Sprouts Farmers Market Is A Good Stock Despite Concerns About Margin Compression
Summary
- Sprouts Farmers Market is a strong niche grocer that has seen steady revenue growth over the years.
- The company's performance and efficiency metrics stack up well against more established competitors.
- The company's valuation suggests that there is a good margin of safety at today's price.
If you're from the USA (we're not), you are probably familiar with Sprouts Farmers Market, Inc. (NASDAQ:SFM). If not, here's a quick intro. Sprouts operates grocery stores that offer fresh, natural, and organic food products in the United States. As of January 03, 2021, it operated 362 stores in 23 states.
Thesis
We've read a few of the recent Seeking Alpha articles about Sprouts Farmers Market and the talk is often about its margins being in potential danger due to competition and not having a real moat. This has some people concerned about the company. To us, this would be concerning if the stock was expensive, but, it's not.
Our idea is that Sprouts Farmers Market is still a good stock at this price despite not having a great competitive advantage. Even if you are pessimistic on margins and expect them to drop, it is still not an overvalued stock based on its cash flows.
In this article, we'll give a brief overview of the business, compare it to peers, and do two different discounted cash flow valuations to show that there is still value in this stock even if margins drop a bit. Let's dive deeper.
Value Creation Strategy
Sprouts Farmers Market has had consistent and predictable growth in the past through expanding its store count. See its revenue below.
Rising revenue has also brought along a steady rising adjusted diluted EPS with it.
Source: Finbox
Here's how Sprouts plans on keeping this momentum going moving forward.
1. Unit Expansion
The company will continue to expand into more areas going forward and it expects 10% or more growth in units after 2021, with a slight slowdown (only opening 20 locations) this year due to COVID-19.
Source: Investor Presentation
2. Smarter Promotions
This quote from SFM's Chief Financial Officer in the most recent conference call was already quoted in a recent SFM article but it's worth showing again (please note that all other quotes in this article are also from the conference call):
If you think about what happened in the last few years, a lot of the promotion and promotion activity, which is trying to serve absolutely everyone and kind of everything, really wasn't working right? To put it really simply at this point what we're reverting back to is not running loss later promotions, because that's not the game we can win.
And what that was really doing was hurting both of our sales and our profitability with running those promotions, but not necessarily attracting the target customer that really would fuel the rest of the growth in the store.
Fundamentally we had cherry pickers. So ultimately, I think we believe that we can get back towards our IPO EBIT margins, which we clearly were able to do this past year. But we all recognize that part of that had a bit of COVID tailwind associated with it.
Sprouts Farmers Market was not running optimized promotions, and they've realized that. The company wants to target its core customers who fall into the two categories mentioned in the conference call:
First, our new brand and marketing program is vital to attracting more spend from our core customers. And while it was released in the fall, much of the heavy lifting occurred towards the end of last year.
Many of our customers today fall into one of two target customer segments, health enthusiast or experience seeker. However, we're only capturing a small percentage of target customers available in our markets due to low brand awareness.
Once those customers are acquired, they have a strong affinity to our stores as seen in our Net Promoter Scores. We started working with media partners one being Verizon, who has over 350 billion daily proprietary data signals at their fingertips.
The strategy makes sense. Focusing on core customers that are more likely to be engaged and spend more on the products that SFM offers is only logical. SFM's products are more expensive than products offered by grocers like Walmart and Costco, therefore, the people who are more likely to spend are the health enthusiasts and experience seekers, as the company claims. Many people that aren't part of the core audience mostly care about low prices/saving money.
Here are the Net Promoter Scores that management was referring to in the quote above. SFM does indeed have a strong customer affinity as you can see below. 70% are promoters while only 5% are detractors. This is among the best of the other examples shown.
Source: Investor Presentation
3. Optimizing Store Sizes
Management plans to go from 30k sq ft stores to 21-25k sq ft going forward. According to SFM, the benefits to this are as follows:
- Lower cost to build
- Reduce non-selling space
- Decreased occupancy cost
- Reduce operating cost
- Sales remain flat, despite downsizing
Sprouts claims that it can have roughly the same amount of offerings with smaller stores by taking away non-productive space. If the company can pull this off, this should generate a good amount of shareholder value going forward. SFM expects the first "ground-up new store format" to open later in the summer in Phoenix.
4. Improving The Supply Chain
The company wants to open more distribution centers this year. The Colorado one may already be open as the quote below is from late February but here's what the plan is:
We will open two new fresh distribution centers this year, one in Colorado next month and one in Florida in early summer. These openings will drive us closer to our goal of having our stores within 250 miles of our DCs to optimize our supply chain efficiencies and result in carbon savings of nearly 3000 metric tonnes of CO2 from reduced miles on the roads.
New distribution centers should allow for an improvement in shrink and overall product freshness.
5. Stock Buybacks
Sprouts Farmers Market is no stranger to buybacks, as the company has seen its share count steadily go down over the past 5 years.
We can expect buybacks to continue because in recent news, on March 4th, SFM announced a $300M share repurchase authorization that expires in 3 years from the start date. The company generates a lot of free cash flow and isn't trading at a high price, so spending some money on buybacks isn't a bad idea to drive shareholder returns.
