Sprouts Farmers Market: Recent Pullback a Buy Opportunity (NASDAQ: SFM)

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Investment thesis

Sprouts Farmers Market (NASDAQ:SFM) is an attractive investment opportunity. The stock has provided lackluster returns over the past 5 years against the S&P 500, and is now trading below its first-day closing price of $40 per share. However, there are good reasons to believe that the trend will reverse. SFM is launching a new store format and expects unit growth of 10% per year from 2023. Another factor that should lead to outperformance is cheap valuation. SFM trades at ~10.6x LTM free cash flow and ~11.4x LTM earnings. I believe SFM offers a good risk-reward opportunity at the current price.

SFM share price

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Company details

Sprouts Farmers Market, Inc. is a food retailer. The business operates as a grocery store that offers fresh, natural and organic foods including fresh produce, bulk foods, vitamins, packaged groceries, meat, seafood, deli meats , baked goods, dairy products, frozen foods, body care and natural household products. items that meet consumers’ interest in health and well-being. The company classifies the varieties of products it sells as perishable (57.2% of fiscal 2020 revenue) and non-perishable (42.8% of fiscal 2020 revenue). As of October 2021, SFM operated 366 stores in 23 states.

The market opportunity

The organic food market includes sales of organic food, beverages and related services. Organic food production involves practices that promote ecological balance and aim to conserve biodiversity. These food products generally do not use any food additives.

The global food and grocery market size was valued at $11.7 trillion in 2019 and is projected to grow at a compound annual growth rate of 5.0% from 2020 to 2027. biologics represents only a small fraction of that and is expected to grow at a CAGR of around 13.5%, growing from $201.77 billion in 2020 to $380.84 billion in 2025. The main reasons for this growth are the growing health concerns due to an increasing number of cases of chemical poisoning around the world and increasingly health-conscious consumers.

In the United States, the organic food market is estimated at around USD 56.4 billion and is expected to grow at a CAGR of 4.5% to reach USD 70.4 billion by 2025. The major factors driving this market are growing awareness and growing availability through over 20,000 natural products. food stores and conventional grocery stores across the country.

Business strategy

SFM was originally created for health enthusiasts and experienced seekers. These days, the company covers a wide range of incomes and age brackets, from Gen Z to baby boomers. According to SFM, the company is targeting a $200 billion market.

Sprout Growers Market - Opportunity

SFM Investor Platform

SFM stores are designed to provide an excellent customer experience. The typical store has a small box size, usually between 28,000 and 30,000 square feet. Going forward, the company aims to further reduce the size to a range between 21,000 and 25,000 square feet to allow for fast in and out service. Also, the cost of building new stores will come down with the new format, and as new stores become more profitable, I think it will make new openings easier.

Sprouts Farmers Market - Innovative Products

SFM Investor Platform

SFM sources its supplies from national and international suppliers. The company has built a strong relationship with suppliers and now has a competitive advantage to offer high quality products at lower prices than conventional organic food retailers. Additionally, the company has its own private label products, which are generally sold under the Sprouts brand. These products accounted for approximately 16% of FY2020 revenue and SFM is continually expanding the breadth of Sprouts branded products (approximately 3,500 products available in SFM stores).

SFM sources and distributes almost all of its products itself. As part of its long-term growth strategy, SFM is creating an advanced supply chain and aspires to locate its distribution centers within 250 miles of its stores. SFM currently has 7 distribution centers: two of them are located in California and one in Arizona, Texas, Georgia, Colorado and Florida. The last two distribution centers were opened in 2021.

Sprouts Farmers Market - high growth retailer

SFM Investor Platform

SFM competes for consumer spending in a highly fragmented market that encompasses a wide range of food retailers, including large conventional supermarkets, warehouse clubs and small grocery stores. SFM competes with traditional retail giants like Kroger (NYSE:KR)Albertson (NYSE: ACI)or Whole Foods, and also with online retailers like Amazon (NASDAQ:AMZN).

From fiscal 2016 to fiscal 20, SFM managed to steadily grow revenue from $4,046 million to $6,469 million at a CAGR of approximately 10%. This was due to a positive mix of low-single-digit same-store sales growth coupled with unit growth. From FY16 to FY19, same store sales growth averaged 2.2% per year, while the number of stores increased from 253 in FY16 to 366 in Q3. ‘EX21. Going forward, SFM is betting that the new store format will lead to unit growth, low single-digit same-store sales and a higher EBIT margin. In my opinion, I think the potential is there for 10% unit growth going forward. However, my main concern is with the comparable store sales numbers, which have been very weak for the past three quarters. If the company is able to achieve low single digit same store sales as directed by management, I am quite confident that SFM will be able to achieve revenue growth of 10% per year.

Sprouts Farmers Market - Long Term Strategic Financial Goals

SFM Investor Platform

In terms of profitability, management expects higher EBIT margins in the future. However, I don’t see a clear catalyst that will lead to improved profitability, although I think the new store format can play an important role. That said, I would be cautious about expanding margins at this point given that this is a highly competitive industry with low barriers to entry. From a historical point of view, the company managed to improve its gross margin. However, the operating margin stagnated around 5-6% and even declined to a low of around 4% in FY19.

Sprout Farmers Market Stock

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Business valuation

Based on 114.2 million shares outstanding and a price of $27 per share, the company has a market capitalization of approximately $3.08 billion. In this part, I used a discounted free cash flow model to value the business. The following assumptions were made in the model:

  • Free cash flow estimated at $200 million for FY22, based on Wall Street estimates.
  • Growth rate of 8% over the next four years to FY25.
  • A terminal growth rate of 2%.
  • A discount rate of 7%.

Valuation of SFM shares

Author’s model

Based on the model, I found a value close to ~$41 per share. Considering the current price, SFM is undervalued in my opinion. Also, I think my model provides a conservative number since I didn’t take into account any takeovers the company is doing. Also, I think SFM can achieve a higher level of free cash flow in FY22, given that the business has already generated about $227 million in the first three quarters of the fiscal year. 21.

SFM stock

Refinitiv Eikon

Key points to remember

In summary, SFM has an attractive business model which should continue to provide stable cash flow. I think revenue could reasonably grow 8-10% per year over the next 5 years as the business focuses on delivering a new competitive store format. I like that the company returns capital to shareholders through share buybacks, which are done by management at a fair price. In terms of valuation, I think the stock is well priced to deliver a long-term return of over 7% per year.

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