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As the popularity of organic and fresh grocery stores has risen in recent years, numerous grocers have gone public as their popularity has risen. One such recent initial public offering was that of Sprouts Farmers Markets (NASDAQ:SFM), a natural and organic grocer established in 2002 that targets customers seeking affordable specialty and fresh groceries. While the concept of providing an affordable outlet for higher-quality groceries is appealing, the stock appears to be a bubble ready to pop at any moment. Although I am a frequent shopper of Sprouts, I do not recommend buying the stock anytime soon for a variety of reasons.

Financials
In order to understand the underlying figures behind this overinflated stock, we should examine the financial data. On November 7, 2013, the company reported earnings for the quarter ended September 29, 2013--the third quarter of 2013. The numbers were quite promising:

  • A 24% increase in sales over 2012 to a figure of $633.6 million
  • Diluted earnings per share of $0.08 cents and adjusted diluted earnings of $0.13 cents per share, compared to $0.01 cents and $0.06 cents per share in 2012, respectively
  • Comparable store sales growth of 10.2% and the opening of seven new stores in three different states, adding up to growth of 13% for 2013 in terms of new store openings
  • $9.5 million pre-tax dollars paid towards debt extinguishment, reducing the company's total liabilities to $696.2 million from $716.5 million in 2012

If these figures were not enough, the company increased their financial outlook for 2013 on almost every factor, including modest increases in expected income, earnings per share, and same-store sales growth for the remainder of the year. Sprouts has every reason to be optimistic as the outlook and hard figures support an optimistic future full of growth, and the company is doing extremely well. Normally, this would stink of a screaming buy, but there is more to the story.

Wait for the Bubble to Pop

The company is doing great in practice and on paper. However, the stock should definitely be avoided, and sold immediately if you are the owner of shares.

First, the stock currently trades at a growth premium, with the price reaching nearly 130 times earnings. Obviously, the projected rapid growth of the company is already factored in, and the stock is starting to crack. After reaching an all-time high of over $49 on October 21, 2013, the stock has since lost around 10.5% in value, closing at $43.05 on November 15, 2013. This includes a 7.6% loss since the company reported earnings on November 7th, and the stock has since continued to drop without a break. With such an enormous price to earnings ratio, there is no certainty regarding a justifiable price to finally "rest," meaning the stock may freefall further or turn around abruptly with no rhyme or reason. Hope alone--to either head back up indefinitely or to simply stop falling for you to potentially time a purchase-- is never a good investment strategy.

Second, the company's growth is far more modest than such a P/E ratio would reasonably justify, and the stock price, with no evidence of a split planned in the foreseeable future, is far too high to provide room for price appreciation. To compare, competitor Whole Foods Market (NASDAQ:WFM) first debuted on the Nasdaq in 1992. In this time, the split-adjusted price has risen over 40 times to its current price of around $58, with a $0.48 cent annual dividend. Whole Foods Market has 367 stores as of November 18, 2013, with over $12.9 billion in sales for 2013. Sprouts has approximately 160 stores as of the same date, with only $1.8 billion in sales for the thirty-nine prior weeks of 2013.

I feel it is naive and simply a shot in the dark to conclude the current stock price is justified when compared to the 360+ stores and nearly $13 billion in sales Whole Foods has. Further, it is important to consider a somewhat weak business model upon which Sprouts operates. The grocer focuses on providing cheap produce with small profit margins as its main product, while marking up other non-produce products with higher profit margins. To prove this, I compared prices for the week of November 10, 2013 between a San Francisco Bay area Sprouts to a similarly located Safeway (NYSE:SWY). Small avocados from Mexico, for example, were only $0.67 cents in Sprouts, while the same sized avocado was over $1 at my local Safeway . The same goes for $0.49 cent bell peppers at Sprouts with the equivalent being a $0.98 cents at Safeway. Clearly, Sprouts is the winner. However, most other goods, including packaged dairy products, toiletries, and even butcher meats were noticeably higher in price, such as a tooth brush being advertised on page 8 of the Sprouts November specials as $3.99, yet a similar basic manual toothbrush coming in a double-pack for $2 at Safeway. The Sprouts "Frequently Asked Questions" section of their official website confirms this business model, when asked, "How is Sprouts able to keep its fresh produce prices so low?":

...because we are a farmers market store, we focus on produce, and are willing to accept lower profit margins on fruits and vegetables than most other stores.

I personally shop at Sprouts only for produce due to the low prices, thanks to the low profit margins. For everything else, I head to Safeway, and, concerningly, I am not a rarity. To quote further from the website:

We are larger than many independent stores, and we sell a higher percentage of produce than most larger chain stores.

Essentially, the company sells more of a low-profit item than chain stores, such as Safeway, while marking up its lesser-selling items, being non-produce products. It is difficult to picture that such a business model can someday allow financial figures needed to justify a present-day 130 price to earnings ratio and a $45+ stock price in less than a year of going public. I am especially weary considering that Sprouts main strength is its cheap produce and marked up non-produce items.

Conclusion

In summary, Sprouts is a great place to shop if you are interested in fresh produce at cheaper prices. However, the stock is a different story, with overinflated ratios and an unreliable stock price killing any potentially to safely invest at this time. I recommend waiting until the share price decreases and further earnings reports justify such lofty growth prospects.

Source: Sprouts Farmers Market's Stock Price Should Wilt Before You Buy