2023-08-16 09:17:42 ET
Summary
- The new store format which now represents less than 10% of total stores could reduce costs per store and increase ROIC.
- Sprouts Farmers Market has some negative aspects, like low skin in the game from management and operating in a competitive industry.
- Sprouts Farmers Market is reducing its outstanding shares at a fast pace and increasing margins could expand valuation multiples.
I have been following Sprouts Farmers Market ( SFM ) for a few years now since I believe it is in my circle of competence and got some knowledge of supplying supermarkets with olives and olive oil while working as CFO.
Even though I don't consider SFM an outstanding business and have some negative aspects, I like the recent developments and believe it could provide investors with good returns over a long time at the current valuation.
I don't consider it an outstanding business because I'd like to see more skin in the game from management and their compensation structure is not fully aligned with investors' interests. They are in a really competitive industry with low pricing power, and sensible to economic cycles (especially in the organic food sector), so I can't consider it a defensive business from an earnings perspective and their profits could be damaged in both inflationary and deflationary environments.
Even with these negative aspects which I believe are priced in SFM's stock valuation, the company is taking positive actions to improve its ROIC and margins, while allocating its free cash flow to share buybacks.
If the company is able to meet management's expectations for the upcoming years and increase its store count by 10% annually, reduce its operating cost with the new store format, and keep reducing outstanding shares, I expect the company to grow its EPS by mid-double digits, with the possible added upside of a multiple expansion.
Company background
Sprouts Farmer Market is a natural and organic food retailer that brings lifestyle-friendly ingredients such as organic, plant-based, and gluten-free in its 391 stores and online sales. It was founded in 2002 in Arizona, in 2011 and 2012 it acquired 43 Henry's Farmers and 38 Sunflower Farmer Market stores and it currently operates in 23 states.
Their business is focused on differentiation, and they don't try to compete with conventional groceries, instead, they appeal to a market segment that looks for more quality and healthy products.
The heart of their stores is fresh produce (20% of the store's selling square footage) which is surrounded by specialty grocery offerings.
The company leases all its stores for a 10 to 15-year period with three or four renewal options of 5 years each and supplies them from its seven distribution centers, with two located in California, and one located in each Arizona, Colorado, Florida, Georgia, and Texas. Most of their stores are located in California (34.5%), Texas (12.5%), Arizona (12.2%), and Colorado (8.1%).
Their average store is 28,000 square foot (which is smaller than many of their peers' average) and is designed to maximize personal connections to generate engagement with its customers, increasing visits and purchases over time. Their stores usually employ between 75 and 100 full and part-time staff.
They have recently redesigned its store format and reduced its size to 21,000 to 25,000 square foot, which reduces building costs, non-selling space, occupancy, and operating costs. This new prototype only accounts for 6.9% of its stores ( 14 openings in 2023, 9 in 2022, and 4 in 2021).
The new store format requires a $3.2 million investment on average, including CapEx, inventory, and pre-opening expenses, and is expected to generate $16-$18 million annually in sales by year 4. The cost is significantly lower than the $4 million required for its previous format for bigger stores (32,000 square foot).
Sprouts Farmers Market 2022 and 2017 Annual Report
Nearly 26% of total sales are from organic food products and 58% are from perishable products (produce, meat, seafood, deli, bakery, floral, and dairy). Their own Sprouts brand produces 20% of sales, and they launched 200 new Sprouts brand items in 2023.
It is interesting they decided to locate produce further away from the entrance. Since it is one of the products that attract customers, they are now forced to pass through the other sections, which I believe could enhance cross-selling.
SFM aims to locate its distribution centers within 250 miles of stores, with the goal to create an efficient supply chain that allows them to deliver fresh products from local farmers. Because of the nature of Sprout's products, we believe it will be important to keep an eye on how they are performing on their logistics and distribution goals.
The company leverages its scale to opportunistically acquire produce from farmers and distributors at better prices, providing better value for its customers.
90% of their produce sales are from local farms. Their main supplier for dry grocery and frozen food products (KeHE Distributors, LLC) accounted for 45% of total purchases in 2022, and their contractual relationship until 2025 ensures that KeHE will be their main supplier for all their stores. SFM's main supplier for meat and seafood accounted for 13% of their total purchases.
