Tuesday, October 31, 2023

Sprouts Farmers Market, Inc. (SFM)

Sprouts Farmers Market, Inc. (SFM) is a grocery store chain headquartered in Phoenix, Arizona that specializes in natural and organic foods. The company has 401 stores in 23 states, but the majority of them (so far) are in California (139), Texas (50), Arizona (45), Florida (44), and Colorado (33). Here is how management described the business on this quarter's earnings call:

We are a specialty food retailer. We curate products that contain attributes appealing to the health enthusiast customer. For example, in proteins, more than 50% of our beef sales are grass-fed, more than 50% of our chicken sales are organic, and 90% of our grocery sales have specific diet attributes such as vegan and non-GMO. Even in produce, which many consider a commodity, over 40% of our sales are organic.

The Sprouts stores are extremely well run and well merchandised, putting pressure on the tired old grocers that are owned by Kroger and Albertsons. (Imagine how much more run down those companies' stores will become if their merger happens.) And the business generates free cash flow even while expanding, which the company has been using to cannibalize its own shares. Since 2015, Sprouts has grown its store count from 217 to the current 401 while shrinking its share count by almost 40%.

Giving customers the best experience while allocating capital for shareholders' benefit has gotten our attention. Let's look at recent results:

During the first nine months of 2023, Sprouts did $5.1 billion of sales (up 6.4% y/y) and generated $409 million of cash from operations (8% FCF conversion), spending $178 million on capital expenditures and an acquisition (compared with $198 million of depreciation and amortization), while paying off $100 million of debt, and repurchasing $180 million of stock. They have decreased the share count by 3.3% year-to-date.

The market capitalization is $4.3 billion and the enterprise value is $5.8 billion. That gives a FCF/EV yield of 4% and a (potential) shareholder yield on the market capitalization of 6.5%. Reported net income per share (diluted) is $2.01 for the year-to-date, which gives a P/E ratio of 16x.

Sprouts is on track to open 30 new stores this year. Management have said in the past that new stores cost about $4 million and they start out at $13 million in sales at break even margins, doing $16 million at an 8% EBITDA margin (so $1.3 million EBITDA) by year four. That gives a 33% EBITDA return on new store openings.

Sprouts is not the cheapest stock, but they are doing so well operationally and they have lots of room to grow. Our impression is that the big chains are neglecting their customers who like to cook, and neglecting operations generally, since they have locked in very low rents. Sprouts ought to be able to keep taking share from the big, obsolete grocers.

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