Sprout Farmers Market - Healthy Food Provider Trades At Non-Healthy Valuation Multiples

Aug. 5.13 | About: Sprouts Farmers (SFM)

Sprouts Farmers Markets (NASDAQ:SFM) made its public debut on Thursday, August the 1th. Shares of the specialty retailer of natural and organic food, focuses on health and wellness, ended their first day with gains of 122.8% at $40.11 per share.

After the spectacular returns, the valuation of Sprouts has become way too expensive for my taste. With continued selling interest from Apollo being likely, I remain on the sidelines.

The Public Offering

Sprouts Farmers Markets is rapidly growing retailer with a focus on natural and organic food. The company was founded back in 2002, and has shown rapid growth ever since.

The company currently operates 157 stores across eight different states, making it one of the largest specialty retailers of natural and organic foods within the United States.

Sprouts Farmers Markets sold 18.5 million shares for $18 apiece, thereby raising $333 million in gross proceeds. As the selling shareholders sold some 0.8 million shares in the offering, gross proceeds for the company itself will total about $319 million.

The public offering values the equity of the firm at $2.6 billion. The offering took place above the preliminary $14-$16 offer range. Some 13% of the total shares were offered in the public offering. At Friday's closing price of $39.98 per share, the firm is valued around $5.8 billion.

The major banks that brought the company public were Goldman Sachs, Credit Suisse, Bank of America/Merrill Lynch, Barclays, Deutsche Bank and UBS.


Sprouts opened its first store in Arizona, a little over a decade ago. After the company fell in Apollo Management's hands it has shown rapid growth, fueled by acquisitions.

In 2011, the company combined its operations with Henry Holdings. This deal added 35 Henry's Farmers Market stores and eight Sun Harvest Markets. The deal was followed by the 2012 acquisition of Sunflower Farmers Markets, which added 37 stores. As a result of these deals and organic growth, Sprout now operates 157 stores.

The company operates under the "Healthy Living for Less" principle offering healthy products at prices below those of competitors.

For the year 2012, Sprout generated annual revenues of $1.99 billion. The acquisition of Sunflower added almost $200 million in revenues. The company reported a $24.5 million net profit, including a $5 million contribution from Sunflower. In 2011, Sprout reported a $27.4 million loss on amortization charges related to the Henry's transaction.

The company operates with $51.8 million in cash and equivalents, which excludes the $319 million in gross proceeds from the public offering, which will mostly be used to repay outstanding debt. Sprout operates with $107.6 million in long-term debt and $1.09 billion in capital lease obligations.

The current $5.8 billion valuation values Sprout at 2.9 times annual revenues and over 200 times annual earnings.

In comparison, market leader Whole Foods Market (NASDAQ:WFM) is valued around $20 billion, or 1.7 times annual revenues. The company is valued at 43 times last year's earnings, after reporting net earnings equivalent to 4.0% of total revenues.

Investment Thesis

As noted above, the offering of Sprout Farmers Market has been a huge success. Shares were offered 20% above the midpoint of the preliminary offering range. On top of that came opening day returns of almost 123%, implying that shares were valued 167% above the midpoint of the preliminary offering range.

There are a few reasons for the successful public debut. First of all, natural and organic foods is a hot area in the market. The fact that the company is profitable, helps a great deal as well. Last, the market for initial public offerings remains very solid as market sentiment remains very optimistic.

Sprout has been growing rapidly in recent years. An illustration is seen in 2012, when the company started the year with just 103 stores. As a result of nine store openings, and the acquisition of another 37 stores, the company ended the year with 148 stores. At the same time comparable-store sales growth accelerated towards 9.7% while the average size of a store increased towards 27,500-square feet. Sprout continues to target strong revenue growth through comparable sales growth and store openings. For 2013, Sprout aims to open 19 new stores.

While the organic growth rates, store openings numbers and acquisition-driven growth remains impressive, net profit margins are still rather low at 1.2% of total revenues.

The current valuation is way too high for my taste. First of all, the revenue multiple of 2.9 times annual revenues represents a 70% premium to market leader Whole Foods. On top of that comes the inferior profitability as Sprout generates earnings, which amount to just 1.2% of total revenues, compared to 4.0% for Whole Foods.

While Sprout's normal operations report decent comparable sales growth and increase revenues at a healthy pace by store openings, the current valuation is too high. The company trades at a significant premium to market leader Whole Foods, while Sprout still has to prove itself in terms of profitability.

The great opening day returns implies that Apollo and other investors have left money on the table, otherwise they would have priced the public offering at a higher level. Given that Apollo continues to hold a 45% stake in the business post-IPO, some persistent selling pressure might continue in the coming months and years. This selling pressure does not bode well in combination with an excessive valuation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.