Management
The company is led by Jack L. Sinclair (age 62), who acts as CEO and Director of the company since June 2019. He has extensive experience in the retail industry, and since 1990 he has worked at Safeway PLC, Walmart as Vice President of the U.S. grocery division, and 99 Cents Only Stores. He has been recently appointed as Chair of the Board of Directors at the Federal Reserve Bank of San Francisco. As a fun fact, his favorite SFM product is Rosemary Italian Crackers, which are currently at a 14% discount .
His compensation structure is 17% base salary in cash, 22% annual cash incentives, and 61% in long-term incentives.
Executives directors are compensated with a mix of 34% cash base salary, 28% annual cash incentives variable payment, and the remaining 38% in long-term incentives.
The long-term incentives program is received 50% in shares that are vested if EBIT targets are met during a 3-year period. 25% is received as RSUs and the other 25% is received in stock options.
2023 Sprouts Farmers Market Proxy Statement
Even though I don't consider their compensation excessive for a $3.8 billion company, I don't like the structure. More than half of the executive director's salary is received in cash, and I don't consider a 3-year period to be a long-term enough period for the long-term incentives plan.
Furthermore, their variable retributions are based on EBIT and comparable store sales growth. Because of inflation, comparable sales growth should always grow, and it doesn't mean investors beat inflation.
I also don't like EBIT as a measure of performance, since it doesn't incentivize management to bother enough about financial costs, taxes, and return on capital.
The non-executive director's structure is also not better, since even if they receive a bit more than 50% of their compensation in RSUs, the vesting period is just one year.
All non-executive and executive directors as a group only hold 1.2% of SFM's shares. While the CEO owns almost $20 million in shares (528,001 shares), the rest of the management receives more every year in salary than their shares holdings (2023 Sprouts Farmers Market Proxy Statement).
They recently announced the retirement of CFO Lawrence ("Chip) P. Molloy at the end of 2023.
A more positive aspect is that management usually delivered as expected regarding growth in a number of stores. I have been analyzing their expected openings for the next year from annual reports since 2013, and they just missed in 2021, where they expected to open 20 new stores and just opened 12 of them.
In the 2014 annual report they were expecting to grow stores by 14% annually over the next five years, they archived 12.2%. I consider it important to check how management has been delivering in the past to believe their guidance for next years.
Market and competitors
The food retail industry is a really fragmented market that includes large national chain supermarkets, warehouse clubs, small convenience stores, independent grocers, and online retailers. It is a labor intense industry, but none of SFM's employees is subject to collective bargaining agreement .
Sprouts Farmers Market is seeking to capture market share from conventional supermarkets and specialty concepts and capitalize on increasing awareness of eating habits. We believe they can attract customers with their assortment of fresh and organic products and get extra sales from non-perishable products if they can keep their prices competitive.
The organic food market has been growing at 8% (Inflation adjusted) from 2011 to 2020 and saw a 6% decline in 2021. The number of certified farms with operating organic acres has nearly doubled over the last decade, which shows us a reasonably strong demand for organic products in the U.S.
Economic Research Service U.S. DEPARTMENT OF AGRICULTURE
This growth has been mainly driven by increasing consumer awareness about the environmental and health impact of agricultural pesticides, and the switch from conventional agriculture to products with the absence of chemicals.
The organic food market is expected to grow at 11.7% annually from 2023 to 2023. If we assume a 3% inflation, it would be a net growth similar to the one we had last decade. For 2022, organic produce accounted for 15% of all fruit and vegetable sales in the U.S.
Currently, SFM has fewer stores than Trade Joe's ( 563 locations ) and Whole Foods Market ( 515 locations ), but they expect to gain market share in the food-at-home segment. By 2024 they expect to complete its brand redesign and are currently pursuing an aggressive digital marketing strategy focused on its higher-value target customers. In 2022, they garnered more than 20 million weekly digital flyer impressions, they got a 27% increase in SMS subscribers and 16% in email subscribers year over year.
To determine SFM's competitiveness compared to its peers, I selected a basket of products and their prices from stores located in the center of Los Angeles. I complemented this research with a Los Angeles Times research conducted in 2022, obtaining similar results.
As we can see, Trader Joe's provide, on average, better prices for its customers, while Whole Foods has the highest prices for organic food. I can't conclude that SFM has a competitive advantage from the price perspective.
