Since its August IPO, Sprouts Farmers Market (SFM) shares have soared 158%. Even assuming Sprouts is able to grow sales 20% per year while achieving 7%+ operating margins, at today's prices Sprouts is selling for a whopping 53x 2014 EPS and 42x 2015 EPS. It's enterprise value to expected 2013 sales is a whopping 2.9x. At this valuation, shareholders are assuming that 1) Sprouts can grow at a very fast rate for the next 5+ years and 2) that Sprouts can maintain its industry leading margins. Are these reasonable assumptions?
To be sure, Sprouts has fewer than 170 stores - located mainly in the Southwest (California represents 44% of stores today) versus nearly 400 at Whole Foods and Trader Joe's and over 1,000 for Safeway. Thus the company has a long way to go before it has fully saturated its market. Similarly, the company has had a strong tailwind of same-store sales (which management says have been positive for over 6 years) and registered a whopping +10.8% YoY in the second quarter and expects to be up 8.5-9% for the 2013 full year (management guides to 6% thereafter). Another positive is that there seems to be no end in sight to healthy eating trends - this is Sprouts' target market.
While margins were just 2% or so prior to acquiring Sunflower and Henry's stores, in 2012 Sprouts reported 4.5% margins (though there were likely some acquisitions costs embedded in this figure) and has done 7% in the first half. In a recent management presentation, the company guides that it expects further operating leverage and increased margins going forward. While 7% is a far cry from the 2-2.5% earned by traditional grocers like Safeway (SWY) and Kroger (KR), it is in-line with health food grocers like Whole Foods (WFM) and The Fresh Market (TFM).
The competitive environment for grocers, even natural food grocers like Sprouts appears to be getting significantly more competitive. While Tesco recently sold the struggling Fresh & Easy chain to Yucaipa, a private equity fund focused on retail, it seems that there is a strong possibility that these stores will be converted to a natural food concept under the Wild Oats brand. These stores which would be targeting precisely the same consumer Sprouts is pursuing. To make matters worse, 2/3 of these stores are located in California - creating a credible new competitor in Sprouts' largest market virtually overnight.
Similarly, Wal-Mart (WMT) introduced its neighborhood market concept into California starting in 2012 and is already operating more than 30 stores in the state. Neighborhood market is also expanding in other key Sprouts markets such as Texas and Arizona. The Neighborhood Market concept is a small box, low priced offering featuring low priced produce. Sprouts uses low cost produce to draw customers into its stores in hopes of selling them other higher margin items.
Whole Foods is a threat as well. While Sprouts has long competed against the upmarket chain, WFM has announced that it is looking to nearly triple its store count (by adding up to 50 stores per year) and is continuing to add stores in Sprouts key markets. Potentially worse, Whole Foods is working hard to change it's 'Whole Paycheck' perception and is reinvesting purchasing savings into lowering prices. Additionally, The Fresh Market opened five stores in California earlier this year and is adding another three by year end. This company offers customers a very similar proposition to Sprouts and is trying to maintain a rapid growth rate to appease its shareholders (note that when it failed to meet expectations earlier this year shares plummeted - falling 42% from their 52 week high achieved just 6 months prior).
In addition there are numerous private chains in Texas and the Southeast catering to healthy eaters which are expanding their numbers at a good clip. With 0% interest rates and a bubbly equity market, this is a great time for these companies to raise capital to fund a more rapid expansion (and indeed more than a few have). Similarly, while customers in the Southwest clearly like Sprouts, regional taste differences could spell trouble as it expands beyond its home market. Further, retail is laden with logistical and operational pitfalls - stumbles seem to be the rule rather than the exception.
While Sprouts may well achieve its financial objectives in the next 3-12 months, looking out 2-3 year the competitive landscape promises to be more difficult both in its existing markets as well as new markets (which are needed to meet long-term growth objectives underpinning the stock's valuation). Should competitive conditions cause same store sales to slow and force the company to lower prices to maintain competitiveness, we could see growth falter and operating margins decline. A decline in growth and margins would likely cause investor's to put a lower multiple on the stock. Were growth to be 15% per year and operating margins closer to 5%, it is unlikely investors would be willing to pay much more than 20x EPS (still a 50% premium vs. the 13x at which Safeway and Kroger trade). This could result in stock price of $15 which represents a 68% decline from today's prices. If things go perfectly, the stock looks fairly valued. In my view this is a highly asymmetric situation - it represents return-free risk.
I am short SFM.