Image Source: Sprouts Farmers Market Inc – IR Presentation
By Callum Turcan
Sprouts Farmers Market Inc (SFM) is a grocery chain that focuses heavily on selling organic foods, healthy foods, and other higher priced items in nearly two dozen US states through 331 stores as of August 1. The company does not pay out a common dividend at this time, and please keep in mind Sprouts’ fiscal year and calendar are slightly different (fiscal year 2018 ended on December 30). While Sprouts has a lot of room to grow as it enters new domestic markets, we caution that the company is operating in a very competitive industry and shares of SFM already appear fully valued, if not generously valued, as of this writing. Management recently downgraded 2019 guidance, with comparable store sales growth expectations getting decimated.
Additionally, growing competitive pressures from the likes of Amazon Inc (AMZN) and Wal-Mart Inc (WMT) could stymie Sprouts’ growth trajectory and ability to grow in certain markets. Those two aforementioned giants are rolling out same-day and one-day grocery delivery services, along with pick-up services, in the US. Sprouts doesn’t have the kind of scale required to be competitive on that front, particularly when it comes to delivering groceries as large distribution networks are needed to offer such services.
To fight back, Sprouts partnered up with delivery service provider Instacart. Instacart is privately owned and offers grocers a way to leverage its distribution system to get groceries from the store to the customer’s doorstep.
Declining Operating Margins Worrisome
Sprouts’ operating margin peaked in FY2014 and has moved steadily lower ever since. On a GAAP basis, Sprouts’ operating margin clocked in at 6.7% in FY2014 before falling down to 4.8% in FY2017 and lower still in fiscal FY2018, touching 4.3% last fiscal year. While its GAAP revenue surged from $3.0 billion in FY2014 to $5.2 billion in FY2018 (up 75% during this period), its GAAP operating income has grown by less than $0.1 billion (up just 12% during this period). That poses a huge problem for the company, as its GAAP gross margin has grown by ~375 basis points over this timeframe to 33.6% in FY2018. Sprouts’ inability to meaningful grow its operating income is entirely the result of ballooning operating costs.
Sprouts is doing a good job ensuring its stores sell products at solid prices, instead of racing to the bottom as with most other grocery stores in America, meaning its problems could be surmountable. If management finds a way to put a lid on operating expenses, namely SG&A (which represents the lion’s share of Sprout’s operating costs), Sprouts could realize meaningful margin expansion. That isn’t expected to be the case this year, which we will cover later on.
What’s interesting is that online sales aided Sprouts’ gross margin (but not necessarily its operating margin), according to management commentary during the firm’s second quarter FY2019 conference call (emphasis added):
“Our online sales, while still relatively small in total, increased 170% expanding our reach to new customers while also providing a convenient alternative to current customers. The online basket has a higher penetration of private label items and less promotional items producing a higher gross margin. In addition, our click and collect test has expanded in the Phoenix market as we further engage with customers regardless of how they shop. Product innovation continues to drive double-digit sales growth in private label items, which reached 14% of total company revenue in the second quarter. More than 45% of our baskets contain a private label item, a testament to the consumer adoption of our brand.”
Rising private label sales (represented 14% of second quarter revenue) will help provide support for Sprouts’ gross margins going forward. Please note that management isn’t expecting future gross-margin expansion so much as “stabilizing” of its gross margins, as the US grocery market remains very competitive with giants (both new and old, such as Amazon and Wal-Mart) looking to take a greater slice of that pie. Sprouts is fighting back with its own digital investments, pick-up services, and delivery partnerships, but that represents a small part of its business right now. Considering past growth in its gross margin, Spouts appears to be communicating that there isn’t too much room to push gross margins higher (particularly given its flat comparable store sales growth) over the medium-term. Management expects Sprouts’ gross margin will contract modestly in FY2019.
When it comes to operating margins, Sprouts appears to be waiting until its growth phase ends before focusing on expanding its profitability levels. We caution that the company is still very much focused on growing its store count. Management mentioned that one of its long-term goals was to leverage economies of scale, indicating Sprouts aims to use a larger store count footprint to cut SG&A expenses on a relative basis. The company expects SG&A expenses will rise by 10.5% in FY2019 on an annual basis, outpacing expected revenue growth and implying additional operating-margin pressure.
