times EBITDA, five times earnings. So hey, could be something worth investigating. I think that's why I'm going

to make my next stock research report. So that's what we have to look forward to. But Ryan, thank you for going through these two stocks. Thank you everyone for listening. Make sure to listen to us on any platform you want, which is YouTube, Spotify, Apple Podcasts. As I mentioned before, if you want the graphics, if you want the charts, we have a free newsletter that can help you learn more about these companies after listening to this episode. But let's go through the disclosure. We are not financial advisors. Anything we say on the show is not formal advice or recommendation. Ryan, I, or any podcast guests may hold securities discussed in this podcast. They've held them in the past and may buy, sell, or hold them in the future. Thank you everyone for tuning in.

I will see you next time. We'll see you next time.