From analyzing Google Customer Reviews for Sprouts and their main competitors in the specialty food sector, I do not see a clear preference for buying at Sprouts instead of its competitors. Sprouts have an average of 4.4 stars rating in Los Angeles, while Trade Joe is at 4.7 stars, and Whole Foods Market ( Amazon-owned since 2017 ) has a bit worst rating at 4.3 stars.
Comparing Sprouts with conventional supermarkets, I realize a competitive advantage in customer satisfaction. Food4Less, one of Kroger's (NYSE: KR ) companies has an average of 4.1 stars rating, and Albertsons (NYSE: ACI ) has a 4.3 stars rating.
Financials
Sprouts has been growing sales at 11.3% CAGR since it went public in 2013, which is 9.9% from store growth and 1.4% organic growth. The 1.4% organic growth has been in line with average food inflation during the 2013-2021 period, but the company has not been able to pass price increases in a higher inflation environment in recent years.
Author (Data from Annual Reports 2013-2022)
As highlighted in the chart above, store increases accelerated in the years after the company went public, but the store growth rate has been significantly diminishing since 2016.
For the first half of 2023, sales grew by 6% (3.2% comparable store sales), they opened 14 new stores, closed 11 stores that were 30% larger on average, and acquired the last two licensed stores. The 11 stores closed had a $27.8 million charge impact in 2Q 2023 accounts. Even these numbers are not encouraging at simple sight, I see the company making some changes to optimize costs, which could result in higher profit margins in the future.
The company has been improving its net profit margins since 2017 from 3.1% to the current 4.18% (1H 2023). The inventory turnover rates are higher in Sprouts (14x) compared to Albertsons (11x), which we believe is the nature of Sprout's business since they provide fresh products that need higher rotation.
Higher rotation could mean higher costs on transportation, but operating margins for Sprouts are higher compared to its peers, which shows us an effective supply chain.
The company is allocating most of its free cash flow into new store expansion and share buybacks. Even though the company doesn't disclose the CapEx in the maintenance of current stores and the CapEx used to open new stores, from the 2022 annual report we see they spent $124 million in total and opened 16 new stores. Assigning a $3.2 million cost for opening a new store on average, we can determine that maintenance CapEx would be $194,000 per store.
Sprouts have a healthy net debt situation, which mainly compromises $175 million used from its $700 million Credit Agreement maturing in March 2027. The interests of the Credit Agreement consist of a fixed 0.95% per annum plus a variable SOFR+0.1%. SOFR current rate is at 5.3%. With current interest rates, every hundred points variation would mean a $1.75 million increase or decrease in finance costs. At current rates, I expect interest expenses to be close to $9 million for 2023.
The aspect I really like about SFM's financials is share buybacks. Since 2015 they reduced its outstanding shares by 40% and returned over $1.5 billion to shareholders. Their current buyback program until 2024 still with $256 million remaining for further stock buybacks.
Expected growth
From management guidance, I expect store opening to accelerate this upcoming year. They expect 16 new stores to open for the second half of the year and from 2024 to grow at 10% the number of stores.
They already have 100 approved new stores and 60 executed leases. With current numbers, we could expect 40 new store openings for 2024.
Based on research conducted for us, we believe that the U.S. market can support approximately 1,200 Sprouts Farmers Market stores operating under our current format, including 400 in states in which we currently operate.
Growing the number of stores by 10% annually, they would reach 1,200 stores in 2032. Since cash from operations per store has been at $1 million on average for the 2013-2022 period, we assume it will keep at this rate and just increase a 3% because of inflation and no margin increase.
If management is able to open 10% new stores annually until 2028, if the outstanding debt is refinanced, we expect the Free Cash Flow highlighted above to be used for share repurchase and they could reduce outstanding shares by 6% annually if there is no valuation multiples expansion.
I assume the same inflation increase in maintenance CapEx per store and new store CapEx because of higher material costs.
Even it is soon to see the effects of their new store format in the financial data since they represent less than 10% of total stores, we expect sales per store to stay similar for the upcoming quarters but costs to decline as more new and smaller stores are opened.
So the sales per square foot that we're getting in the V6s, which are 23,000 square foot as opposed to the V5s, which we were building at 32,000 square foot is seeing a very significant increase. So we're really encouraged by categories like Deli, which we've taken the space and the cost down fairly substantially, and we're getting exactly the same sales from them. So that's encouraging in terms of the returns.
The company is also looking to improve its margins through the implementation of Fresh Item Management Software, self-checkouts, and more efficient sequencing promotional tags.
