Description

“We think it’s a fabulous environment to be selling. Over the past 15 months we’ve been a net seller. We’re selling everything in our portfolio that’s not nailed down, and if it’s nailed down, we’re refinancing it. It’s almost biblical. There is a time to reap and there’s a time to sow. We’re harvesting.” – Leon Black, Apollo Global Management, May 4.

Apollo has IPOed 8 companies so far this year, and has filed for a 9th. One IPO we think Apollo will want to sell its stake in as soon as possible is Sprouts Farmers Market (SFM). SFM more than doubled in its IPO on August 1^st, and is currently trading 120% above its offering price. Sprouts is one of the growing number of publicly-traded natural food supermarkets. It currently operates 154 stores in the Southwest, and thinks it can eventually grow to 1,200 stores.

Besides Black’s stated intention to sell everything possible, let’s examine a few more reasons why Apollo (and anyone else) would want to sell (short) Sprouts Farmers Market at its current prices:

This IPO, like several others this year, was dedicated to benefiting existing shareholders, rather than the company itself. On April 23^rd of this year, Sprouts refinanced and increased their term and revolving debt limits. Then on April 24^th they took a $282 mm distribution, which was approximately the size of the IPO before the greenshoe, then used IPO proceeds to pay down the term debt.

While Sprouts touts its unique store layout with more space devoted to fresh produce, open floor plans, and low displays, it is critical to remember, this still is a supermarket. It’s not a new category they’re creating. The market is highly penetrated so some of the ambitious growth they target must come at the expense of other players. And if their merchandising strategy is better than their competitors, copying Sprouts’ better practices will not be impossible. Yet, Sprouts is valued as if all of this were not true. In fact, while we think some of their competitors, like The Fresh Market and Natural Grocers are also good shorts, Sprouts is in a league of its own on relative valuation. Here’s a snapshot of where Sprouts and peers trade on a variety of metrics. As you’ll see, despite having similar gross margins and same store sales growth, and actually worse sales/sq ft., Sprouts trades between 1.6 and 4.2 times the median multiples for this group of already high-flying stocks. 

(Note, most data above from bloomberg, hence the difference with my diluted mkt cap and ev in the writeup’s header. Also, the reason total rev growth % is not a meaningful comparison is that the Sprouts-Sunflower acquisition distorts Sprouts' growth this last year).

Additionally, we can look at the Apollo-led Sprouts acquisition of Sunflower Farmers Market in May of 2012 as a good benchmark for how much Apollo (i.e. a rational player) values this business. Buying Sunflower was a significant deal for Sprouts, as they increased their store count by 36%, revenue by 37%, and gross margin by 47%—so the transaction should be large enough to provide a representative valuation benchmark, whereas a very small or large acquisition may have a skewed multiple for strategic reasons. In the deal, Sprouts bought Sunflower for approximately $220 mm (cash and stock for $200 + $20 mm debt assumption). This results in the following deal multiples: 0.5x sales, 20x ebit, and 10x ebitda—and this was for a company growing sales at 21%, a faster rate than Sprouts as a whole is currently growing, on a pro forma basis. Hence, it seems that the private market value for Sprouts as a whole has a very credible benchmark in the values derived from its own transaction acquiring Sunflower last year. If we take those multiples and apply them to the current combined entity, we get an implied valuation less than one quarter the company’s current enterprise value. I think Apollo will gladly take that kind of markup and run!

Since the grocery business doesn’t have enormously high barriers to entry, it seems fair to consider the vast disparity between the market valuation, and the replacement cost of the company, as measured by gross investment (pp&e + a/r + inv - a/p), in comparison with Sprouts’ peers. Surely, if they’re doing something right, the others can invest similarly and target similar results. Yet what we find is that SFM is only remarkable in that their gross investment per square foot is well below their peers, and their market valuation/gross investment is far in excess of their peers.

We can also look at how the company has valued itself with respect to management incentives. Only 5 months ago, Sprouts awarded options to employees which by their Black-Scholes model, resulted in a fair value per share of $9.15. Applying that to current, diluted shares outstanding implies a similar value as the Sunflower transaction—i.e. about a quarter of current enterprise value:

Is there any plausible scenario in which Sprouts is fairly valued? Not really. Even if you assume they build ALL the 1,200 stores they think the U.S. market can support, and these earn 35% cash-on-cash returns, as they say their stores generate after 3-4 years, and the cost-to-open does not change from the current reported value of $2.8 mm, and then you assume all this happens instantly so there’s no time discount, then the company trades at 8.1x ebitda—a full 2 turns higher than where a mature, no-growth supermarket tends to trade. The risks and time you have to ignore, and the growth you have to assume, in order for this valuation to be appropriate seem simply preposterous to us.

Bulls may point to their robust same store sales growth as a reason to be optimistic, but we would suggest some healthy skepticism around these numbers. With the company having done a major acquisition/merger in each of the past two years, and conversions of all of the acquired stores, most of which while kept open, we think there has been plenty of room for the company to report same store sales growth favorably. We have no evidence of accounting shenanigans here, but also don’t see reason for a lot of confidence in the numbers either.

So, if we weren’t completely sure Leon Black was serious when he said they were selling everything possible, after looking at Sprouts in particular, we’re pretty confident it won’t be the exception. We recommend selling Sprout short for all the above reasons, and in anticipation of Apollo, with 45% of the shares outstanding, being an eager and heavy seller as well, as soon as their lockup expires, or sooner if they can get a waiver.

Catalyst