Description

Phoenix, Arizona-based Sprouts Farmers Market, Inc. (NYSE: SFM) operates a chain of grocery stores. The Company focuses on organic and natural foods, and its value proposition surrounds underpricing the competition on produce. It does not carry any large consumer packaged food brands in the stores.  Essentially, Sprouts is a healthy food store for people who are looking for high quality organic produce at a lesser price. Sales have compounded at a 12.4% rate over the past five years, and comparable sales have increased at a 3.1% CAGR over the past five years.  Produce soaks up 23% of sales, while fresh products are 60% (including produce), and natural and organic products are 90%+ of sales.

There are several attributes that make Sprouts a compelling investment:

• The organic food market represents ~$120 billion of the $800+ billion U.S. grocery industry, and it is growing at a 6-8% pace (Source: Euromonitor).

• Sprouts has plenty of room for expansion in the United States; the store count is only 361 (out of an estimated potential 1,200 units), and it has not yet expanded into the northern part of the United States. It is opening about 30 net new stores per year, which should provide a meaningful growth tailwind for years to come.

• Produce deflation in recent years, driven by the Amazon acquisition of Whole Foods and general produce inflation at the farm level, has squeezed same-store sales and margins. When produce deflation at the farm level eases, Sprouts (and other grocers) should benefit.

• Sprouts has an opportunity to expand its high-margin private label business. Only 14% of sales is

• private label, and that metric should head towards 20% over time, which should be a margin tailwind. Private label products have been growing at ~25% at Sprouts.

• ROICs are mid-teens and appear poised to remain that way, so the Company should continue to aggressively open new stores and gain additional economies of scale.

• The balance sheet is reasonably capitalized with net debt/EBITDA of 0.3x in a defensive industry.

• Valuation is attractive.

The Company

Sprouts opened its first grocery store in Chandler, AZ in 2002. In 2011, Apollo Management acquired a majority share of the fast-growing Sprouts grocery chain. Apollo then combined Sprouts’ 56 stores with regional grocer Henry’s (43 stores) to create a single unified chain under the Sprouts name. The new Sprouts then acquired Sunflower Farmers Market in 2012, which added 37 stores which were converted to Sprouts stores. Currently, the Sprouts brand is the Company’s only banner.

Sprouts had its initial public offering on July 31, 2013. It priced the offering at $18, and shares closed that day at $40. Apollo owned 45% of Sprouts following the offering, and Apollo exited its Sprouts investment through multiple secondary offerings in 2013, 2014, and 2015.

Sprouts has created a specialty food retail experience at accessible prices. It strikes a balance between a conventional grocer and a natural specialty grocer. While most of the organic food competition fights to work through price perception issues (“Whole Paycheck”), Sprouts flips the script on price; it differentiates itself through its large and competitively priced produce offering. In other parts of the store, it offers natural, better-for-you products and does not stock items from large consumer packaged goods companies, which are typically lower margin.  Sprouts attracts customers from a wide range of income levels by offering competitive prices and consistently offering sales and promotions. It also carries over 500 bulk items (~10% of sales) and has a wide assortment of vitamin and beauty products (13% of sales), which is unique among food retailers other than Whole Foods.

A layout of a typical store is unique, as most grocers strategically place produce at the front of the store. Sprouts puts the produce at the back of the store (or sometimes in the middle of the store) in order to force customers to walk through the entire store to get to the most important section to its customers – produce.

Sprouts believes that its produce prices are 20-25% below conventional grocers. In turn, it generates about 2-3x the amount of sales from produce as compared to conventional grocers, despite the lower selling price. Sprouts self-distributes produce, given its strategic importance. By controlling the entire distribution process from the farm to its shelves, Sprouts can ensure a high level of quality and freshness – and a competitive price.  Non-perishable items (primarily dry grocery and frozen goods) are priced in line with competitors; KeHE Distributors accounts for 40% of total purchases, and United Natural  Foods accounts for 3% of total purchases.  Because of its value pricing strategy, Sprouts attracts customers who span a wide range of income demographics. The Company estimates that, in some markets, its customers are in the 30th to 90th percentile of income ranges. It gets the majority of its shoppers from conventional grocers. Based on an internal study, Sprouts found that ~60% of its consumers shopped at a conventional grocer before switching to Sprouts.

