Grocery Outlet Holding Corp. (NASDAQ:GO) Q3 2023 Earnings Call Transcript November 7, 2023
Grocery Outlet Holding Corp. beats earnings expectations. Reported EPS is $0.31, expectations were $0.27.
Operator: Greetings. And welcome to Grocery Outlet Third Quarter 2023 Earnings Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. We ask that all callers limit themselves to one question and one follow-up. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Christine Chen, Vice President of Investor Relations. Please proceed.
Christine Chen: Good afternoon. And welcome to Grocery Outlet’s call to discuss financial results for the third quarter for the period ending September 30, 2023. Speaking from management on today’s call will be RJ Sheedy, President and Chief Executive Officer; and Charles Bracher, Chief Financial Officer. Following prepared remarks from RJ and Charles, we will open the call for questions. Please note that this conference call is being webcast live and a recording will be available via telephone playback and on the Investor Relations section of the company’s website. Participants on this call may make forward-looking statements within the meaning of federal securities laws. All statements that address future operating, financial or business performance or the company’s strategies or expectations are forward-looking statements.
These forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from these statements. A description of these factors can be found in this afternoon’s press release, as well as the company’s periodic reports filed with the SEC, all of which may be found on the Investor Relations section of the company’s website or at sec.gov. The company undertakes no obligation to revise or update any forward-looking statements or information. These statements are estimates only and not a guarantee of future performance. During today’s call, the company will also reference certain non-GAAP financial information, including adjusted items. Reconciliations of GAAP to non-GAAP measures, as well as the description, limitations and rationale for using each measure may be found in the supplemental financial tables included in this afternoon’s press release and the company’s SEC filings.
And with that, I would now like to turn the call over to RJ.
RJ Sheedy: Good afternoon, everyone, and thank you for joining us. We are pleased with our third quarter performance and the underlying trends in our business. We continue to drive industry-leading sales growth due to our differentiated value proposition and we are delivering on our mission of touching lives for the better. Customers are increasingly seeking value in their everyday lives and we provide unbeatable value and access to affordable quality food. Our third quarter sales increased 9%, driven by a 6.4% increase in comparable store sales. Transaction count remained strong in the quarter, increasing 9%, which is consistent with the prior two quarters. Traffic increases continue to be a combination of more new customers in our stores and existing customers shopping with us more frequently.
Gross margin was also very strong in the quarter, up 80 basis points to 31.4%. This, together with sales growth, drove a 20% increase in adjusted EBITDA to $68 million. Adjusted EPS grew 24% to $0.31 per diluted share. While pleased with our third quarter performance, we experienced operational disruptions as we transition to upgraded systems. On prior calls, we have discussed our approach and history of investing in modernizing systems to improve capabilities and drive efficiency. We began to implement our most recent enhancements in late August, which include upgrades to product, inventory, financial and reporting platforms. One important component of this upgrade is a new store portal that will provide operators with improved data to make better purchasing, merchandising and marketing decisions.
We are excited for the improved functionality, scalability and data analytics that this and other enhancements will provide. The transition to these new systems has resulted in ordering and inventory disruptions that have impacted third quarter and fourth quarter results. We have been partnering closely with our independent operators to minimize the impact to customers and sales. We have also elected to provide commission support to our operators as we continue to make steady progress adapting to the new systems. We anticipate the transitional impact to be largely behind us by the end of the year. Charles will provide more details in his commentary. While food inflation has been moderating, consumers are still challenged with higher food prices and other financial burdens.
Our 40% average basket savings compared to conventional grocers saves customers money at a time when they need it most. We also continue to wow customers with an ever-changing treasure hunt assortment that includes savings on many items of up to 70% or more. This unique value proposition has been driving new shoppers to our stores throughout the year, resulting in ongoing increases in market share. Our recent customer survey shows that increased trip frequency is resulting in higher spend. Our consistently low prices and unexpected great deals are driving high customer satisfaction, as value remains the most important criteria for store visits. And our overall brand awareness continues to increase, with customers intending to spend more with us in the next 12 months.
