Description

We believe natural and organic foods will continue to take share from traditional grocery over time. Sprouts is well positioned as a lower-cost provider and niche retailer of these types of foods. We think they can take market share for a long time and the valuation is reasonable.

Business Description:  Sprouts Farmers Market Inc. operates a chain of natural and organic retail grocery stores. It was founded in Phoenix, Arizona in 2002 and has grown to 320 stores today.  It went public in 2013 at $18 per share and despite growing sales and earnings significantly since then ($2.4 billion/$0.46 EPS to $5.4 billion/$1.29 EPS) trades just a couple dollars higher than that today.  The company focuses on organic and natural foods and generally has tried to underprice Whole Foods. Basically, this is a healthy food store for people who can’t afford to spend their money at “Whole Paycheck.”

The market:

The natural/organic food market represents ~$120 billion of the $800+ billion U.S. grocery industry and grows mid-single digits according to Euromonitor. This seems poised to continue.

Sprouts growth potential:

We view two primary sources of growth for Sprouts.  1) Store footprint growth and 2) Mix shift to higher margin private label and prepared foods.

1)   Footprint Growth

Sprouts is particularly well positioned because it has plenty of room for expansion.  Its store count is currently 321 and it has not even expanded into the northern part of the country yet (e.g. Illinois, New England, etc.).  It is opening about 30 new stores a year which should provide a meaningful growth tailwind for years to come.

2)   Private Label/Prepared Food Growth         

Additionally, Sprouts has an opportunity to expand their high-margin private label business.  It is only 14% private label and that should head towards 20%+ over time.  This should provide some margin tailwind. The industry-wide private label average is about 18%.  Likewise the company has put a lot of money into improving their deli/prepared foods which are also higher margin, so I would expect that portion of the mix to grow over time.

Sprouts Solid Financials:

Sprouts has reasonably high margins for a grocery store (4.0% EBIT margins).  Whole Foods had similar margins and Kroger operates on much lower margins (2.3% EBIT margins).  ROIC is around about 14%, so the company appears smart to continue growing. Same store sales are mid to low single digit positive and seem poised to remain that way.  The balance sheet is not stretched with less than 1.5x net debt to EBITDA. Sprouts has been reinvesting its excess cash flow into share repurchase and the share count has fallen by 20% in the last 4 years.

Anecdotal store visits:

This one is anecdotal, but I encourage you to go visit the stores.  They are well laid out and easy to navigate. It is definitely a more efficient shopping experience than Whole Foods in my opinion. It blows traditional grocery out of the water. Compare for yourself.

So why has the stock been a dog?

            The stock sold off recently on a number of worries around a change in management (the CEO left at the end of last year), sluggish produce inflation, margin pressure due to store/IT investment, and fears over Amazon’s acquisition of Whole Foods.

Let’s address these issues in turn:

1.    Management change

The former CEO, Amin Maredia, resigned from Sprouts at the end of last year (somewhat abruptly).  The COO Jim Nielsen and CFO Brad Lukow took over as interim co-CEOs while the board conducts a search.  Then in May during the Q1 call the company announced that Nielsen is on a medical leave of absence. So there is clearly some disarray at the top.

However, when I look at the board of directors, it is entirely independent and includes the founder of the company Shon Boney and many people with industry experience: Joe Fortunate – former GNC CEO; Kristin Blum former CIO Latin America at Pepsico; Chip Malloy former CFO of Petsmart; Joe O’Leary who served in a bunch of operational roles at Petsmart as well; Steve Townsend who was CEO of United Natural Foods.   This is a group of people who knows how to run businesses- we think they will get the leadership right.

2.    Produce Inflation

Produce inflation is hard to predict, but with recent bad weather for farmers and potential tariffs on Mexican goods, we wouldn’t be surprised to see it pick up.  A big worry for the company had been produce deflation and its potential to drag down comps since produce is about 23% of revenue.

3.    Margin Pressure

Gross margins have been fairly stable (~33% last three years), but operating margins have been under pressure due to investments the company is making in implementing Workday and also some fresh item management tools.  Coupled with a wage increase last year it has driven 20 to 25 basis points of deleverage this year. Most of this (aside from wages) seems one time in nature though, so we would expect margins to flatten out and potentially show increased leverage as the company finishes these projects and grows off of this base.

4.    Amazon Whole Foods Acquisition

Finally, Amazon has not really made an impact on the market with their Whole Foods purchase (which was basically the entire short thesis posted by VIC_member2015). Anecdotally, we have heard that the change in management style has hurt some of the culture that made Whole Foods unique.

https://www.bloomberg.com/news/articles/2018-12-20/amazon-s-grocery-push-keeps-stumbling-after-whole-foods-purchase

https://www.wsj.com/articles/whole-foods-is-losing-executives-under-new-owner-amazon-1521711002

https://randocity.com/2018/09/20/whole-foods-everything-wrong-with-amazon-in-a-store/

There are also lots of gripes from Whole Foods employees on Glassdoor about how they have ruined the culture as well (take those with a grain of salt though- all retailers face lots of gripes).    

Being in the natural and organic foods business is a tough thing.  It requires a certain aura of authenticity. The Amazon purchase of Whole Foods seems to have hindered their authenticity.

A word about online…

One thing that gets a lot of airplay with the sell side and media is online grocery shopping.  The truth is this market is years behind other retail markets in terms of adoption. Online grocery is less than 3% penetrated.  SFM has (wisely in my opinion) partnered with Instacart to offer online orders and their penetration is about inline with the industry numbers for now.  I question whether people will trust buying produce online. It seems to me that you would only need to get burned a few times with produce you wouldn’t have chosen yourself and then you would be done with it.  But I guess you have to be careful not to underestimate people’s laziness. Basically, this area gets a lot of play on earnings call, but it doesn’t move the needle and probably won’t for quite a while. Sprouts seems well positioned to respond to rising online share over time with their Instacart partnership.

What could Sprouts be worth?

Let’s assume that Sprouts continues to open 30 stores per year for the next 5 years.  That should get them to 470 stores or about $7.6 billion in revenue. Throw on top of that about 2% comp growth per year.  Then you are around $8.4 billion. Assume that margins remain about where they are and the company continues with share repurchase so share count drops another 15%.    Basically you should be looking at something like $2.40 in EPS. With a long term potential store count of 900-1,200 stores I don’t think the multiple will compress much.  Maybe to 15x. So that’s a $36 stock. Discount back at 10% and you get to fair value of $22.35 today. That is basically what you are buying- a good business at a slightly better than fair price that can compound your money at 10%+.  

If the company accelerates its store rollout or gets better traction on the margins than expected (both of which seem possible) you will obviously get a better return.

Risks:

o   New management changes the strategy which appears to be working fine.

o   Tariffs drive a too big increase in pricing and it impacts traffic as a result.

o   The company has to execute on the expansion opportunity.

o   This is a retail business, so if the economy goes into recession, sales may suffer, but hopefully less than a more discretionary category.

Catalyst

• New CEO gets put in place addressing management worries

• Margin pressure abates as tech investment slows in 2020

• Continued store expansion

• Potential take out by private equity or other strategic – this is a rare natural and organic retail chain with scale, most of the others have been consolidated or acquired already.