Sprouts: Specialty Grocer With Solid Execution and Capital Allocation

Jeff Sutton of ValueTree Investments presented his in-depth investment thesis on Sprouts Farmers Market (US: SFM) at Best Ideas 2021.

Thesis summary:

Sprouts operates 360 specialty grocery stores in 23 states, spanning the entire southern half of the U.S. from California to Virginia and Pennsylvania. The company focuses on the healthy living segment and provides consumers a unique assortment of fresh, natural, and organic food products, including plant-based, gluten free, keto-friendly, and grass-fed items.

As a testament to the secular growth that is behind the healthy living segment of the economy, over the last fifteen years, the market share of traditional grocers has declined from ~73% in 2005 to ~63% in 2018. Presumably, this decline in market share by behemoths such as Kroger, Albertsons, and Walmart, has been replaced by the growing market share of specialty grocery stores such as Whole Foods (WFM), The Fresh Market (TFM), and Sprouts (SFM).

Sprouts has experienced tremendous growth of its store footprint, revenue, and free cash flow over the last ten years, at annualized rates of 15%, 21%, and 32%, respectively. Perhaps even more astounding, such growth rates have not been achieved at the expense of the company’s unit economics, profitability, or shareholder value. For example, the average revenue and gross profit per Sprouts grocery store has maintained a nearly constant level over the last ten years. The company’s average cash flow per store and its average cash flow per share have both grown at rates of 6% and 24% annually over the same time period. The growth rate in per-share economics has been accomplished partially due to a dedicated return of capital to shareholders, in the form of nearly $1 billion of share buybacks since the end of 2015.

In spite of the underlying fundamental performance Sprouts has demonstrated over the last ten years, the stock price has declined by almost 50% since the IPO in 2013, trading at ~$20 per share at yearend 2020. Although such stock price performance is not dissimilar from its peers, WFM and TFM from 2013 through 2017, astute analysts should notice that Sprouts appears to have outperformed both WFM and TFM across almost all profitability and valuation metrics.

Yet at the same time, both competitors were acquired at high valuations compared to Sprouts’ recent market valuation. For example, WFM and TFM were acquired at valuations of ~27x FCF, compared to SFM’s recent quotation of ~8x FCF. If Sprouts were to be priced according to the valuation metrics that applied to the acquisitions of Whole Foods and The Fresh Market, SFM could be worth $60-80 per share, or roughly 200-300% above the recent stock price.

Regardless of whether Sprouts may or may not be acquired, Jeff believes the company’s continued execution of its business plan could lead to ~50% upside potential in the next few years. Sprouts has announced a commitment to grow the store base by ~10% annually for the foreseeable future. Such a growth rate could double the company’s size in seven years, and improved unit economics could lead to stock price appreciation sooner, even if SFM was valued using the same metrics at which it traded recently (~9.5x P/E, ~7.7x FCF).

Jeff believes a company’s intrinsic value is driven by a growing stream of FCF that accrues to shareholders. As such, SFM generates ~$2.60 per share in FCF. Pricing SFM at a 6% FCF yield, implies a stock price of ~$44 per share.

Jeff estimates that Sprouts generates what he refers to as “normalized maintenance FCF” of ~$3.70 per share. This estimate represents the amount of FCF Jeff believes a company could generate without re-investing into new growth initiatives. Capitalized at an 8% yield, Jeff estimates Sprouts could be worth ~$47 per share, based on his estimate of normalized maintenance FCF.

Looking out several years, SFM could be worth as much as $48 per share as a result of continued execution on the company’s business plan.

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About the instructor:

Jeff Sutton has over 18 years of investment experience, and has been a Chartered Financial Analyst (CFA) charterholder for over 14 years. Prior to founding ValueTree, he worked as an equity analyst for a long-short hedge fund, as a project manager at a $1 billion family office, and as an associate at a Southeastern private equity firm. Academically, Mr. Sutton graduated summa cum laude and Phi Beta Kappa from Rhodes College with two B.A. degrees, with majors in International Business and French. He has served as a member of the Rhodes College Alumni Executive Board. He has also earned a Master of Business Administration (MBA) degree from the Darden Graduate School of Business Administration at the University of Virginia, where he was the Senior Portfolio Manager of the Darden Fund.

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