Sprouts Farmers Market – Can a boring company can be a good investment? $SFM

Sprouts Farmers Market ($SFM) is quite a boring company. However, boring companies can turn out to be great investments. Is SFM one of them?

The goal of this post is to analyze the company's fundamentals and provide insights into the business fundamentals, financials as well as valuation. Feel free to disagree with the analysis and share your views.

Let's get started!

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What is Sprouts Farmers Market?

In a nutshell, it is a grocery store chain featuring an open layout with fresh produce at its heart. The company sources the produce locally which makes it less exposed to certain global supply chain issues. One of the components of its business model is its distribution centers. The produce from the local farmers initially goes to these centers and then is delivered to the individual stores. They aim to have one within a 250-mile (400 kilometers) radius of all of their stores. Currently, that's the case for 85% of their stores.

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How does a grocery store chain grow?

I always try to simplify the way companies bring revenue in. In this case, the revenue would be equal to the # of stores multiplied by the ARPS (Average revenue per store), plus the eCommerce sales (currently 10% of the total revenue).

Let's start with the number of stores. This number grew from 285 at the end of 2017 to 374 at the end of 2021. This net increase of almost 90 stores is outstanding, especially if we take into account that they've closed only 3 stores during the last 5 years. The company is doing a great job choosing good locations. As the growth depends hugely on the success of opening and operating new stores, this is a positive indicator.

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Based on the available numbers, the revenue per store is flat for the last 5 years (a bit over $16m/store). However, this can be a bit misleading, especially since the company is focused on decreasing the store size from 30k square feet (2.8k square meters) to 23k square feet (2.15k square meters). Smaller stores would require a lower initial investment and come with lower operating costs. Hence, we cannot make any conclusion on the information that the average revenue per store is flat over a 5-years period.

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Key financial and operating points

• The revenue has increased from $4.7b in 2017 to $6.1b in 2021, an almost 7% average annual increase. During the same period, the gross margin increased from 34% to 36%, and the operating margin from 4.8% to 5.5%. The industry is known for having low margins, so we cannot forecast a substantial increase in this area. The management is aiming for a 6% operating margin, which is not far from the current level.
• What I personally find very interesting about the company is the development and improvements around their inventory management. The inventory turnover has improved from 13.5x to 14.7x and the average inventory per store has decreased from $0.81m to $0.71m (let's not forget, the average revenue/store remained flat).
• It is worth mentioning that roughly 16% of the company's revenue comes from their private label offering (Sprouts branded products). These products allow them to charge less to the final customer, yet the margins are either same or higher.
• Since 2015, 52m shares have been repurchased ($1.2b) leading to a 34% reduction of shares outstanding. The management has almost $600m remaining in the authorized repurchase program.
• As of Q1/2022, the company had $300m in cash, $250m in long-term debt, and $1.3m in capital leases.

What's ahead of the company?

The management is forecasting revenue growth of around 4% for 2022 but is aiming to grow the number of stores by 10% as of 2023. This is a big target, which means roughly 40 new stores are to be opened in 2023.

The valuation

I used a DCF model to estimate the company's value. The assumptions are listed below:

Revenue growth: 4% for the next 12 months, followed by 6% in the 4 years after that and declining over time to 3.16%.

Operating margin: To remain at the current level of 5.5%. The management is aiming for 6%, but they're not there yet. Could they reach that level? Absolutely! However, I am always using assumptions that the company can deliver with high probability. I'd rather be conservative than too optimistic and lose money.

Discount rate: Currently 4.84% (based on WACC – which is way too low due to its low beta), increasing to 10.9% over time (also due to the fact that the FED is raising the interest rate)

Outcome: $22.90 (Current share price $25.72)

*Note: In the DCF calculation, the outstanding equity options are also taken into account.

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What if my assumptions are significantly wrong?

Based on the assumptions stated above, the revenue will grow by 62% to $10b in the next 10 years and the operating margin remains at 5.5%.

Let's take a look at how the valuation of the company (per share) changes based on different assumptions related to the revenue 10 years from now and the operating margin:

Looking at the company's performance, I do like how it is evolving. It is growing through opening new stores and not through acquisitions, which makes it less risky as they're copying what is proven to be working. The inventory management has improved and the margins are looking great. Although I do not have a position in the company, I'll definitely consider opening one if the price drops below $20/share.

What are your thoughts?