Description

Summary Thesis & Recommendation. SFM is a healthy grocer trading near all-time low multiples despite a leading growth/margin profile, strong balance sheet, and a plan to profitably grow store count 10%+ annually. I believe SFM shares provide asymmetrical upside given 2x+ potential if it executes its growth plan with modest success. Investors also have a put option on SFM shares given heavy sponsor interest in grocers and SFM’s under-leverage and over-capitalization. 2021 may challenge SFM given comparable store sales (“CSS”) growth faces transitory pressure, plus a record 2020 to lap; investors may consider deploying capital into SFM slowly as new stores hit CSS in year 2, boosting CSS growth as they ramp to maturity. I recommend SFM a BUY with a near-term price target of $36/share (45% upside) reflecting modest, yet warranted premia on multiples of lower growth/margin, higher levered peers.

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(1)   Source: SFM filings. Balance sheet data is as of 7/4/21.

(2)   Includes 114.191M common shares (as of 8/3/21), 0.840M RSUs, and 0.111M options as calculated using the treasury stock method.

(3)   Includes $250M Sr. Sec. Revolver ($700M capacity) at L+125bps due 3/27/23, $10M financing leases, and $9M interest rate swaps.

(4)   Forward estimates reflect Base Case cash flow model. “Adj.” figures add back non-recurring/non-cash expenses.

Brief Description & Valuation. SFM is a fresh, natural, and organic food market founded in 2002 in Phoenix. It grew to 56 stores by 2011 when it sold to Apollo, later combining with Henry’s (43 stores) in 2011 and Sunflower Farmers Market (37) in 2012. Apollo IPO’ed SFM in July 2013 at $18, exiting fully by 2015. Today, SFM operates 363 stores in 23 southern US states. SFM is currently valued toward the bottom of its recent trading ranges, ~5-13x EV/EBITDA and ~10-30x P/E, and most peers as investors believe recent performance is unsustainable (discussed more below).

Business Model and Key Value Drivers. SFM is a differentiated grocery store concept operating between a local produce market and healthy grocers (e.g., Trader Joe’s, Whole Foods); this is highlighted by its ~60/40 mix of net sales from perishables vs. non-perishables (as compared to traditional grocers, e.g., Kroger, at ~40/60) with a focus on produce, which is internally-sourced/-warehoused/-transported, purposefully placed at the back of the store, and comprises 20%+ of SFM’s net sales. Among non-perishables, SFM focuses on healthy options that deliver higher margins over typical CPG brands. SFM has effectively brought scale to the local produce market, beating them on price and service (e.g., omnichannel via web/mobile, Instacart) while also benefiting from  the secular tailwind around healthy/fresh/organic. SFM boasts of broad customer appeal (boomers to Gen-Z’ers) and believes their stores are more complimentary to than competitive with (a) other healthy scale players such as (i) Trader Joe’s, which lags in produce and has few/no brands and (ii) Whole Foods, which has edged toward traditional 40K-SF grocer in the years since selling to Amazon; and (b) grocery delivery (e.g., Amazon Fresh, FreshDirect), which, despite much ado as the key disintermediation threat to stores, has low single-digit market share and is not a destination for perishables/produce nor discovery of healthy options. The result: SFM has performed at/toward the top of their public peers across several key metrics — 5-year CAGRs on net sales of 10%, store count of 11%, CSS of 3%, and adj. diluted EPS of 24%, plus mid-30% gross margins and ROICs of ~10-11% (similar to Kroger), nearly 15% recently, which is core to the store count growth plan now underway. This growth plan, along with CSS growth performance, which can often times prove monolithic to share price impact, will be the core value drivers for SFM, as discussed below.

Fundamental Merits and Risks

(A) CSS Growth. SFM’s recent CSS growth, including a -9.4% 1Q21 and -10.0% 2Q21 given a tough comp to CSS records set in 2020, trails peers on both 1- and 2-year bases. I believe this is ultimately transitory as it is tied to COVID-related vulnerabilities, specifically as (1) customers have consolidated shops to one trip, evidenced by similar struggles at peer Grocery Outlet, and (2) SFM has decided to reduce its promo activity to avoid “renting” customers, evidenced by SFM’s contemporaneous gross margin expansion. As such, I assume CSS growth reverts to the mean in 2022 in my base case. Further helping CSS growth prospects is the growth plan (see below) given when new stores hit CSS in year 2, they provide a significant boost to CSS growth as they ramp to maturity.

