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Investment thesis
Sprouts Farmers Market (NASDAQ:NASDAQ: SFM) is an American supermarket chain specializing in fresh foods with a focus on healthy products. At the time it was thought that this would be a passing fad and During 2021/2022 it was trading at a P/E of 10 times, but it has submitted a re-rating as it shows that its concept works and it has better margins and growth than its competitors.
However, with a forward P/E of 31 times, I find it difficult to justify a buy at this point, so I think it's better to wait on the sidelines if you're not yet a shareholder and hold if you luckily become one.
Opportunity for expansion and relative quality
Sprouts has been undergoing rapid geographic expansion and with the 12 stores opened to date, management expects to reach 431 stores. to reach 450 this year.
While this is already more than 378 Albertsons storesstill has a way to go 517 Whole Foods and Kroger's nearly 2,900 stores. Especially considering that people increasingly want to eat healthier and are more aware of their diet, a concept as differentiated as Sprouts would have a lot of opportunity to grow.
Sprouts Investor Presentation
One sign that the concept is working is the gross margin, which is considerably higher for a supermarket and has remained that way consistently since 2020.
This is the advantage of offering products for which people are willing to pay a higher price because they consider that there is a benefit that justifies it (healthier eating). This is also reflected in the net margin, which has increased compared to 2020.
As a result of these higher margins, the company has also shown better returns on its investments than its competitors, which confirms the quality of the business and that we could treat it as a higher quality supermarket.
In recent quarters, the company has recovered its low double-digit growth and even during the second quarter of 2024, revenue grew by almost 12% annually. We will go into more detail on this later, but this has been one of the factors why the company has accumulated an extraordinary profitability of 112% YTD.
Second quarter of 2024: one rhythm after another
During the second quarter of 2024, the company not only increased its revenue by 12%, but it did so with comparable sales growth of 6.7% and beat analysts' expectations by 3%, which were already high. This is extremely positive because it shows that growth does not only come from building new stores, but that each store is becoming more profitable.
The CEO also had very positive words about the company's future and confirmed that the profile of the health-conscious consumer has had a lot to do with Sprouts' success and growth.
Our target customers, health enthusiasts, continue to respond positively to our differentiated product range and unique shopping experience. As consumer preferences shift towards healthier living, we anticipate There will be even more health enthusiasts in the future than those that exist today.
CEO Jack Sinclair on the Q2 2024 earnings conference call
One surprising finding was that net profit margin reached 5% compared to 3.95% a year earlier, well above analysts' expectations and one of the reasons that drove the stock price higher following the report. This improvement in margins appears to be due to good inventory management and sales mix, which has increased gross margin, as well as optimizations that have leveraged the supply chain, according to CFO Curtis Valentine.
| Estimate | Current | Win/Fail | |
| Revenue | $1.84 billion | $1.89 billion | +3% |
| EBIT | 108 million dollars | 127 million dollars | +18% |
| EPS | $0.78 | $0.94 | +20% |
This image makes it clear that this positive trend has been brewing for some time and could provide signs of the sustainability of current margins. Thus, between sales growth due to demand, improved margins due to operational efficiencies and the usual share buybacks, there are several levers to believe that EPS will continue to grow in the coming years.
Introducing Sprouts Q2
Valuation
While the business has demonstrated a lot of relative quality compared to its competitors, with high margins and notable growth, I don't know if this could justify the current valuation. In other words, I think we are looking at a stable and quality business valued as such, which does not leave much room for above-average performance.
The company is currently trading at a P/E of almost 33 times. In fact, it is quite striking that during 2021 and 2022 it was trading at around 10 times due to the uncertainty of whether this concept would be just a passing fad (it has been proven that it is not).
Walmart has shown us that a stable business like this can maintain a high multiple for a long time. So, looking at it another way, let's say that over the next few years we get 0% multiple expansion, 8% sales growth, 1-2% margin improvement, and 3-4% share buybacks. That would give a potential return of 12-15%, which wouldn't be too bad.
The problem comes if the company faces some temporary problem that brings with it a reduction in the multiple, because going down to a P/E of 20 times would represent a 33% drop in the multiple, so the risk/reward does not seem so interesting right now. Let's not forget that the company is still in the process of expansion and does not have a business as stable as Walmart to maintain such a high multiple consistently.
The final result
I love the business and am personally a regular customer. Plus, the numbers show that Sprouts is a quality business (compared to its competitors) and there is still room for growth.
However, at the current valuation I find it difficult to justify a buy rating. Management gave it a mid-range rating. $3.33 EPS guidance By fiscal 2024, at a forward P/E of 20 (my target multiple), the stock would be worth around $65. I know it seems difficult to see a 35% decline in the near term, but I believe investing is about putting the odds in your favor.
Another possibility is that the company remains at a sideways level for years but continues to grow its EPS, in this way the multiple would adjust without the need for a sharp drop. In any case, the result for investors would be unfavorable, so I think it is better to hold.