The Value In Organic Sprouts

| About: Sprouts Farmers (SFM)
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Summary

Sprouts’ net income grew from $45.39 million in September 2013 to $99.23 million in September 2014.

Sprouts’ net sales increased by 21% between third quarter 2013 and third quarter 2014.

Sprouts undercut Whole Foods’ prices on 148 name brand organic items by 13%.

Sprouts has been able to undercut Wal-Mart and Kroger’s prices on some produce by as much as 25%.

Despite its success, Sprouts could be expanding too fast.

Sprouts Farmers Market (NASDAQ: SFM) is the value play in the organic grocery sector that you may not have heard of. For those of you who are unfamiliar with it, Sprouts sells a selection of foods similar to Whole Foods Market (NASDAQ: WFM) at considerably lower prices.

Sprouts' business model is to try to give consumers the kind of prices on organic groceries that pay for regular groceries at traditional supermarkets such as Kroger (NYSE: KR). Unlike Whole Foods, Sprouts also employs some traditional grocery marketing tactics such as newspaper inserts, newspaper advertising, and weekly specials to attract customers. Another big difference between Sprouts and Whole Foods is that Sprouts, like Kroger, engages in some deep discounting. Sprouts' financial numbers indicate that strategy seems to be paying off.

Sprouts' Business Model Pays Off

Sprouts reported a TTM revenue of $2.309 billion in September 2013 that grew to $2.841 billion in September 2014. Sprouts also reported a net income of $45.39 million in September 2013 that more than doubled to $99.23 million in September 2014. Not bad for a modest grocer that only operates around 190 stores in 10 states.

Whole Foods reported a TTM revenue of $12.92 billion in September 2013 that grew to $14.19 billion in September 2014. Whole Foods reported a net income of $551 million in September 2013 that grew to $579 million in September 2014. Whole Foods operates 385 stores in the U.S., 10 stores in Canada, and nine stores in the United Kingdom.

Revenues and income are not the only things that are growing at Sprouts. Between third quarter 2013 and third quarter 2014, its net sales increased by 21%, or $766.4 million. Adjusted net income increased by 41% during the same period.

What's even more astounding is that comparable sales growth in Sprouts stores that had been open one year was 9% between third quarter 2013 and 2014 and sales growth in stores open for two years was 19.2% in the same period. The sales growth translated into a gross profit of 19% for third quarter 2013 and a gross profit margin of 29.5%.

How Sprouts Does It

Sprouts' success is based upon old-fashioned deep discounting-simply giving customers the lowest prices possible on produce and organic items. The strategy is paying off well in this era of stagnant incomes, tight middle class budgets, and concern about health.

Sprouts undercuts Whole Foods by 13% on 148 brand name items, Bloomberg reported. Sprouts has also been able to undercut Kroger's and Wal-Mart Stores Inc.'s (NYSE: WMT) prices on some produce items by as much as 25%.

The produce prices act as a loss leader to draw in middle and working class customers that want organic fare but cannot afford to shop at Whole Foods. It also puts Sprouts in a position to take advantage of a growing market: organics, supplements, and natural food. Kroger's private natural food label, Simple Truth, has grown into a $1 billion brand in less than two years.

Is Sprouts Growing Too Fast?

There is a potential problem at Sprouts: it could be growing too fast. The company's CEO, Doug Sanders, told Bloomberg that the chain has plans to grow to 1,200 stores, or about three times the size of Whole Foods, in 15 years. Sanders would like to see Sprouts grow by around 14% a year for the foreseeable future.

If that came to pass, it would make Sprouts a major player in the grocery business, comparable to Kroger, which operates 2,631 grocery stores in 34 U.S. states. Kroger reported a TTM revenue of $106.48 billion and a net income of $1.632 billion on October 31, 2014.

Yes, that could equal big revenues, but it could also equal big trouble. One is reminded of another discounter that expanded way too fast: Family Dollar Stores Inc. (NYSE: FDO). The dollar store operator grew to 7,600 locations in recent years before revenue growth came to a screeching halt earlier this year. Since then Family Dollar has had to close 370 stores, and its management team is trying to sell the company to Dollar Tree Stores (NASDAQ: DLTR) in a desperate bid for survival.

Sprouts Faces Serious Competition

Sprouts faces some huge obstacles in its expansion bid, including Kroger, which is making a big push into the organic sector. In addition to a deep discounting capacity that rivals Sprouts, Kroger offers amenities that Sprouts does not. These include 2,107 in-store pharmacies and 1,293 supermarket fuel centers. That gives time-strapped soccer moms another incentive to shop at Kroger.

Wal-Mart, which also operates gas stations and pharmacies at its supercenters and neighborhood markets, is also making a big push into organics. The behemoth from Bentonville has added Wild Oats organic products to its inventory.

Another massive competitor that could stand in Sprouts' way is Costco Wholesale (NASDAQ: COST), which is now America's second largest retailer. Costco's organic price list now contains hundreds of items, according to the Naturalthrifty.com blog. Like Wal-Mart and Kroger, Costco also operates gas stations and pharmacies at its stores.

Sprouts is an intriguing value play, but it's also taking some huge risks as a company. It is expanding aggressively in a highly competitive sector that includes some very aggressive rivals. It will be interesting to see if Sprouts can survive with its deep discounting strategy.

Disclosure: The author is long KR.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.