New Stores Drive Revenue Growth
During Sprouts’ second quarter of FY2019 (earnings report was released on August 1), its comparable store sales were up just 0.1% year-over-year while its GAAP gross margins moved lower by 35 basis points. Management expects Sprouts’ gross margins will fall by 20-30 basis points in FY2019 versus FY2018 levels. Six new stores were opened in the quarter (one lease expired and wasn’t renewed) and another five were opened in the third quarter to date, giving Sprouts 331 store locations by the beginning of August. Revenue was up 7% year-over-year in the second quarter, largely due to new store openings.
Sprouts opened stores in Louisiana and New Jersey for the first time during the second quarter, and now has a presence in 21 US states. The organic grocer plans to expand into Virginia this year as well. There’s room to grow further but note that the US grocery market (even for organic food sales) is already full of supermarkets. Sprouts’ growth trajectory will need to contend with existing competitors and the possibility for serious e-commerce disruption (which we are already beginning to see). For now, Sprouts is targeting 30 new store openings per year over the coming years.
Image Shown: There are plenty of new domestic markets Sprouts could expand into, providing for a longer growth runway, but keep in mind the increasing competitive pressures in the US grocery industry. Image Source: Spouts – IR Presentation
Here’s how we view the Food Retailers industry, keeping in mind Sprouts has yet to build up the kind of scale needed to realize the benefits its much larger peers already enjoy:
“Firms in the mature food retailers industry generally have slim profit margins and face significant competition from brick-and mortar locations (discount, department, drug, dollar, warehouse clubs and supermarkets) as well as Internet-based retailers (including Amazon). Though the industry is not terribly cyclical, economic conditions, disposable income, credit availability, fuel prices, and unemployment levels drive ticket size and traffic trends. Offering consumers a compelling value proposition is a must, even as higher-priced organic food offerings proliferate. We’re generally neutral on the group.”
Guidance Cut
After cutting guidance during the second quarter earnings release, management now forecasts Sprouts’ revenue will grow by 7%-8% annually this fiscal year, largely due to 28 new store openings as comparable store sales are expected to be flat. Capital expenditures are expected to be broadly flat year-over-year at $170 million – $175 million, while diluted EPS is expected at $1.05 – $1.09 in FY2019, down from $1.22 in FY2018 on a GAAP basis.
Note that Sprouts sharply cut its FY2019 guidance from the forecast given out during its fourth quarter FY2018 earnings release. Initially, management saw 1.5%-3.0% comparable same store sales growth and net sales growth of 9.0%-10.5% year-over-year, with diluted EPS expected at $1.16-$1.24 this fiscal year. Capital expenditure guidance was not changed. Sprouts’ updated FY2019 forecast leave little room for enthusiasm and highlights the serious competitive pressures facing US grocers. The complete lack of comparable store sales growth is very worrisome, as is the decline in Sprouts’ gross margins.
Even worse, Sprouts updated its FY2019 guidance during the first quarter, raising the bottom end of its full fiscal year diluted EPS forecast while keeping its other forecasts the same, before sharply cutting that guidance just a few months later. That speaks to management’s lack of clarity on where the US organic grocery market is heading.
Very Free Cash Flow Positive
Although Sprouts is facing some problems, its free cash flows have been quite strong historically. Over the past three fiscal years, Sprouts generated $101 million in free cash flow, on average. The firm spent an average of $252 million per fiscal year during this period buying back stock, and once again please note Sprouts doesn’t pay out a common dividend.
The organic grocer had a sizeable net debt load at the end of the second quarter of FY2019, which stood at $469 million when defined as cash & cash equivalents less current portion of finance lease obligations and long-term debt and finance lease liabilities. When including operating lease obligations (both short- and long-term), Sprouts’ total liabilities grows considerably. Its net debt is a product of Sprouts’ share buybacks, as the firm is very free cash flow positive and can organically cover its ongoing growth program (specifically as it relates to opening new stores while investing in digital offerings, delivery partnerships, and pick-up services).
Concluding Thoughts
Using its average annual free cash flows from FY2016-FY2018 and assuming a discount rate of 10% along with a perpetual growth rate in the mid-single-digits (which is a tad generous), we arrive at a total equity valuation that’s similar to where Sprouts is trading at as of this writing (Sprouts’ market capitalization stood at $2.1 billion on August 7). We see shares of SFM as fully valued, if not generously valued, as the organic grocer’s growth story is contending with major headwinds and pressures on its margins don’t appear to be fading anytime soon.
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Callum Turcan does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.