Value Investors Club / Sprouts (SFM)

Description

Business Description

Sprouts Farmers Market operates 278 grocery stores under the Sprouts, Henry’s and Sunflower banners

in 15 states across Southern United States with 38% of stores in CA and another 41% of stores in TX, AZ

and CO. Sprouts is focused on the affordable fresh/natural/organic segment for the suburban middle

income demographic. The average basket price is $29.

Sprouts historically has attempted to differentiate itself from its competition, specifically premium

“supernatural” chains like Whole Foods, by dedicating 15% of its selling square footage to produce and

pricing at a 30% discount (although the conventional grocers have been able to eliminate this pricing

gap over time). The rest of the store is also priced at a 20-30% discount to Whole Foods. Given the

extraordinary Sprouts/Whole Foods store overlap (~80% of Sprouts stores are within 10 miles of a

Whole Foods), this strategy has been a perfect foil to Whole Foods, driving traffic to Sprouts while

Whole Foods has gone through its well-known pricing and profit troubles providing fundamental

tailwinds for Sprouts. As a result of the first half fundamentals, Whole Foods previous public statements

that it wouldn’t sell itself and press reports suggesting other grocers such as Albertsons or Amazon may

look to acquire Sprouts instead, Sprouts stock had appreciated from ~$19 to ~$25 this year. This >30%

appreciation came from not only higher earnings estimates, but also from a significant expansion in its

multiple due to takeout speculation, resulting in Sprouts trading at the highest multiple in the industry.

We believe Amazon’s acquisition of Whole Foods has severely changed the competitive landscape for

grocers in general, but Sprouts in particular, as everything described above that originally was an

advantage for Sprouts has become a severe headwind to the business. Remarkably, despite Amazon’s

acquisition of Whole Foods and these disadvantages, Sprouts’ still trades at a higher price than when the

year started.

Thesis

“Amazon closed its Whole Foods Market acquisition, and announced that the two companies will

together pursue the vision of making Whole Foods Market’s high-quality, natural and organic food

affordable for everyone.” – Amazon’s August 24th press release announcing the close of the Whole

Foods acquisition.

While Sprouts has traded down 17% since the press release, we believe that this is simply takeout

premium flowing out of the name and that there is still substantial downside to shares. Stepping back

for a moment from the last week of trading and looking forward, the stock continues to trade at a higher

price than where it was just six months ago, before Amazon’s entry into the grocery space, which

negatively affects the industry on the whole, but is particularly devastating to Sprouts’ business given

both their store footprint overlap with Whole Foods and their strategy that had been specifically

targeted in response to a now outdated Whole Foods pricing model that no longer applies. The result of

Amazon’s purchase of Whole Foods and subsequent strategy change will drive a decline in traffic, sales

and multiple of Sprouts, which should revert to the industry average multiple of ~6x EBITDA from its

industry leading 9x forward EBITDA.

For years, Whole Foods shares had languished in the public markets as a result of its overpriced

merchandise and inability to generate positive same store sales traffic. Despite the need to give on

pricing to remain competitive and grow same store sales, management was handcuffed by the public

market’s focus on margins. This dynamic changed when Amazon agreed to take Whole Foods private

on June 16.

Amazon’s tactics when entering a new market is well documented: they slowly kill the incumbents on

price while driving customer loyalty to eventually gain leverage over its suppliers. When Amazon first

launched the Kindle e-reader, it priced bestsellers below what it paid to the publishers with the

intention to renegotiate price lower later on as it gained market share. To the surprise of skeptics,

Amazon has not only been able to maintain, but further reduce pricing on these books beyond what the

publishers thought were already unsustainably low prices at launch.

Based on our recent store checks, Whole Foods cut prices on its highest volume fresh produce goods by

an average of ~25%. Typical loss leaders like milk and eggs were reduced by 13% to 14% while organic

bananas were cut by 38%. Amazon will eventually extend this “everyday low price” strategy to the rest

of the store as local store managers become accustomed to the higher traffic volume. Note: as you

diligence you may see sell side notes saying that the average basket at Whole Foods still remains at a

20%+ premium to SFM. However, this is misleading and not nuanced (and one of the reasons Sprouts

stock remains inflated). Amazon began by targeting high velocity SKUs like eggs and milk first to price

down while leaving the rest of the basket approximately the same, making the average of the basket

appear higher than what the high velocity traffic drivers in produce really are priced at. Further, it’s a bit

of a moot point - the rest of the basket will follow suit in pricing down in phases as stores prepare for

higher traffic.

As a result, through one fell swoop, Amazon has basically eliminated all of the price gap between itself

and its peers, including Sprouts (AMZN shares have been flat since the announcement, which shows

their shareholders’ indifference to grocery margins and thus the support for Amazon’s aggressive pricing

strategy). According to Morgan Stanley, 70% of shoppers who previously did not frequent Whole Foods

listed price as their primary reason; a reason that no longer exists, driving volume away from Sprouts

and towards Whole Foods.

