Sprouts Farmers Market: Improving Profits In A Growing Market Creates Shareholder Value

Summary

Given the company’s strong market position and cheap valuation, we continue to see upside in the stock.

This company is more profitable than it was pre-pandemic and is expanding its reach in the fast-growing health and wellness and natural/organic grocery markets.

The demand for health and wellness products, along with natural and organic products, is growing at a rapid pace that provides Sprouts a long-term runway for growth.

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krblokhin/iStock Editorial via Getty Images Despite missing top-line estimates in 3Q21 and giving back some of the pandemic-induced sales of 2020, this company is more profitable than it was pre-pandemic and is expanding its reach in the fast-growing health and wellness and natural/organic grocery markets. Sprouts Farmers Market (NASDAQ: SFM ) remains a Long Idea. Sprouts Farmers Market Has Very Attractive Risk/Reward

We made Sprouts a Long Idea in November 2020 , and the stock has underperformed the market by 10% since then. However, given the company’s strong market position and cheap valuation, we continue to see upside in the stock.

Figure 1: Long Idea Performance: From Date of Publication Through 11/9/21 Sources: New Constructs, LLC and company filings What’s Working:

Sales Remain Up from 2019 and Shoppers Are Spending More. Sprouts Farmers’ Market beat bottom-line expectations, despite missing top-line estimates, as sales slowed from record levels seen in the prior year period when grocery sales soared amidst lockdown orders and rising COVID-19 cases. Despite falling from 2020 highs though, 3Q21 revenue is still up 5% over 3Q19.

Compared to 2019, Sprouts notes that customers are buying more products per purchase and paying higher average prices via “a combination of mix, fewer promotions, and inflation.”

Going forward, management expects sales to grow “in the low- to mid-single digits” year-over-year (YoY) in 2022.

Margins Remain 2 nd Only to Amazon. Other grocers with more commoditized offerings may struggle to maintain margins as inflation rises. However, Sprouts notes that outside of certain protein products, it has been “able to pass on what’s been passed on to us”, which is why net operating profit after-tax (NOPAT) margins of 5.5% over the trailing twelve months (TTM) remain higher than any year of our model.

Additionally, Sprouts’ focus on local sourcing means the company has a powerful negotiating position over much smaller suppliers to which Sprouts is a “big customer.” Per Figure 2, Sprouts’ NOPAT margin ranks above all competition except for Amazon (NASDAQ: AMZN ), whose margin undoubtedly gets a boost from its software/cloud business.

Figure 2: Sprouts’ NOPAT Margin Vs. Competition Sources: New Constructs, LLC and company filings

New Store Format Helps Maintain Margin Improvement. Any further increase to the cost of its products can also be mitigated with the roll out of Sprouts’ updated store format. The new stores aim to tap into the “farmer’s market” experience Sprouts is known for and expand frozen and refrigerated offerings.

The new stores cost on average 20% less to build largely due to 50% lower cost in deli fixtures and 50% lower cost in protein fixtures. Additionally, Sprouts estimates the smaller stores cost on average 20% less to operate due to lower rent and reduced labor costs from the addition of self-checkout.

Most importantly, despite being smaller in size, the more efficient layout means Sprouts is not reducing the number of products sold, and management expects “sales to be at least equal to the larger boxes we built in the past.”

Store Growth Increases Market Reach. Sprouts Farmers Market has improved profitability while continually expanding its store count. From 2013 through the end of 3Q21, Sprouts has grown its store count 10% compounded annually. The firm plans to open nine new stores in 4Q21 and another 25-30 stores in 2022. Increasing its return on invested capital (ROIC) (from 7% in 2013 to 12% TTM) while also growing its store count at a high rate is no small feat. Very few companies are able to achieve growth and improve ROIC at the same time.

Private Label Also Aids Profitability. Sprouts’ private label business helps differentiate it from the larger box retailers, while boosting profitability. The company notes its private label products also provide customers with “lower prices while still delivering generally higher margin as compared to branded products.” Sprouts’ private label products as a percent of revenue have grown from 10% in 2016 to 16% in 2020. Ecommerce Gains Have Persisted. In 3Q21, ecommerce sales made up 10% of […]

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