In terms of products, we are pleased with continued strength in opportunistic supply and the solid execution of our purchasing team. The closeout market remains strong and our growing size and scale provide increasing access to products. We remain highly selective with our opportunistic purchases and we continue to buy only the best deals that are presented to us. We look forward to becoming a more valuable partner to suppliers as we grow and expand our geographic reach. As one of the largest buyers of consumable closeouts, we quickly buy and sell through large volumes of product, which helps our suppliers manage their excess inventory. Suppliers have increased their manufacturing capacities over the past several years and more recently have been rapidly adjusting and innovating their product assortments.
These dynamics create more opportunities for our purchasing team as we work in close partnership with our suppliers to help them with their surplus inventory situations. We continue to strengthen our longstanding partnerships with large CPG suppliers. We maintain strategic relationships throughout these organizations and we manage the partnerships for long-term, mutually beneficial sales and profit growth. New supplier acquisition and development remains another important buying focus. Many smaller suppliers rely on us to not only assist them with surplus inventory, but to also help them scale more quickly. We help them build production lines, and we provide a unique opportunity to grow their brands more easily than through other distribution channels.
These partnerships allow us to offer our customers more brands, items and value, particularly within our fast-growing natural, organic, specialty and healthy categories. Our NOSH product offering appeals to a broad customer base and further strengthens the treasure hunt shopping experience that drives a bigger basket, more frequent visits and new customer acquisition. Turning to operator support. We continue to work collaboratively with operators to build programs and initiatives that support and enhance their business. Our relationship with our IOs is a true partnership and we are continuously reinvesting to upgrade fixtures, implement new technology and processes, and deliver efficiencies that help them grow sales and profits. For example, we recently consolidated the purchasing of many store supplies that IOs previously bought on their own.
Our scale and distribution network allow us to save operators money on many items they use to run their business. The new store portal is another example of investments we make to help IOs. This new system will help them more efficiently receive inventory, manage the assortment and access data to improve their operations. We look forward to realizing these benefits as we move past our initial transition period challenges. Average store operator income continues to grow, driven by the sales and gross profit growth that we split with our IOs in the form of commission. In the third quarter, operator commission payments increased by low double digits on a comparable store basis versus the prior year. Commission growth has been very healthy this year and we look forward to helping IOs with future efficiency and business enhancements.
We opened eight stores during the third quarter, including our 450th store, which was also our first store in Las Vegas. We ended the quarter with 455 stores and we are on track to open 27 net new stores for the full year. We continue to be pleased with our new store performance, including those in our Southern California and East Coast markets. We also look forward to opening our first Ohio store before the end of the year, in addition to stores and other new communities within our existing supply chain reach. Our new store growth efforts for 2024 and beyond remain focused on organic growth, together with new real estate opportunities that align with our long-term geographic expansion and store growth strategies. Complementary growth opportunities include expanding strategic relationships with large property owners, evaluating opportunistic real estate lists and exploring strategic regional acquisitions.
Our white space remains huge with the potential to operate over 4,000 stores across the U.S. Finally, we are extremely proud to have recently published our first annual ESG report. This report showcases the positive impact that we have on our communities, our people and our planet. Our mission of touching lives for the better has been core to the business from the start and fulfilling this purpose has resulted in positive environmental and social impact throughout our 77-year history. Our report highlights seven key impact areas. The first three areas positively impact our communities. First, we save customers a tremendous amount of money. Over the past five years, we have saved customers over $10 billion compared to conventional grocers and we aim to provide customers $3 billion in annual savings in 2024.
Second, we provide access to affordable, quality food. About 10% of the U.S. population is food insecure. We increase food access in our communities by providing customers with affordable, quality food from trusted, name-brand suppliers. And third, we give back to our communities, since its founding in 2011, our independence from Hunger Drive has raised over $16 million to fight food insecurity in our local communities. The next two highlighted areas positively impact our people. First, our highly differentiated model creates unique opportunities for our IOs to become local business owners and entrepreneurs. Operators enjoy the autonomy of running their own businesses, selecting localized products and providing outstanding service to their customers every day.
