Overview
My recommendation for Sprouts Farmers Market (NASDAQ:SFM) is a buy rating, as I now believe the business is able to sustain growth and margins because of its differentiated business offerings. Additionally, with its growth profile, margins, and business model, I believe it should be valued relative to peers in the supermarket industry. Note that I previously rated a hold rating as I was worried the business would experience a decline in sales volume if a price war were to occur, and coupled with the ramp-up in store expansion, the increased fixed cost could really hurt its bottom line. My concerns did not play out, and instead of volume decline, SFM went on to continue producing strong results, driving the share price up from ~$40 when I covered it to the current ~$64.
Recent results & updates
SFM reported earnings about a month ago, so I will just touch briefly on the results before I move on. 4Q23 EPS saw $0.49, which beat consensus expectations for $0.45. Driving the beat was same-store sales growth [SSSG] of 3.3%, led by positive traffic and the stabilization of average unit revenue [AUR] and units per transaction. Improved SSS came with 20bps expansion in gross margins to 36.5%. That said, this expansion was offset by 25bps increase in SG&A costs as a percentage of sales due to higher wages and benefits. SFM’s 4Q23 performance has led me to change my view on the business. Previously, I thought the elevated gross margin that SFM enjoys was due to non-structural reasons, and there is room for collapse when a price war starts. However, I now believe that it is due to the distinctive business model that SFM offers, where it offers differentiated products to a different target customer base than typical supermarkets. The fact that SFM was able to report a consistent SSSG in the ~3% range, supported by inflation and, importantly, positive traffic both online and in stores with volumes stabilizing, really shows that the SFM differentiation strategy is working out. Also, if there were to be any price war, it would have already happened during the previous few months where inflation was high and consumers were tight on their budgets—industry players should be out there competing for traffic, which should’ve hurt SFM if my previous view was right. As such, SFM has really proven that their differentiated assortment continues to resonate with its core customers, and management has specifically highlighted category strength in grocery, dairy, frozen, and meat, along with 13% growth in private label (note they have managed to increase this penetration rate to 21% of sales in 4Q23). I believe this should continue to support margins as SFM-targeted consumers are those who prioritize health and wellness over price, which has actually been a key cause of SFM margin resilience, especially when compared to traditional food retailers who are vying for the business of budget-conscious consumers. Management has guided gross margin expansion of 20–25 bps in FY24, which is a step up from its prior flat indication, and I think this is possible as they seem to be stepping back from promotions and SFM is going to lap the distribution centers [DC] expansion headwind in FY24. Management has also done a good job of finding efficiencies, lowering supply chain costs via distribution center expansions, and ensuring the close proximity of its stores to those distribution centers. The thing is, all these cost savings are not showing up in the P&L yet because of the ongoing store buildouts. The typical SFM store takes about 4 years before it ramps up to maturity, and SFM has stepped up on their store opening over the past 3 years: 12 in FY21, 16 in FY22, and 30 in FY23. Along with this is the current labor inflation in the US, which is further depressing margins. My view is that as these stores mature and labor inflation gradually cools, coupled with improvements in margins, SFM should have no issues seeing attractive incremental margins. So, at the beginning of the year, we were a lot more stores in new markets, which, as you know, take 3, 4 years to mature, whereas our existing markets start off quite well. from: 3Q2016 earnings call
Valuation and risk
Author’s valuation model
According to my model, SFM is valued at $74.36, representing a 16% increase. This is a big step up from my previous model, as I have a refreshed view of the business, acknowledging its ability to sustain growth and margins. Based on its recent performance, I believe it should be able to continue growing in the mid-single digits (6%) for the foreseeable future. Management guided a modest margin drop in FY24, which I think is reasonable as they opened 30 stores last year, and with labor inflation still being hot, it makes sense to be conservative. However, as the store ramps up and the labor market cools, margins should expand back to 4.3% in FY25. Lastly, the biggest cause for my target price upwards revision is that I think SFM can continue to trade at 22x forward earnings, in line with typical supermarket peers in developed markets (like Woolworths Group, Coles Group, and Grocery Outlet). Although I am not modeling further upside, I note that Walmart is trading at 25x but has lower gross margins (24%) and a similar growth profile, so there is potential for SFM to be rerated upwards.
Bloomberg Risk
Key growth for SFM is expanding its stores throughout the country, and new stores might not perform as well as legacy cohort stores. If that is the case, the runway for growth would be a lot more limited than I expected. In addition, the fixed-cost leverage narrative might not play out as well, limiting net margin expansion potential.
Summary
Summarizing this post, the recommendation for SFM is an upgrade to buy rating. My view on SFM business has changed, now believing that its differentiated product offerings resonate with health-conscious customers, which should continue to drive consistent SSSG and margin resilience. Hence, I also believed that SFM should trade in the range where supermarket players are trading at (typically 20+ forward PE). While new store performance is a risk, the execution so far has been great (has 386 stores now).
