Sprouts Farmers Market Shares Can Rally 45%, Says Fund Manager

Recent price: $24.17

Timeframe: 1-2 years

Thesis

At its recent price, representing a 10% steady-state free cash flow yield despite high single-digit growth potential at attractive returns on invested capital, Sprouts Farmers Market represents an extremely low-risk/high-reward opportunity.

Basic Business Overview

The grocery space is highly competitive, but we believe Sprouts operates in a growing and defensible niche, with attractive and differentiated “better-for-you” offerings in a convenient neighborhood “medium box” format, which is about 20,000 to 30,000 square feet. That’s larger than a pharmacy or Trader Joe’s at 8,000 to 15,000 square feet, but much smaller than a big-box Kroger or Safeway, which can be 100,000 to 150,000 square feet.

Crucially, Sprouts provides its offerings at a price point for the 40th-80th percentile household income demographic. Unlike a trip to Whole Foods Market, shopping at Sprouts won’t break the bank—which is why my family has shopped at Sprouts for about a decade. Sprouts has a differentiated mix, with the “center of the store” being produce (20%-25% of sales, or roughly double the Food Marketing Institute’s industrywide average). Sprouts’ produce basket (albeit not necessarily every individual item) historically has been priced 15%-20% lower than conventional supermarkets. It also has a differentiated bulk section with nuts, chocolates, grains, trail mixes, etc.

Sprouts’ aisles don’t carry conventional consumer packaged goods from the likes of Coca-Cola and Procter & Gamble. Instead, they hold a mix of private-label goods and items from brands considered “healthy/natural/organic/premium” such as Annie’s and Vital Farms.

Relative to a conventional supermarket, Sprouts has much better offerings in attribute-driven products such as keto, paleo, vegan, Whole30, gluten-free, meat alternatives, etc. Notwithstanding that many of these diet trends fall in and out of style, the general trend away from conventional processed food toward “healthier” alternatives is clear, and Sprouts is well-positioned to address it.

As a result of these differences in business model, Sprouts’ Ebitda (earnings before interest, taxes, depreciation, and amortization) margins (6% in 2019, an estimated 6.7% in 2021) are meaningfully higher than peers. With high Net Promoter Scores among its target customers and a large demographic of Americans interested in “healthier” foods, Sprouts has a lot of white space on the map. It is well established in the Southwest (California, Arizona, and Texas) and has been expanding into the South as well as up the East Coast with generally good results. With only 362 stores (versus 2,800 much larger stores for Kroger), the total addressable market is not really the issue here. As long as Sprouts executes, it has a long growth runway ahead.

Brief History Pre-2019

When the company went public, it was rapidly growing units as well as comps, and traded for a stratospheric multiple. Looking at the pre-Covid 2015-2019 period, fundamental business performance was actually quite good, perhaps even “compounder” like. Through a combination of comparable-store sales growth but mostly new store openings, gross profits roughly doubled, with Ebitda up about 50% (with a decent chunk of the difference due to the essentially sector-wide decision to reinvest some tax savings into wages.)

Over this period, the company used robust free cash flow to retire more than 20% of shares outstanding. The company’s unit economics allow it to grow at a high single-digit rate while still generating plenty of excess capital to return to shareholders.

In 2018 and 2019, the story stalled out a bit for a variety of reasons. This can be summed up as Sprouts trying to be a bit of everything to everyone. The cost of new stores increased meaningfully, with a lot of incremental space allocated to initiatives like an expanded deli. The company also started opening stores in far-flung geographies (such as far up the East Coast) where it wasn’t able to benefit from nearby distribution centers or marketing leverage/brand equity across multiple locations. Thus, while the stores performed quite well from a revenue perspective (i.e., customers like them a lot), they had trouble translating that revenue into appropriate margins.