We provide support to help them achieve the American dream. Second is that we also create exciting opportunities for our employees. We continue to hire great talent to support growth and we continually reinvest in development and career advancement opportunities for our best-in-class team. In addition, our focus on our core values and ED&I initiatives help strengthen our culture and business overall. Our final two highlighted areas have a positive impact on our planet. Our opportunistic sourcing model reduces food waste by creating value from products that may otherwise be discarded. Our partnership with suppliers keeps food out of landfills, reducing methane emissions while providing accessible nutrition to communities that need it. Lastly, we are focused on improving operational efficiency in our business and we partner with IOs to manage energy use in stores.
These investments are good for both Grocery Outlet and IO profit growth, as well as for the environment. We are proud of the positive impact we have had throughout our history. As we continue to grow our business, we remain committed to exploring new and innovative ways to further enhance the positive impact that Grocery Outlet has on our communities, our people and our planet. In closing, I want to thank our amazing IOs for their partnership and service. I also want to thank the entire GO team for all that they do, which enables us to support our IO partners and deliver outstanding service and value to our customers. We see tremendous opportunities ahead of us and believe that the investments we are making today will position us for long-term growth and increase profitability.
I will now turn the call over to Charles to discuss our financials.
Charles Bracher: Thanks, RJ, and good afternoon, everyone. Our third quarter results reflect the continued momentum we are seeing in our business, which drove strong comparable store sales growth and margin expansion. For the quarter, net sales increased 9.3% to $1 billion, primarily due to a 6.4% increase in comparable store sales and the impact of new stores opened over the past 12 months. Our system upgrades impacted comparable store sales by an estimated 150 basis points as comps were running in the high single digits before the transition. Transaction growth remained strong, increasing 8.6%, slightly offset by a 1.9% decline in our average basket. We opened eight new stores during the quarter, ending with 455 locations.
Our new stores are performing well and building in line with our expectations. Third quarter gross margin increased 80 basis points to 31.4% and gross profit increased 12.5% to $315.7 million. Healthy deal flow and a favorable buying environment drove margin expansion and more than offset inventory inefficiencies related to our system transition, which we estimate to have impacted gross margin by approximately 50 basis points. SG&A expense increased 8.7% to $278.1 million compared to the third quarter of 2022. The increase was driven by higher commission payments to IOs, store occupancy costs due to new unit growth and higher incentive compensation expense reflecting our strong performance, partially offset by vendor receivable. Higher commission expense reflects strong gross profit growth, together with support we elected to provide to our IOs in connection with our system upgrades.
As a percentage of sales, SG&A decreased by 20 basis points to 27.7%. Net interest expense decreased 11.9% to $4.2 million due to a reduction in long-term debt versus the prior year and higher interest income, partially offset by the impact of higher effective borrowing rates. With respect to the bottomline, GAAP net income for the third quarter increased 55.1% to $27.1 million or $0.27 per diluted share. Adjusted net income increased 23.4% to $31 million or $0.31 per diluted share. Adjusted EBITDA increased 20% to $68.1 million for the quarter. As a percentage of sales, adjusted EBITDA increased 60 basis points from the prior year to 6.8%. Turning to the balance sheet. We ended the quarter with $155.7 million of cash, slightly above normalized levels, as we experienced longer payable processing times as a result of the system transition.
We ended the third quarter with $308.6 million of inventory. Gross debt was $296.3 million at the end of the third quarter, with net leverage less than 1 time adjusted EBITDA. During the quarter, we generated $119.1 million of operating cash flow and invested $42.7 million in CapEx, net of tenant improvement allowances, primarily for new store growth, upgrades to our existing fleet, and technology and infrastructure investments. Now let me provide some commentary on our expectations for the fourth quarter and update our outlook for the full year. While our underlying business remains strong, we do expect the system transition to significantly impact financial results in the fourth quarter and to a greater degree than the third quarter, given the additional months affected.
With respect to the topline, we expect fourth quarter comp growth to be approximately 2%, which assumes a 300-basis-point headwind from the system transition. For the full year, we now expect our comp sales growth to be in the range of 7% to 7.5%. In terms of unit growth, we expect to open 13 new stores in the fourth quarter and 27 net new stores for the year. We continue to expect fiscal 2023 net sales of approximately $3.95 billion. We expect fourth quarter gross margin to be approximately 30%, reflecting normal holiday seasonality along with approximately 150 basis points of impact due to the system transition. For the full year, we now expect gross margin of approximately 31.2%, a 70-basis-point improvement over last year. With respect to the bottomline, we project fourth quarter adjusted EBITDA margin of approximately 5% of sales, reflecting the previously mentioned system transition impacts along with commission support that we are electing to provide operators.
