SPROUTS FARMERS MARKET, INC. 
Sprouts Farmers Market was launched in Phoenix, Arizona, in 2002. Admittedly, the gamble was pretty crazy for the time: how could a grocery store function if it refused to sell the country's best-selling sodas and other snacks? Until then, grocery stores offering fresh, organic produce were either too expensive or too hard to find. As well as offering a healthier alternative, Sprouts also came up with a new experience for customers. Gone were the labyrinths of narrow aisles with no one to help, and the ingredient lists with 40 unpronounceable chemicals. It was time to get back to basics and make healthy food, with products sourced from farmers rather than factories, accessible to everyone, not just the wealthy.
A new model for organic grocery stores on a human scale
The stores are organized according to a conventional "inverted" food sales model, with fresh produce at the center of the store, surrounded by a wider range of specialized grocery products. Fresh produce is therefore the heart of the store, generally taking up around 20% of the sales area. The stores are designed with open layouts and low displays, to provide an easily accessible environment that evokes the farmers' market experience and allows their customers to see the whole store. The small-box format allows for quick service in and out, and their assortment of innovative, locally sourced and responsible items offers pleasant shopping experiences that contrast with the impersonal, ponderous look of competitors' huge superstores. As a result, management has also overhauled its new stores, reducing their surface areas from 30,000 square feet (≈ 2780 m²) to 23,000 (≈ 2130 m²), lowering operational costs while focusing communication on promiscuity with customers but also local producers.
From there, 70% of the products on offer are "attribute-based", meaning that these products have specific characteristics or attributes that differentiate them and are valued by consumers (origin, non-GMO, fair trade, sustainability...). In other words, Sprouts Farmers Market is aimed at discerning consumers concerned about the value or health benefits that these products can provide.
SFM focuses on a product range composed mainly of fresh, natural and organic foods:
- Fresh products are characterized by minimal processing and the absence of preservation techniques such as freezing.
- The company's natural products are defined by their low level of processing and the absence of synthetic preservatives, artificial sweeteners, colorants, flavors and other additives, as well as GMOs, antibiotics and hydrogenated oils.
- Organic products are distinguished not only by their quality, but also by the production methods used. In addition, the company must adopt rigorous practices to ensure the biological integrity of its products, particularly during handling, storage and marketing.
As a result, the diversity of the company's offering is divided between perishable products (57%) of prime freshness and non-perishable products (43%), including vitamins, food supplements and natural body care products.
A growth market
According to a forward-looking analysis by Partner Cap Securities, by 2030, the US population will be dominated by Millennials (born between 1980 and 1990), Generation Z (born between 1990 and 2010) and beyond. These demographic groups, increasingly attentive to the ethical consequences of their consumption, favor companies such as Sprouts Farmers Market. Organic products, perceived as a healthier alternative to conventional products, are increasingly influencing consumers' purchasing decisions.
Meanwhile, data from the United States Department of Agriculture's (USDA) National Agricultural Statistics Service (NASS) reveals that domestic organic production generated $11.2 billion in 2021, with California leading the way (31% of revenues). This performance is all the more remarkable when compared to 2008, when total organic sales reached $3.2 billion for the country as a whole. Between 2011 and 2021, certified organic farmland expanded by 79%, covering 4.9 million acres, and the number of certified organic farms climbed by over 90%, to a total of 17,445. What's more, according to the Organic Trade Association (OTA), 88% of organic sales are made via conventional and specialty supermarkets and grocery chains, testifying to the growing integration of organic offerings into mainstream distribution channels and thus increasing Sprouts Farmers' potential market share.
Source : Investor deck
We can therefore better understand the momentum of Sprouts Farmers Market, whose share price has doubled since the beginning of the year. The U.S. market and changing consumer habits represent a huge opportunity for the company. In addition, certain regions such as the Great Lakes, the Midwest and New England represent market shares that the company can conquer, and where the market could be very receptive (large conurbations are present). The company estimates the potential for new stores at over 300 nationwide. These new stores will be smaller.
Why the sudden interest? It has to be said that Sprouts Farmers Market is experiencing annualized sales growth of 10.86% between 2013 and 2023. Yet over the same period, its share price has risen by just 30%. The reasons for this sudden surge are varied, but it also reflects the marked skepticism of the analysts who had been following the company. I really like what the analysts at Wells Fargo wrote in one of their notes:
"We were clearly wrong: we criticized SFM's ability to become a growth player again, especially since a significant part of its plan was based on reducing promotions and laying off low-value customers. This was simply never done (as far as we know). Issues such as inflation, easy comparisons and digital growth made progress difficult to assess, while valuation seemed ahead of measured progress. In the end, we underestimated the turnaround and held our opinion too long (...)"
This note sums up both the company's excellent management, which, thanks to an unprecedented strategy, has silenced the many critics. Despite rising sales, SFM bought back a third of its outstanding shares over the previous decade: the market was slow to understand the company's growth potential, which it was able to capitalize on at a time when valuation ratios were contracting. The EV/EBITDA ratio, for example, fell from 20.4x to 9.12x, while the number of shares fell from 150 to 101 billion over the same period.