Finally, and perhaps most importantly, Sprouts had gotten too deep into “loss-leader” promotions, trying to compete with mainstream supermarkets by offering deep discounts on individual items in an attempt to drive traffic to the stores. These promotions were successful in driving traffic, but mostly only for those items. In other words, the shoppers they were attracting were people like my mom—those who will drive halfway across town to different stores to get the cheapest milk from one, the cheapest chicken breast from another, the cheapest spinach at a third, etc. These are obviously not profitable shoppers for the company.

A review of the conference call transcripts and/or sell-side notes will elucidate all of these issues in detail. It is worth noting that even with these various operational and strategic missteps, the company continued to generate robust cash flow and didn’t exactly implode. Even when somewhat undermanaged, the value proposition continued to resonate with consumers. As competitive as the industry may be, it also has the benefit of being extremely defensive: People always need to eat (which led to windfall profits during the Covid-19 pandemic, but we’ll get there in a second).

Enter Jack Sinclair

Jack Sinclair was named CEO of Sprouts in mid-2019, and quickly set about fixing all of the above issues. Jack has an impressive background, having previously run Walmart’s U.S. grocery division for eight years, including leading the growth of Walmart Neighborhood Market, which coincidentally is the second-largest share of my grocery wallet (there are a lot of similarities between the concepts, including value and convenience, although they are strongest in different parts of the basket).

Sinclair possesses a brilliant mind and chooses to zig where others zag. In his first conference call, he immediately noted many of the differentiating positives about Sprouts that we referenced in the overview, while simultaneously recognizing that the stores could not be all things to all people.

He temporarily slowed down the store expansion while reviewing the optimal store footprint and layout, and decided to refocus store growth on key geographies that were proximate to distribution centers (some of which are being built out in 2021). Most importantly, he pulled back on some of the overpromotion that was going on in the prior quarters. This started to show up almost immediately, with gross margins expanding by about 120 basis points in the fourth quarter of 2019.

After that, Covid muddies the waters a bit on margin expansion, making it hard to tell exactly how well the strategy is working. During the pandemic, grocers obviously have benefited massively from the increased consumption of food at home, and most of this share will probably be given back to restaurants as the coronavirus fades in the rearview mirror over the next several quarters. This led to increased leverage on fixed costs, lower shrink/waste, etc. Similarly, with many consumers concerned about health and also trading down from more expensive restaurant meals, price/promotions probably took a bit of a backseat this past year to other factors such as convenience, etc.

These trends mostly helped Sprouts, but they may have hurt the company a bit, too: You can’t shop for all your needs at Sprouts, insofar as you’re probably still getting your toilet paper and dish soap from somewhere else. The industrywide trend toward trip consolidation and bigger baskets probably didn’t play to Sprouts’ strengths, and while it had strong margin leverage, it also had a lot of Covid-associated costs such as increased personal protective equipment and sanitation. Similarly, Covid-19 caused a massive jump in e-commerce penetration (up 290% year over year to 11% of sales in Sprouts Farmers Market’s fourth quarter), which is a lower-margin channel for everyone, and the margin improvement in 2020 (and expected in 2021) comes in spite of those issues.

Sprouts also has used the pandemic to accelerate its shift from deep promotions to a more balanced mix of promotions and everyday low pricing (EDLP), while also replacing paper flyers with targeted digital engagement, both through its own app and other channels such as TV.

In any event, 2020 results were fantastic, allowing the company to generate monster cash flow of nearly $500 million (vs. 2019 Ebitda of about $340 million) and pay down substantially all of its modest debt balance. But 2020 is clearly not representative of go-forward results. Nonetheless, despite the windfall profits in 2020 and the traction on margin initiatives, the stock trades at more or less the same price it did during early 2019, suggesting the market now has a more negative outlook on Sprouts than it did before all these initiatives. In today’s market, companies generally don’t trade at around 6 times Ebitda or around 10 times ex-growth free cash flow unless there’s something really wrong with them, and it’s difficult to look at Sprouts’ financials and claim there’s anything really wrong with the company.

Unprofitable Customers Are Bad Customers

We believe the market pessimism is due primarily to a combination of:

• a fundamental misunderstanding of Sprouts’ business model and value proposition to consumers; and
• a myopic focus on certain metrics (comps, traffic) that miss the forest for the trees.

