2023-09-20 02:40:40 ET
Summary
- I recommend holding SFM due to concerns about gross margin compression, declining sales volume, and rising SG&A expenses outpacing revenue growth.
- In the event of a price war, SFM has much more to lose (in terms of gross margin) than peers.
- The rapid expansion of new stores is expected to increase expenses, potentially impacting SFM's net margins in fiscal year 2024.
Overview
My recommendation for Sprouts Farmers Market ( SFM ) is a hold rating, as I have concerns of potential gross margin compression, continuous volume decline, and SG&A growth outpacing revenue growth. This stems from the fact that, although it reported strong second quarter results, it is facing a declining volume headwind that trails peers. In addition, SG&A is expected to continue ramping up due to rapid new store expansion, which will negatively impact margin as it has been growing faster than revenue. Lastly, SFM profit margins is at a high premium to peers, making the room to fall a lot larger than peers. If a price war were to occur, SFM could suffer significantly, given its declining sales volume.
Business
SFM provides a distinctive grocery shopping experience characterized by an open store layout where fresh produce takes center stage. Their commitment to promoting natural wellness is evident in their thoughtfully curated selection of health-conscious products, supported by a dedicated team with a shared purpose. They consistently introduce innovative, wholesome items crafted with lifestyle-friendly ingredients like organic, plant-based, and gluten-free options.
Over the last five years, SFM has achieved a CAGR of 4.2%. However, it's worth noting that its revenue growth rate has decelerated from double-digit figures to low-single-digit [LSD] percentage range. For reference, in 2018, its year-over-year revenue growth was an impressive 11.6%, in stark contrast to the 5% recorded in 2022. This shift suggests that SFM's growth momentum is slowing down, signaling an entry into the mature growth phase. That said, despite this slowdown, its EBITDA margin has consistently averaged a healthy 7.18%. This margin performance does underscore management effective cost management.
Recent results and updates
While SFM reported strong results for the second quarter, there are concerns about volume challenges that could impact the upcoming quarters. In the second quarter, SFM achieved robust comp store sales growth of 3.2%, resulting in net sales of $1.69 billion, a 6.1% increase year over year, primarily driven by average unit retail [AUR] inflation. However, this positive performance was offset by a decline in the number of units sold. Consequently, the company has reaffirmed its comp outlook for FY23, expecting growth in the range of +2% to +3%, indicating a deceleration in the second half of the year. Specifically, for the third quarter, SFM anticipates comp sales in the LSD range of 1% to 3%, suggesting a slowdown compared to the 3.2% comp growth seen in the second quarter. This slowdown is primarily attributed to the weakness in sales volume.
My negative outlook for the business is further amplified by the fact that SFM has a considerable gross margin premium of 860bps vs peers, which means there is more room for margins to collapse. For instance, peers like Grocery Outlets has gross margin of 30.5%, Kroger has 21.4%, Village Super Market has 28.12%, Albertsons Cos has 28%, Natural Grocers By Vitamin C has 28%, Wets Markets has 25%, Ingles Markets as 25%, overall a medium of 28%. My concern is that SFM has not faced significant price competition recently, and this substantial margin difference leaves it potentially exposed to increased price competition in the grocery industry, especially given its position as a retailer that balances both high-and low-priced offerings. In the event of a price war, SFM could face significant repercussions, especially given its ongoing volume decline. Moreover, SFM's volume decrease is consistently trailing industry norms, amplifying the potential impact of a price war on the company.
Ever since 2021 began, there has been constant inflation. inflation of 3.7% as of August 2023 is still hanging above the Fed's goal rate of 2%. The gaping budgetary holes that inflation has chewed into have frustrated consumers. Food sellers are actively trying to alter their position in response. Positioning themselves as friends in the struggle against high pricing is becoming more and more prevalent. Retailers like Aldi, Wegmans, and Kroger are already preparing to attract clients by cutting prices to help clients save money. Therefore, the likelihood of a price war amongst grocery stores retailers is mounting.
Moreover, in the second quarter, sales, general & admin expenses grew at a faster rate (7.8%) than net sales (6.1%), and this trend is expected to continue into the coming quarters, with a ramp-up anticipated in Q3. As SFM plans to expand its store network rapidly, the increasing expenses could potentially hinder net margin in fiscal year 2024.
Valuation and risk
Author's valuation model
According to my model, SFM is valued at $35.84 in FY24, representing a 12% decrease. This target price is based on my revenue growth expectation of deceleration in FY24 after meeting management guidance in FY23. The deceleration reflects my conservative view that SFM will continue to see volume decline given the weak consumer sentiment and that SFM new stores are not in the mature phase. In addition, my model forecasted that margin will be flattish as SFM see increasing SG&A expenses that outpaces any operating leverage that its business see.
SFM is now trading at 15x forward earnings compared to peers (as listed above) who are trading at a median of 13x. While I acknowledge the premium vs peers, given that SFM has a higher gross margin, my concern (as stated above) is that SFM might collapse due to any potential price war. When that happens, this premium in multiple is likely to contract. I am giving SFM the benefit of doubt that they can somehow find ways to protect their gross margin in an event of a price war, so my model assumes 15x forward earnings. That said, even at 15x, the upside is not appealing at all.
Risk
If the elasticity of SFM’s products increases, it means that consumers are becoming more sensitive to changes in price. In this scenario, even a slight price increase could lead to a significant decrease in demand, potentially causing its comparable sales to decline. While SFMs have been experiencing favorable input cost conditions, there is always the possibility of a reversal in this trend. If input costs start to deflate, it could impact profit margins, especially if SFM is unable to adjust its pricing strategies to maintain profitability.
Upside risk includes increased customer preference for healthy eating and food-at-home tailwinds which will drive demand for SFM. In addition, a better and sooner than expected execution of new store growth plans might result in revenue growth outpacing SG&A growth. if cost pressures lowers such as wages and promotions, it will lead to better than expected margin.
Summary
In summary, my recommendation for SFM is a hold rating, driven by concerns over potential gross margin compression, continuous volume decline, and rising SG&A expenses outpacing revenue growth. While SFM reported strong Q2 results, it faces challenges with declining sales volume and a considerable gross margin premium compared to peers, making it vulnerable to price competition in the grocery industry. Furthermore, the rapid expansion of new stores is expected to increase expenses, potentially impacting net margins in fiscal year 2024.
For further details see:
Sprouts Farmers Market: Volume Challenges And Rising Expenses