Revenue is Forecasted to Grow
In terms of revenue growth, here are the analyst expectations. Besides this year, revenue should grow pretty consistently as it has in the past. Earnings growth will also come with revenue growth.
Source: Seeking Alpha
Comparing To Peers
Let's take a look at how SFM compares to other companies in the grocery sector. The peer group we chose consists of these companies: Costco Wholesale Corporation (COST), Walmart Inc. (WMT), Albertsons Companies, Inc. (ACI), United Natural Foods, Inc. (UNFI), The Kroger Co. (KR), Target Corporation (TGT), Natural Grocers by Vitamin Cottage, Inc (NGVC), Ingles Markets, Inc. (IMKTA), Grocery Outlet Holding Corp. (GO), and Weis Markets, Inc. (WMK).
Below, we have several metrics. We compared CFO and EBIT margins, 5-year average ROIC, 5-year estimated revenue CAGR, days inventory outstanding, days sales outstanding, and days payables outstanding. Here are the results:
Source: Author, using data from Finbox
Sprouts Farmers Market is better than average in every metric except for days payables outstanding. In every metric that it places above average, it comes in at top 3 or better. Basically, SFM is expected to grow more than most of its peers while having higher margins and returns on capital than most companies compared.
In regard to days inventory outstanding and days sales outstanding, those numbers are better when lower. A DIO of 23.71 for SFM means inventory is held for about 23.71 days before being sold, and a DSO of 0.24 means that the company takes less than 1 day to collect receivables.
Days payables outstanding is generally better when higher because it is the average number of days a firm has to pay its suppliers. This is the only category where SFM falls short, having only an average of 11.72 days to pay suppliers.
This DPO number could be interpreted in 2 ways. The first is that SFM might have lower operating leverage than its peers and thus is required to pay back its suppliers faster. The second way is that given its strong cash flows and very quick DSO, it's probably not due to a lack of operating leverage. Rather, it could simply be that the company chooses to pay its suppliers quicker because it can. We believe that the latter is more likely than the former.
Overall, based on these comparisons, it seems that Sprouts is an above-average company. Now, let's take a look at the valuation.
Valuation
With this valuation, we'll show you that SFM is good value, regardless of margins potentially shrinking in the future. The valuation was done using a 5-year DCF template from finbox.com. We'll show a bull case valuation and a base case one.
But first, here are the assumptions:
Discount Rate: 6.3%, taken from simplywall.st
Terminal Growth Rate: 2%
Tax Rate: 26% as per management expectations mentioned in the conference call.
Below is the capital expenditures forecast, in line with management expectations that you can find in the investor presentation:
Below is the net working capital forecast automatically generated by Finbox:
Below is the depreciation & amortization forecast:
The forecasts above will remain constant for the valuation. However, the revenue and EBITDA forecasts will be altered to show the bull and base case scenarios.
Here's the revenue and EBITDA forecast automatically generated from Finbox based on analyst estimates, and they are actually slightly lower than the analyst estimates shown on Seeking Alpha, which is something to note. Revenue is expected to grow to $9.16B by Jan 2026, and EBITDA is expected to be 7.3% of that, at $665M.
Keep in mind, those are analyst estimates, and they already factor in EBITDA margins going lower over the years from the most recent 8% margins. Regardless, these estimates spit out a fair value of $41.75/share.
Let's say, however, you're pessimistic on margins and expect them to fall lower than expectations. We'll do a valuation for that too. This scenario has margins slowly reverting back to pre-covid levels and eventually going lower (2019 EBITDA margins were 6.1%). EBITDA margins in this scenario drop to 5.9% by January 2026.
Regardless, with the more pessimistic estimates above, SFM is still trading near fair value. The current price at the time of writing is $26.10, while the valuation according to these estimates is still $26.20.
Some may argue that 6.3% is a low discount rate if their methods don't align with ours. Therefore, we decided to also show how high the discount rate would need to go for the bull case scenario to come close to fair value.
You would need a discount rate of 8.1% to get the value down to current prices. See below.
We don't necessarily agree with having 8.1% as the discount rate however. We think that the method simplywall.st used to get 6.3% makes the most sense. It was calculated as:
Risk Free Rate + (Levered Beta * Equity Risk Premium)
= 2.04% + (0.816 * 5.23%)
= 6.3%
Also, the "base" case scenario we came up with may not be that likely to play out. Management believes that they can keep margins at stable levels or even increase them going forward through the initiatives mentioned earlier. Therefore, we think the bull case is fairly reasonable.
Source: Investor Presentation
Conclusion
Sprouts Farmers Market was overpriced when it first IPOed years ago and has since seen its stock price come down while fundamentals have gotten mostly better. Regardless of the potential for declining margins going forward, the stock is now trading at what we believe to be an undervalued price or at least a fair price based on the two valuations above.
Overall, it is a good company compared to many peers, with a solid strategy for sustained growth going forward. If you believe that the company can somewhat maintain its margins going forward, then it is likely a buy.
This article was written by
Analyst’s Disclosure: I/we 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.
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Comments (11)
Interested in your insight, thanks.