In investing and business, I’m fond of the joke about hikers and bears: You don’t have to outrun the bear, just your hiking buddy. (This is bad advice, by the way; bear spray is more effective.)

There are plenty of customers who won’t shop at Sprouts, and that’s perfectly fine—different strokes for different folks. Different businesses have different value propositions and won’t be everything to everyone. For example, convenience stores still exist, and (I believe) were generally comping positively ex-Covid, even though most things sold in a convenience store or pharmacy can generally be purchased elsewhere at a much lower price. Unless I’m on a road trip, I almost never buy anything from one of these stores. Yet they still have a value proposition to their core customer segment (which is clearly not me), and create value for their shareholders by effectively serving that customer segment’s needs.

Sprouts’ core value proposition, as discussed in the introduction, is a basket of healthier, better-for-you groceries that is priced more attractively than most nearby competitors. Certainly, there are some places (e.g., Costco ) where you could probably save money on some of the same selection as Sprouts, but there is obviously a trade-off (convenience).

Within the demographic of people who live near a Sprouts and want to shop for healthy ingredients and snacks without breaking the bank, I would posit that Sprouts is the best overall value for your money. I am squarely in the center of Sprouts’ target demographic—despite having a higher income, I’m value-conscious when it comes to my groceries—which is why I continue to shop there weekly.

I recognize that my affinity for the brand may bias my investment perspective in certain ways, but I think it’s important because the vast majority of investors and analysts looking at Sprouts probably don’t shop there. (The company isn’t targeting the 1% and has no presence in New York, Chicago, or San Francisco.) This is, I believe, why Sprouts has seen a long string of market misunderstandings. First, Whole Foods was supposed to eat its lunch, then Aldi was supposed to eat its lunch. Aldi is certainly a competitor I take seriously, but it hasn’t really historically affected Sprouts’ market position.

What Jack Sinclair is doing at Sprouts today is refocusing its marketing and promotional spending on appealing to customers within that demographic, who end up being profitable customers for the brand (because they value a mixture of price and convenience, so they want a well-priced basket, but aren’t, like my mom, going to cherry-pick the cheapest items from three different stores twice a week.)

A necessary corollary to this approach is that you’re going to lose some customers (i.e., traffic and comps) whom you previously served, albeit unprofitably. And that word, “unprofitably,” is the key issue. Most of the commentary I’ve seen on Sprouts is some form of hand-wringing about how its traffic and/or comps aren’t as good as they should be. To which I answer, yeah, of course, that’s intentional. Why in the world would you want to have negative-margin revenue? It’s good business to shed unprofitable customers; if anything, it’s a sign of good management not to grow for the sake of growth if profitability doesn’t accompany it.

There are, of course, certain situations in which negative-margin revenue might have strategic value, such as increasing brand recognition or landing a benchmark referenceable customer. But this does not seem to be the case in grocery shopping, insofar as grocery shoppers’ decisions are independent. What appeals to Customer A is different than what appeals to Customer B; you can simultaneously become more attractive to A while becoming less attractive to B.

Anyway, although the metaphor gets a little stretched here, what Jack Sinclair decided to do was to stop trying to outrun the bear (i.e., compete with the entirety of the rest of the industry) and instead just focus on being able to outrun the hiking buddy (i.e., deliver the best value proposition to the target customer). Many of the new initiatives are appealing to core customers. For example, Sprouts has very noticeably delivered on its new “treasure-hunt” ideology, focusing on having a significant portion of SKUs be limited-time specialty offerings.

These both provide an incentive for those interested in new foods to keep shopping (like a farmer’s market, you never know what cool thing you’ll find), and also deliver higher margins (you’re less likely to price shop for a honeynut squash, and who the heck even knows what the market price is if you’ve never seen one before?). Although you could find some of these items at other retailers, they would generally either be higher priced (e.g., Whole Foods, HEB’s Central Market) or less convenient (e.g., ethnic grocers like HMart or Patel Brothers that can be confusing for the average American).