Stores (30K square feet) are much smaller than the typical Whole Foods or conventional grocers (50-100K square feet). Stores need to be located within 10 minutes from a population of 100,000 or more, and they need at least 140 parking spots. Its small box format means that time-starved shoppers do not have to spend an inordinate amount of time walking its aisles. When combining this convenience with its traffic-driving, low-priced produce, it is easier to generate frequent repeat trips by the consumer. Since fresh produce does not last as long as other items, it is harder for shoppers to stock up on perishables for long periods of time. This phenomenon leads to more frequent trips, even if they are smaller in scale. Sprouts plans on opening ~30 stores per year in 2021 and beyond. Stores are located in a variety of mid-sized and larger shopping centers, lifestyle centers, and, in certain cases, independent single-unit, stand-alone developments. Each store is staffed with 80 – 100 associates, none of which are represented by collective bargaining agreements.

Sprouts’ stores are located almost exclusively in the southern part of the United States. The Company plans on continuing its expansion into new markets. When Sprouts enters new markets, it needs 5-10 stores before it achieves sufficient brand recognition and stores become more productive. It also takes 4-5 years for a store to reach maturity. It has an efficient new store development plan that usually generates a 30-45% pretax cash-on-cash returns by the third or fourth year of operation. With the inclusion of tax payments in years three and four, the cash-on-cash after-tax return is about 30%. It spends about $3.1 million to open a new store, consisting of a $2.6 million buildout and $0.5 million in working capital and opening expenses. New stores generate sales between $12-$14 million during the first year but reach $14-18 million by the third or fourth year. Gross margins increase over time as customers who discover Sprouts migrate from the produce section to other, higher margin departments over time.

Historically, one of Sprouts’ key differentiating points has been its ability to price produce at levels that are 20-25% below conventional grocers. Its decentralized buying structure has served as an advantage here, as local buyers have given Sprouts the ability to establish relationships with local growers and capitalize on buying opportunities from gluts of inventory. That said, there is risk that it could be increasingly challenging to source enough low-cost produce to support its pricing strategy without sacrificing too much margin. The Company needs to build more distribution centers to support stores, and it clearly should be building new stores more densely (which is management’s intention) to benefit from scale in distribution and marketing.

In Q3 2020, a combination of COVID-19 related demand and strong new store productivity drove Sprouts’ revenue growth.  eCommerce sales grew by 337% to 11% of overall sales.  Sprouts posted sales growth of 9.5% to $1.6 billion, but its 4.2% comp growth was considerably lower than the grocery channel’s ~7.5% growth during the same period.  Sprouts clearly lost some share in the quarter, particularly so in August and September which implied monthly comps of 2%.  It appears that the larger grocers are benefiting from shopping trip consolidation, as they overindex in categories like cleaning supplies.  Furthermore, the Company is experiencing some choppiness as it narrows its focus to its key target demographics.  As a result of the weak comp number, Sprouts’ stock price declined materially on the day of the earnings release.

Gross margin improved by 400 bps to 37.1%, caused by less promotional activity, lower shrink, and inflationary grocery prices.  Once COVID-19 abates, I would imagine that gross margins reverse themselves somewhat.  With increased eCommerce costs associated with their margin-dilutive Instacart partnership and increased COVID-19 expenses, EBIT margin improved by only 220 bps to 5.0%.  Earnings more than doubled to $0.51.

During the quarter, Sprouts paid down $176 million in debt and ended the quarter with a 0.3x net debt/EBITDA ratio.  It now has $140 million in cash on the balance sheet.  While there was a fair amount of insider selling in the mid-$20s earlier this year, several board directors have been buying Sprouts shares at open market prices recently.