So, SFM has skillfully steered its course since 2018. It took on heavy debt in 2019 before benefiting from the pandemic to emerge as a healthier consumer alternative. In a period of high post-pandemic inflation, SFM has not hesitated to target the most affluent consumers (Cf image Investor deck), which limits the cyclicality of the sector in which it operates, while maintaining high margins.
In 2023, the company benefits from a network effect unseen since its creation: it's hard to carve out a place for yourself on the North American market in the midst of Walmart and Target, but SFM has emerged by establishing itself in a large part of the US territory, enabling it to gain visibility as health and new consumer practices become more widespread. Its strategy is audacious, but it works: it's a high-end grocery store on a human scale... an affront in a country where everything is disproportionately large, and where local commerce is becoming rarer than ever.
Since then, the group seems to have found the right rhythm for opening new stores of a smaller size, maximizing profits and differentiating itself from the competition. The group's astute marketing, focused on well-being and product quality, as well as the e-commerce segment and the marketing of its own products, are, as one might say, "the icing on the cake".
SFM has also been managing its operating cycle very well recently. After a period of relative stability, the company's working capital (FDR) underwent significant variations from 2018 onwards. In 2019, FDR fell significantly, from -0.9 to -69 million dollars in the first quarter, before recovering slightly. This sudden drop corresponds to debt repayments as well as a period of major indebtedness undertaken in 2019 linked to investments that temporarily reduced available liquidity. However, by 2020, then in the midst of a pandemic, FDR showed signs of robust recovery, peaking in 2021 with values as indicative of improved management of short-term assets and liabilities.
Working capital requirements (WCR), meanwhile, have also shown an upward trend since 2018, signaling an increase in cash needs to cover day-to-day operations. This increase is particularly visible in 2019, when WCR climbed to $115 million, a peak that is maintained through 2020 before experiencing a drop in 2021. This rise is attributed to an expansion of inventories following the multiplication of sales outlets, but also to an extension of customer credit as part of the development of its own products and its online business.
Financial performance
SFM delivered a robust performance throughout the year. In the third quarter, with impressive growth in sales and profitability. Total sales reached $1.9 billion, marking a significant increase of 14% over the previous year. This increase was mainly due to a remarkable 8.4% growth in same-store sales.
In addition to organic growth, the company is benefiting from favorable trends in the market penetration of its own products, as well as its e-commerce offering. Online sales increased by 36%, representing 14.5% of total sales. E-commerce relies on a number of partnerships, notably with Uber Eats, Doordash and Instacart. The Sprouts brand contributed 23% of revenues. A loyalty program is under development, based on these e-commerce statistics, to build customer loyalty.
Gross margin strengthened considerably during the quarter, increasing by 150 basis points to 38.1%, compared with an 85 basis point improvement in Q2. This improvement was driven by a reduction in losses, operational improvements, but also very good profitability from new store openings.
Marketing continues to be a key factor for the company. Specifically, social networks have had a significant positive impact, with influencers and celebrities sharing products and experiences, generating additional traffic. As a result, SFM is seeing an increase in new customers, better retention and higher purchase frequency. What's more, the expanded presence on social networks is attracting younger customers to the brand, with the strongest growth seen in the 18-34 age cohort.
Valuation
This is a growth stock with excellent momentum for fiscal 2024. Investors are showing that they are willing to pay a very high premium for SPM, given the sector's solid fundamentals and growth.
However, the analyst consensus is cautious, believing the stock to be well valued, if not expensive, for a grocery chain. The company trades at a price-to-earnings ratio (P/E) of 40x, well above its average P/E of around 22x. This may seem expensive compared with other retail players, but not in absolute terms. Market growth is still far from having exhausted all its potential (not to mention that easy comparisons have so far been detrimental to analysts).
According to my spreadsheet, the company is currently very well valued, which makes it difficult to hope for strong short-term appreciation. My most optimistic scenario suggesting five-year growth of 14% would offer only a small premium of around 5% to the current share price. Thus, in a more appropriate scenario, the current share price would be in the $135-$145 range. Market enthusiasm is such that the consensus "wait and see" period makes sense. But, as you may have guessed, this same consensus has always been wrong! That's why the company's valuation doesn't really matter. And SFM is not the only growth stock in this case, given the very high valuation of the US equity market.
Risks :
- Economic conditions: economic conditions have an impact on consumer spending, which can have a negative effect on business. Inflation, higher prices for commodities, raw materials, fuel and other energies, high levels of unemployment and other macroeconomic factors can undermine consumer confidence.
- Product quality: a poorly preserved or diseased product could have a very negative impact on brand image, especially if the product is from the SFM brand.
- Cannibalism: care must be taken to ensure that newly opened stores do not impact on the performance of older stores. The smaller size of new stores is intended to prevent this phenomenon.
- Loss-making new stores: newly opened stores can have a negative impact on short-term financial results. They need more time to establish themselves in the local landscape and reach the sales and operating levels of more mature stores, if at all.
