SFM - Sprouts Farmers Market Surges On Strong Earnings And Expansion Plans

Summary

• Sprouts Farmers Market, Inc. delivered outstanding Q4 and FY2022 results and provided solid guidance, showing that the company is back in growth mode.
• Sprouts has been buying back shares in a very significant way while opening new stores, both of which should help increase earnings per share going forward.
• Shares are trading with a relatively modest forward p/e ratio of ~14x and below our estimated fair value.

Sprouts Farmers Market, Inc. (SFM) delivered another strong quarter , and shares reacted in a positive way by surging ~12%. This was the result of an earnings beat and strong guidance, including a good number of store openings being planned for this year. While the SFM share price jump might seem excessive, we believe that even at the now higher share price Sprouts Farmers Market remains slightly undervalued.

Sprouts has made a lot of progress improving its profitability, with gross profit margins improving ~300 bps since 2019. Earnings have been growing at a double-digit CAGR, and the Sprouts brand has reached ~$1 billion in annual sales. The company has also seen its e-commerce sales grow quickly, and a partnership with DoorDash, Inc. (DASH) is proving successful. Not everything is good news: Sprouts Farmers Market, Inc. did share during its earnings call that it is seeing some trading down by consumers.

Comparable store sales growth was very healthy in Q4 at 2.9%, which helped push total sales growth to ~6%. During 2022, Sprouts opened 16 new stores and closed 4, ending the year with 386 stores across 23 U.S. states. Importantly, Sprouts Farmers Market has more than 80 approved stores on its pipeline, which puts the company on track to reach its 10% unit growth starting in 2024. Just in 2023, the company is planning to open at least 30 new stores, close 11 stores, a net increase of ~19 stores for a ~5% increase to its store base.

Sprouts has been working very hard optimizing its store layout, and has decreased the average size of its new stores. The diagram below shows a sample layout of its new smaller format stores, and the image below shows how its store count is distributed by states. As can be seen, most of the stores are located in California, Texas, Arizona, and Florida, which means Sprouts Farmers Market has a lot of potential growth left before it reaches saturation.

Q4 and FY 2022 Results

In Q4, total sales were $1.6 billion, up ~6% from the same period in the previous year. Comparable store sales growth was 2.9%, and gross margin was 36.3%, an increase of roughly 60 bps y/y. Net income was $45 million and diluted earnings per share were $0.42.

For FY2022 total sales increased 5% to $6.4 billion, with comparable store sales growth of 2.2% and annual gross margin of 36.7%, up 45 bps y/y. Net income was $261 million and diluted earnings per share were $2.39, an increase of 14% compared to the previous year.

Share Buybacks

One thing we particularly like about Sprouts Farmers Market is that it is a share repurchase-friendly company, with a target to reduce shares outstanding around 4% to 6% per year. As can be seen in the graph below, the company has done an outstanding job reducing its share count over the past decade. It took a pause during the worse of the Covid crisis, but has since restarted buying back shares.

Just in Q4, Sprouts repurchased ~1.5 million shares. During the whole of 2022, it repurchased ~6.9 million shares for ~$200 million, or approximately ~$29 per share. This reduced its share count by ~6% compared to the previous year, and Sprouts still has $412 million remaining under its current share repurchase authorization.

Balance Sheet

Sprouts ended the year with $293 million in cash and cash equivalents and $250 million outstanding on its $700 million revolver. Cash flow generation for the year was very strong, with the company delivering $371 million in operating cash flow while only spending $112 million in capital expenditures. This helped the company pay for the significant share repurchases during the year.

As can be seen below, the balance sheet remains in great shape, with cash and equivalents increasing y/y, while long-term debt remained roughly at the same level, and below the cash and equivalents total.

Guidance

Sprouts' plan for 2023 is to open at least 30 new stores while closing 11 stores, which should help the company deliver total sales growth of 4% to 6%. It expects its comparable sales growth to be in the low single digits and gross margins to be flat to slightly up. Adjusted earnings before interest and taxes are expected to be between $355 million and $370 million, and adjusted earnings per share to be between $2.41 and $2.53. For Q1 2023 the company expects comparable sales growth in the range of 1.5% to 2.5%, and adjusted earnings per share between $0.83 and $0.87.

Valuation

Based on the mid-point of guidance, SFM shares are trading with a forward p/e ratio of ~14x. For a company that just delivered 14% y/y EPS growth for the year, this appears very reasonable. While the forward p/e multiple is not very high, it is actually above that of some of its competitors, such as The Kroger Co. ( KR ), Albertsons Companies, Inc. ( ACI ), and Koninklijke Ahold Delhaize N.V. ( ADRNY ).

While Sprouts does not pay a dividend, its net common payout yield is very high due to the significant share repurchases. One way investors can think about it is as if the company had a nice dividend yield, but that they are enrolled in a dividend reinvestment program. In any case, the share repurchases should help with EPS growth.

Based on our estimates for Sprouts Farmers Market, Inc.'s future earnings, we calculate a net present value for its future earnings stream of ~$37 per share. With SFM shares currently trading around $34, this leads us to believe that they are undervalued by ~10%.

Risks

Sprouts Farmers Market, Inc. competes in a very tough industry against big corporations including Walmart ( WMT ) and Whole Foods Market ( AMZN ). There is a significant risk that these bigger competitors could start a price war to take market share from Sprouts and other smaller rivals.

During the Q&A session of the Q4 earnings call , an analyst made a comment saying he had seen some press saying that one of its largest natural organic competitors has been getting more aggressive on pricing. We believe he was probably talking about Whole Foods Market, but in any case the company responded that so far they are not seeing much irrationality in pricing. This is what CEO Jack Sinclair responded:

Well, we haven't seen too much irrationality, in terms of what's happening in our space. We're very confident that we've got a strategy that we can follow and we're sticking to our guns on our strategy. I haven't seen a lot of volatility in pricing on outside in our direct space in the natural and organic space. We obviously watch that pretty closely. We're very sensitive to our produce pricing and with that particular competitor that you're outlining; we're in a very good shape with regard to produce pricing. Overall, that's something that we would pay a lot of attention to, but we haven't seen anything that causes us too much to worry about right at the moment.

It is also worth noting that Sprouts Farmers Market, Inc. has a relatively high short interest, which means some investors probably believe the company is either overvalued or that its fundamentals are going to deteriorate.

Conclusion

Sprouts Farmers Market, Inc. delivered outstanding Q4 and FY2022 results which show the company is back in growth mode. We continue to like the company, and find its valuation to be very reasonable, even if it is slightly higher than that of some of its competitors. It is also worth adding that Sprouts Farmers Market, Inc. is considered one of the most sustainable corporations in the world, according to Corporate Knights. The company has been buying back shares aggressively, and they are currently trading ~10% below our estimated fair value. After reviewing the most recent results, we are maintaining our "Buy" rating on Sprouts Farmers Market, Inc.

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