Sprouts Is Most Exposed

Without any sustainable competitive advantage in sourcing, technology or operational knowhow against

Amazon, coupled against a strategy against legacy Whole Foods that no longer applies, Sprouts will

inevitably be forced to give up both margin and traffic, forcing a downward death spiral of both earnings

estimates and its multiple cutting Sprouts stock price drastically.

1. According to Goldman Sachs, Sprouts has by far the most exposure to Whole Foods with 53% of

Sprouts stores within 5 miles of a Whole Foods and 78% of stores within 10 miles. Sprouts stores are

largely located in suburban areas, where car ownership is common. We believe that customers, especially the cost-sensitive health-conscious types that formerly frequented Sprouts, will switch to

higher quality organic food at Whole Foods at more favorable prices. Note that Amazon has also

provided more favorable pricing for its Prime customers, a core demographic.

2. Exacerbating the issue for Sprouts; unlike Kroger/Walmart/Costco, Sprouts does not have gas

stations to drive traffic to its stores, so there is no offset to the exodus away from Sprouts to Whole

Foods.

3. Sprouts is already stuck in the middle innings of deploying prepared foods and private label goods

where it hoped to eventually have higher margins, but where it currently still far lags competitors and

leaves Sprouts even less differentiated and more vulnerable vs. Whole Foods.

4. Despite the recent price drop which makes it appear at first glance that negative Amazon news has

been priced in, Sprouts still trades at an unbelievable 52% premium on 2018E EBITDA and 65% premium

on 2018E earnings vs. Kroger and Target, despite each of those companies also selling off materially in

wake of the Whole Foods merger.

Further, there are a number of other ways for Amazon to win share or reduce prices with its existing

technology, such as its implementation of Prime-only sales (Prime shoppers spend 4.6x more on Amazon

than non-prime members and 60% of WFM shoppers are not part of Prime), cashier-less Amazon Go

checkout, 1 to 2 hour delivery, and cross-selling of strategic goods such as the Echo in store. None of the

above analysis have taken this into account, which all only serve to exacerbate the competitive

advantage Whole Foods has with a handcuffed Sprouts. Finally, although Sprouts has exposure in Texas

which was effected by the recent hurricane, we have also not included that here.

Valuation

Sprouts traded to 8x forward EBITDA on temporary deflationary headwinds in 2016, so we expect that at

the very least it will trade a turn below to 7x (or lower) as margins and traffic are permanently impaired

by the Whole Foods merger (note that even 7x is higher than the industry average multiple as we

attempt to be conservative). Even if we were to take the most optimistic case, i.e. that in the absence of

the Amazon-Whole Foods merger, Sprouts would otherwise be able to comp in the mid-single digits

range again as Sprout bulls predicted earlier in the year, it would only take a 5% reduction in traffic or

similar amount in pricing to turn same stores from positive to negative again which compounds in both

earnings and multiple. In discussing this predicament with Sprouts management, we believe Sprouts has

resigned itself to the fact that they will be forced to react with pricing/margin first as it is typically more

difficult to win back customers than raise prices which will lead to a significant downward reduction in

guidance.

Assuming that 50% of Sprouts stores (those with at least one Whole Foods store in a 5 mile radius) are

affected and that those stores experience a 5% traffic headwind with a resulting 1% margin

compression, pro forma 2018 EBITDA falls to $317mm. Applying 7x to PF 2018E EBITDA of $317mm,

results in a value of $13.15/share or 33% downside to today’s closing price of $19.70. Note the results

could be worse than this, as there is 80% store overlap if we extend the radius to 10 miles.

Risks

Sprouts shares had recovered to $25/share following an initial selloff on the announcement of the

Amazon-Whole Foods merger and prior to Thursday’s press release on rumors and wishful optimism

that a larger conventional grocer would pay to enter the natural/organic space in a meaningful way with

Sprouts. Previously, Sprouts investors hoped that potential bidders for Sprouts included Apollo (because

they previously owned Sprouts and recently purchased TFM), Amazon (because they had a 10 store

partnership with Sprouts and Amazon’s first choice of Whole Foods had previously indicated they

weren’t for sale) and Albertsons. Amazon is no longer a potential acquirer, and it’s unlikely any other

operator would wish to pay a premium in order to increase its exposure to Amazon-led Whole Foods

stores.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Downard revisions in earnings estimates, traffic and pricing data

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			2017	2018
Price:	19.85	EPS	0	0
Shares Out. (in M):	136	P/E	0	0
Market Cap (in $M):	2,700	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0	0
Borrow Cost:	General Collateral