For the full year, we now expect adjusted EBITDA to be in the range of $248 million to $252 million. At the midpoint, our guidance represents healthy bottomline leverage and approximately 16% adjusted EBITDA growth versus last year. Moving down the P&L. We continue to expect net interest expense of approximately $21 million for the year, which reflects projected forward interest rates on our outstanding debt. For adjusted net income purposes, we project a full year tax rate of approximately 30%, along with average diluted shares outstanding of approximately $101 million. Based on these expectations, we now expect full year adjusted EPS to be in the range of $1.04 per diluted share to $1.06 per diluted share. Regarding CapEx, we continue to project approximately $155 million for the full year, net of tenant improvement allowances, reflecting new store growth and ongoing investments in our store base and business infrastructure.
In closing, I would like to take a moment to thank our incredible team of independent operators and employees for continuing to execute at a high level on behalf of our customers. Our underlying business remains strong and we are making important investments to further strengthen our value proposition and position us for long-term growth. We will now open the call up to your questions. Operator?
RJ Sheedy: Operator?
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Q&A Session
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Operator: Thank you. [Operator Instructions] Our first question comes from Leah Jordan with Goldman Sachs. Please proceed.
Leah Jordan: Good afternoon. Thank you for taking my question. I just wanted to start off with a couple of questions around the new platforms you implemented this quarter. What has been the biggest challenge related to the ordering? Is it just learning the new program, is there anything specific about the functionality that surprised you? And then you also said the disruption would be largely behind us by year-end, but how should we think about any impact into the first half of next year, especially any cost that we should think about annualizing? And then also, you mentioned that would bring better data analytics. Just curious, how quickly you think you can implement those learnings or have you any insights to share in just the first few months?
RJ Sheedy: Hi, Leah. I will take the first couple of parts of that question and then I will turn it over to Charles to address your question around impact into 2024. First, just some more information on what I shared in my comments. We did upgrade a number of systems at the end of August, inclusive of product inventory, financial and reporting platforms. These upgrades include replacement of our AS400 system, which is our legacy ERP system with SAP, along with other third-party plus some new proprietary applications for buying in store operations. So that was the enhancement that was implemented back a couple of months ago. It’s the continuation of prior ERP upgrades that we have implemented over the past eight years to 10 years and consistent with the approach that we have talked about in making ongoing investments in modernizing our systems to build foundation for future growth and scalability of the business model.
As far as benefits, you asked about data and analytics, we really look forward to the enhancements that these new platforms will provide. They will give us new capabilities for how we manage the business, they will drive efficiencies through better data and analytics that will support us with better decision-making and that will be an improvement, enhancement for both the operator community as well for Grocery Outlet in total. In terms of the challenges and the disruption that we face as we transition to the new systems, we were challenged with inventory visibility and the impact here was on ordering and inventory management in general, and unfortunately, this disruption did have an impact throughout the business and the P&L. And notably, as mentioned in our comments, topline sales were impacted by lighter inventory levels, slightly lower variety.
We had some pressure on margin as it relates to inventory inefficiencies and then SG&A was higher as well as we elected to provide operators with support. I will say that we did expect some disruption during this transition. It was factored into our previous guidance, just not to the degree that we have been experiencing it, and of course, we are very disappointed with the magnitude of it and we own it, we own where we are. And at this point, we have addressed the inventory visibility issues, along with other issues we experienced earlier on. So we have made very good progress there. We have also recently returned to more normalized store ordering practices. We have much healthier warehouse inventory levels and flow throughout the system. So we are feeling good about all of that.
I will also say that we are still adapting to other parts of the new systems. We were working through some of these new processes and working our way back to what I would describe as more optimal inventory levels and margin management, and therefore, the impact that we anticipate throughout the fourth quarter here. Nevertheless, we are making good daily progress, and as I mentioned, we do anticipate the transitional impacts to be largely behind us as we get to the end of the year. And I will kick it over to Charles now to comment on 2024.
