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Shareholders of Grocery Outlet would probably like to forget the past six months even happened. The stock dropped 21.9% and now trades at $13.95. This may have investors wondering how to approach the situation.
Is there a buying opportunity in Grocery Outlet, or does it present a risk to your portfolio? Get the full breakdown from our expert analysts, it’s free.
Why Is Grocery Outlet Not Exciting?
Even with the cheaper entry price, we don't have much confidence in Grocery Outlet. Here are three reasons why GO doesn't excite us and a stock we'd rather own.
1. Weak Operating Margin Could Cause Trouble
Operating margin is a key measure of profitability. Think of it as net income - the bottom line - excluding the impact of taxes and interest on debt, which are less connected to business fundamentals.
Grocery Outlet was profitable over the last two years but held back by its large cost base. Its average operating margin of 1.8% was weak for a consumer retail business. This result isn’t too surprising given its low gross margin as a starting point.
2. Previous Growth Initiatives Haven’t Impressed
Growth gives us insight into a company’s long-term potential, but how capital-efficient was that growth? Enter ROIC, a metric showing how much operating profit a company generates relative to the money it has raised (debt and equity).
Grocery Outlet historically did a mediocre job investing in profitable growth initiatives. Its five-year average ROIC was 2.3%, lower than the typical cost of capital (how much it costs to raise money) for consumer retail companies.
3. Short Cash Runway Exposes Shareholders to Potential Dilution
As long-term investors, the risk we care about most is the permanent loss of capital, which can happen when a company goes bankrupt or raises money from a disadvantaged position. This is separate from short-term stock price volatility, something we are much less bothered by.
Grocery Outlet burned through $37.74 million of cash over the last year, and its $1.74 billion of debt exceeds the $50.91 million of cash on its balance sheet. This is a deal breaker for us because indebted loss-making companies spell trouble.
Unless the Grocery Outlet’s fundamentals change quickly, it might find itself in a position where it must raise capital from investors to continue operating. Whether that would be favorable is unclear because dilution is a headwind for shareholder returns.
We remain cautious of Grocery Outlet until it generates consistent free cash flow or any of its announced financing plans materialize on its balance sheet.