(B) The Growth Plan. Store count growth has slowed in recent years and SFM is expected to open only 20 stores in 2021 (~5% Y/Y); however, in early 2020, CEO Jack Sinclair introduced a plan to grow store count 10%+ annually (i.e., est. 38+ in 2022) and in a smaller-format: 21-25K SF vs. SFM’s current ~30K SF format. SFM will also expand its distribution center (“DC”) network to ensure all stores are within 250 miles of their DC (2 DCs at 130K SF each came online in 2021 with more to follow). Sinclair believes this strategy will drive efficiencies, allowing SFM to match the prevailing targets for current 30K-SF stores. Specifically, he expects stores to (i) mature in 4 years when it will deliver (ii) annual net sales of ~$16-18M/store, (iii) 8% EBITDA margins, and (iv) 40% cash returns on its (v) $2.7M/store outlay (guided 15-20% savings vs. $3.2M larger-format). Sinclair’s guidance implies the smaller-format store will reach annual net sales of $725+/SF at maturity vs. his <$570/SF guidance for the larger-format store. I am skeptical that such a significant increase can be achieved, as well as so many stores delivered on time. For that reason, I instead assume (i) persistent misses on guidance with store growth never reaching 8% Y/Y and (ii) prevailing blended annual revenue of $600/SF reached only after (iii) the store matures in year 5, giving caution to difficulties opening in new markets. Altogether, SFM’s unit economics, low-to-mid-teens ROIC, clean balance sheet, and low-3% cost of capital, makes conceptualizing the growth plan’s potential simple. As it relates to execution, SFM must effectively manage: (i) concentration, avoiding saturation but creating efficiencies with DCs and in marketing (see (ii)) as they seem to be doing currently in FL, for example, where they are aiming to open 10+ stores annually to be served by their new DC in Orlando; (ii) brand awareness, which SFM reports at 61% among aided subjects (vs. 80%-90% for peers), which creates an opportunity, but addressing it risks pressure on margins from both net sales, via underproductive stores, and costs, via marketing spend, to help drive what is still peer-leading net sales per SF, plus a high NPS score; and (iii) location/competition risks, as SFM must find optimal locations in attractive markets with high population (growth) and income but avoid direct competition with incumbent one-stop-shops. As for the new, small-format store, SFM plans to cut deli/prepared foods square footage, particularly back-of-house and dine-in areas. This strategy bears some risk given the items sold in this section tend to be high margin, but I anticipate SFM will be thoughtful in mitigating this risk. Also, this strategy may relieve risk of SF under-utilization given (i) there are often fewer diners than tables and (ii) COVID or other communicable disease could dissuade customers from staying or force the store to close the area.

Given the assumptions/considerations above, my base case cash flow analysis suggests SFM is worth $50+/share, or 2x+ shares today. My downside case assumes SFM opens fewer, less productive stores, among other punitive CSS and margin assumptions, and suggests SFM would experience compressed margins and cash flow, cutting shares by ~30%. I give the downside case a markedly lower probability weighting and believe SFM provides asymmetrical upside.

Other Key Considerations

·         (+) Buyback execution: SFM authorized a $300M buyback in 1Q21. At today’s share price, SFM could retire an additional 7%+ of shares, driving ‘per share’ metrics and shares alike.

·         (±) Macro/inflation effects: If Sinclair, whose last two stops were at 99 Cents Only Stores and Walmart, relies too heavily on everyday low pricing as they have recently done to weed out promo cherry pickers, he could prime SFM customers and risk testing their elasticity and SFM margins if/when SFM gets squeezed by suppliers; if successful, the opposite can be true.

·         (–) Worker availability: Given the growth plan, SFM must find low wage workers in an environment now infamous for sideline-sitters. SFM reports ~$15/hour avg. wages, but that is only an avg. and bottom-end workers may be hard to find.

·         (+) Short interest: 17% of SFM’s float is sold short; this could accelerate a move up in shares.

Financial Buyer. Sponsors have a long history with grocers given their stable cash flow characteristics. Apollo (SFM’s previous owner), Ares, Onex, Cerberus, etc. have all been active in the space, and several grocers have traded sponsor hands more than once (e.g., Supervalu, Smart & Final). A sponsor’s ability to lever SFM would be limited not by interest coverage but by the size of the equity check lenders will expect them to write. For example, given a 25% premium and 5.5x leverage, I estimate SFM would require a $1.2B equity check, much larger than recent, notable PE-grocer deals; the returns to a sponsor (or club of sponsors), however, would be substantial. Assuming my base case projections and no multiple expansion upon a 3-year exit, a sponsor could afford to pay a ~55% premium for SFM shares today and still achieve a 20% IRR. Given SFM’s growth plan, signs of weakness and/or a share decline could draw the attention of PE funds with industry knowledge and several levers to pull, such as paring down growth to harvest cash or deploying the distressed retail playbook: lever and buy cheap, close underperforming stores, drive efficiencies, and re-trade once the decline has ebbed or inflected.

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Catalyst

• CSS Growth reversion to the mean;
• Executing the Growth Plan with modest success;
• Buyback execution; and
• Short squeeze.