Sprout’s Turnaround is Unlikely to Result in Much Profitability Improvement Due to Competition

Business Strategy & Outlook:

Sprouts has capitalized on a natural, health-oriented positioning aligned with culinary trends, but the company believes it faces a competitive onslaught as conventional grocers, mass merchandisers, hard discounters, and online sellers target the same themes. Without the cost leverage of the largest grocers, Sprouts will face continued intense price pressure. Amazon’s 2017 purchase of Whole Foods remains a threat, as the digital juggernaut’s procurement strength and distribution efficiency can fuel price cuts that upend Sprouts’ value proposition (a produce-oriented store featuring fresh, affordable items). Sprouts has room for store growth, but the company believes the ensuing cost leverage will need to be used to keep pace with price cuts in an industry favoring larger firms that can spread fixed costs and omnichannel investments over the broadest possible sales base.

Sprouts relies on Instacart for its delivery and click-and-collect efforts. While the partnership is prudent given Sprouts’ size, it imposes costs that larger firms can mitigate by fulfilling digital orders internally. Delivery can extend Sprouts’ appeal to customers that do not regularly drive past a store, but the channel is margin-dilutive even for firms that are able to scale costs over a much larger sales base. Although the COVID-19 outbreak has lifted near-term demand as shoppers spend more time at home, increased digital transactions could linger, shifting sales into a less lucrative channel long term. New leadership began revitalization work in earnest in early 2020, attempting to stabilize declining operating margins (6.8% in 2014 versus 3.9% in 2019) and optimize an inefficient expansion strategy. While it is expected that the management will hit its long-term low-single-digit comparable sales growth goal, its low-double-digit adjusted EPS expansion target will be harder to achieve, even after considering share buybacks (forecast is in the mid- to high single digits). Nonetheless, the efforts should provide ammunition to fight unending price battles against intensifying competition as large retailers encroach on Sprouts’ natural and health-oriented turf.

Financial Strengths:

Sprouts’ financial health strikes us as sound. Net debt was around 1.4 times adjusted EBITDA at the end of fiscal 2019, before the pandemic-related sales spike nearly erased Sprouts’ net debt by the end of fiscal 2020 (with a similar outcome at the end of fiscal 2021) Sprouts will continue to open stores, although management slowed growth in fiscal 2020 as it optimized new unit size and layout. Company foresees mid- to high-single-digit percentage unit count expansion annually over the next decade, with Sprouts exceeding 700 stores (from 374 at the end of fiscal 2021). Store opening costs are modest (roughly $3.6 million net cash investment for the average new unit; the number should dip to around $3.2 million as new management favors smaller, simpler locations), and Sprouts to fund its growth internally. Company expects capital expenditures to average 3% of sales long term. Despite the growth, free cash flow to the firm should average 2%-3% of sales long term (similar to fiscal 2019’s 3.2%; 2020-21’s 5% average mark was inflated on account of the pandemic) amid intense competition. Sprouts enjoys flexibility as it can adjust store growth plans to suit market conditions; while it spent $81 million in fiscal 2021 on capital expenditures (net of landlord reimbursements), it is suspected that about half was for new stores, leaving roughly $40 million for sales initiatives, remodels, infrastructure, and maintenance (which is sufficient as its stores are fairly new). It is anticipated that management will direct excess cash to share repurchases. The model assumes 45% of operating cash flow is dedicated to buybacks long term. Sprouts could also consider bolt-on acquisitions to accelerate its store growth; the forecast does not incorporate such transactions due to their uncertain timing and nature.

Bulls Say:

Sprouts’ health and value-oriented concept is on trend, consistent with customers’ desire to eat foods that are less processed and contain more naturally derived ingredients.
As a fairly new chain, Sprouts’ relatively small stores feature layouts that are consistent with newer consumer demand trends, such as centrally located fresh produce and robust prepared food and grab-and-go offerings.
Sprouts has ample room for growth as it boosts its penetration in existing markets and extends its footprint elsewhere in the United States.

Company Description:

Sprouts Farmers Market is an American specialty grocer offering an assortment highlighting fresh and naturally derived products. Its offerings are especially focused on produce, which constituted around 21% of sales in fiscal 2021. Founded in 2002, the chain is most heavily concentrated in California, which accounted for over one third of its 374 stores as of the end of fiscal 2021. All of the company’s operations are in the United States, with its stores largely located in the southern half of the country. The firm sells roughly 20,000 products (of which around 70% are attribute driven, such as organic, plant-based, or catering to the keto or paleo diet), with private-label products accounting for about 16% of sales in fiscal 2021. Perishable items accounted for 58% of fiscal 2021 sales.

(Source: Morningstar)

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