It is, of course, an open question what Sprouts’ margins will look like in several years; I am comfortable with the company’s 2021 guidance and its clarification around which items (e.g., suspending flyers, eliminating loss-leaders) it expects to drive permanent savings, and which items (e.g., leverage on fixed costs, shrink) they do not. CFO Denise Paulonis said on the fourth-quarter 2020 conference call:

“I think what we feel really confident that we can control is how we think about our gross margins and how we manage our expenses, which gives us great confidence in what we can deliver this year. Underpinning what we put out there, we expect to maintain a majority of the gross margin benefit we see. So when we think about things that were really Covid specific, there was some outsized shrink improvement when, literally, we couldn’t keep product in stock in the stores during the heavy piece of Covid back in March and April.

“And there was some kind of outsized wins in terms of produce buying when all the restaurants and food service shut down overnight, and there was just a lot of excess supply right there in the market. Outside of that, we feel great about what we’ve done structurally with our promotions, our overall buying practices and long-term improvements in shrink. So choosing to exit having all of bars and our salad bars is a long-term structural improvement in that shrink number as there are a lot of other technology investments we’re making. So think about it as a good majority of that gross margin benefit staying.”

Risks

In addition to general execution risks, or general market risks such as a higher tax rate under the Biden administration, Sprouts is, of course, potentially exposed to a higher minimum wage, although it should be noted it already operates quite profitably with a high concentration of stores in notably high-wage California, and states like Arizona with higher-than-average minimum wages.

However, Sprouts already has invested a significant amount in wages, it has the potential for automation (e.g., it is only now rolling out self-checkout in stores), and I didn’t get the sense from the company that a $15 federal minimum wage was at the top of its list of worries.

Continued growth in e-commerce is also a risk, as this is a lower-margin channel, although 2020 should be the high point at least for a few years (as people return to leaving their houses). That said, I think e-commerce tends to be a little more incremental than cannibalistic for Sprouts, vis-a-vis competitors such as Kroger, etc., as it is less dense and therefore can actually access a bigger trade area via delivery than what its stores might normally serve.

The biggest risk is probably that this is just a hypercompetitive, low-margin industry, albeit one that is defensive (you at least don’t have to worry about demand evaporating, even during a pandemic). It is certainly a possibility, for example, that irrational/unprofitable discounting by competitors might draw some customers away and depress Sprouts’ margins.

Still, Sprouts is very much the growing disruptor more than the disrupted; it primarily sells foods with the health halo increasingly desired by consumers, vis-a-vis having shelf space allocated to Jell-O and Oreos. It has consistently—and profitably—opened new stores, unlike most large grocery peers who are already mature/penetrated, so clearly it has been (and continues to be) a share taker rather than a share donor. From 2016-2019, Sprouts’ revenue grew by 57%, compared to growth of 4% and 11% from Albertsons and Kroger.

And with a different product mix and structurally higher margins than most of the industry—which have not been competed away over time—Sprouts is actually positioned in some ways to benefit from any challenges that might strike the industry (i.e., its margins might decline, but it would still be significantly profitable, while many competitors might be going out of business.)

Given all of the above, the current valuation builds in significant margin of safety. Even if margins reverted to 2019 levels, the company would be trading at around 6.7 times Ebitda and around 11.8 times steady-state free cash flow. Those are hardly aggressive multiples, considering its strong growth story that is not speculative (i.e., it has been demonstrated well over time, and does not require heroic execution). In this scenario, my fair value would still be $27; to justify the current trading price, you’d have to make assumptions that would either result in competitors being put out of business, or the vast majority of public stocks being cut in half.

In any of these situations, the company will continue to throw off lots of cash that will accrue to shareholders one way or another. Earlier this month, Sprouts announced a three-year, $300 million stock buyback authorization. At the stock’s recent price, that would represent 12.5 million shares, or 10%-11% of shares outstanding.

For the full report, including a detailed valuation discussion, please go to SumZero.com.