In my base scenario, I expect Sprouts Farmers Market to continue growing its same-store sales by 3% annually, increase their number of stores by 8% annually (slightly missing management guidance) and buy back close to 6% of the shares outstanding if the valuation doesn't go up. This would represent growth in EPS of mid-double digits and a Free Cash Flow of $388 million for 2028.
Free Cash Flow per share would raise from the current $2.45 to $5.13, assuming the company has 75 million shares outstanding in 2028.
Valuation
Sprouts have been trading at an average of 13x LTM EBIT and 14x LTM EPS for the last five years, and more recently in the 12x-14x range.
I find this valuation range fair since even though they do not have a big moat, they are in a competitive business and haven't been able to raise its prices according to inflation, profit margins are higher compared to its publicly traded competitors and growth expectations are at mid-double digits.
The company is expecting an EBIT for 2023 in the $378-$390 million range and an Adjusted EPS of $2.7, so if they are able to deliver I expect a price per share for the end of the year between $37.8 and $44, excluding share buybacks.
The current price is fair with this valuation and I don't consider SFM to be undervalued in the base case scenario, but I believe it provides some safety margin and investors should expect low-mid double digits return over the next years.
The company hasn't been improving its ROIC over the last years, which is currently at 13% (2Q 2023) but in my best case scenario, as new format stores are opened and represent a higher percentage of total stores, which could take some years, ROIC should increase.
I believe an increase in ROIC would allow the company to buy back a higher amount of shares or fuel their store expansion, even though I suspect they would use it for share buybacks since they could already accelerate growth with current cash flows. I deduce that if they are not doing so is because they are not able to find the right opportunities.
Better ROIC could expand SFM's valuation, and this would provide an extra return for investors.
Risks
The main risk I see for SFM is adverse macroeconomic conditions since the company could be negatively impacted in an inflationary and in deflationary environment.
As we have seen in recent years, the company has not been able to pass price increases to its customers and sales grew slower than food inflation, which was at an average of 6.5% for the last two years while same-store sales grew at 2.2% in 2022 and -6.7% in 2021 .
An inflationary environment combined with reduced consumer spending could affect severely SFM's sales since even if their product is a basic need, consumers could flip to cheaper alternatives.
In a deflationary environment, which depresses consumer spending, the outcome could be similar and reduce margins since they do not have an outstanding competitive position and pricing power, so they would need to compete with lower prices.
On the rising interest rates side, I do not see much impact on SFM's financials, since their debt is low and as highlighted before. A hundred basis point increase in interest rates only would increase its financial costs by $1.75 million per year. Their long-term debt is $184 million while cash is $259 million.
Concentration in sales doesn't bother me much, since even 34.5% of sales come from California, they have 130 stores, so I believe they are properly diversified. From the supply side, concentration is a bit of a concern in dry grocery and frozen food since one supplier accounts for 45% of the total supply, but I understand the company can't have lots of suppliers since it would reduce its purchasing price power.
Finally, disruptions in supply-chain, which I don't expect to continue in a stable or deflationary environment, could also affect their ability to keep up with the store expansion plans as they could face some difficulties with material supply.
Conclusions
All in all, even Sprouts Farmers Market is not the kind of business I usually own in my portfolio and have some aspects that I would like to see improving, such as management compensation structure and ROIC, I believe it is a business that is worth to keep under watch at this valuation.
The company has some positive aspects and that is why even though I don't currently own SFM, after a few years of following the company I decided to place my buy order at $35 and get some extra margin of safety points from the current price. That is why I rate the company as a buy.
In my base case scenario, I don't consider shares to be undervalued at the current price, but if the management meets its guidance for the upcoming years growing its number of stores by 10% annually and the new store format reduces costs and improves margins, I believe it could provide a decent return with a possible upside if valuations go slightly up to 15x-16x LTM EPS.
If valuation multiples don't expand, the company is going to be able to reduce its outstanding shares at a faster pace, so I don't see it as unfavorable as long as it can keep adding new stores in the long term and growing FCF per share.
The company is improving its logistics and reducing the distance from distribution centers from the previous 500 miles to the current 250 miles on average, reducing operating costs with smaller stores, enjoying some market tailwinds, and returning its FCF to shareholders.
For further details see:
Sprouts Farmers Market: New Store Format Will Increase ROIC