Sprouts is undergoing a major strategic shift towards 1) smaller stores, 2) less amenities, 3) less promotional activity, and 4) a narrower geographic focus.  This transition undoubtedly will cause some volatility, but it allows Sprouts to focus on what it is best at.  The brand resonates well with customers, which is a contradiction to high levels of promotional activity.  Increased simplicity should be a margin benefit without meaningful topline sacrifice.  As it makes this transition, Sprouts continues to benefit from 1) increased population growth, 2) net competitor closures, and 3) elevated spending relative to market saturation.

The short interest on the stock has increased of late.  I found one short analysis that highlighted that Sprouts’ comps are underperforming the broader grocery market, as pandemic-driven demand revenue tailwinds reverse themselves in 2021.  Moreover, higher wages, sanitation, and online fulfillment operating costs may remain elevated for the near term and may pressure peak EBIT margins.  In addition, trip consolidation seems to be a new norm during the pandemic.  Even CFO Paulonis does not believe that Sprouts benefits from this trend, as the Company only carries a limited assortment of traditional CPG products, like paper goods and cleaning supplies.   

The analysis also believes that the strategic shift towards everyday low pricing will alienate core customers who supplement food purchases with Sprouts’ discounted produce and healthy foods.  The negative impact of EDLP is predicted to emerge once the COVID-19 tailwinds abate, causing a significant EBIT miss with weakening comps and higher costs. 

Beyond these issues, Sprouts competes against huge companies with far bigger balance sheets and ability to squeeze Sprouts on costs.  Traditional grocery retail is an intensely competitive business, and Sprouts is a tiny player with minimal market share.  Amazon, Costco, Wal-Mart, Albertson’s, Aldi, and Kroger can squeeze Sprouts like an organic grape if they so desired.

Balance Sheet & Cash Flows 

Debt levels are minimal at 0.3x net debt/EBITDA (excluding leases) and interest coverage of 34x.  Total liquidity is $530 million.  All of the debt is in the form of a revolving credit facility with $309 million drawn (out of $700 million total) and a maturity of 2023.  The cost of debt is LIBOR + 1.5% or prime + 0.5%.  The covenants on this debt stipulate that net leverage cannot exceed 3.20 to 1.00, and the minimum interest coverage ratio cannot be less than 1.75 to 1.00.  Sprouts has been paying down its debt with the excess cash flow generated as a result of COVID-19.

Sprouts plans on continuing to grow stores at a double-digit pace for the intermediate period ahead, although current store growth in 2020 was only 6.1%.  Beyond growing its core business, I see Sprouts continuing to buy back shares while the stock is cheap.  Interestingly enough, Sprouts has the least levered balance sheet of its peer group.  I read multiple sell-side reports that referenced Sprouts as a potential take-out candidate, given its consistent cash flows, solid balance sheet, and reasonable valuation.

Risks

• Competition.

• Execution.

• Regulatory.

• Amazon/Whole Foods.

• Weather.

Valuation

I used a 6.8% EBITDA margin on consensus 2021 sales of $6.6 billion.  This compares favorably to Whole Food’s EBITDA margin of 8.3% at acquisition and Sprouts’ 5-Year average of 7.8%.  After applying a 9.0x EBITDA multiple (Whole Foods, Wild Oats, and Fresh Market were taken out at 11.1x, 13.0x, and 7.0x respectively.  Sprouts’ 5-Year average multiple is 9.6x), I reach a valuation of $29. 

Natural and organic foods are likely to continue to take share from traditional grocery over time.  Sprouts is well positioned as a lower-cost provider and niche retailer of natural and organic foods, and it should participate in grabbing share over time.  Valuation is attractive, returns on capital are high, and economic sensitivity is reasonably low.  

Catalyst

- Buyout

- Improved earnings

- Value will out