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Sprouts Farmers Market: Will the stocks deliver profitable growth?

Opdateret: 30. okt.

There are many things to like about Sprouts Farmers Market. It is easy to understand this business as it sells food. It operates in a market that is expected to grow at a compounded annual growth rate of 11% until 2030. And the famous investor, Phil Town, has included it in the top 5% of his portfolio. In this analysis, I will investigate whether Sprouts Farmers Market should be added to my portfolio.

This is not a financial advice. I am not a financial advisor and I only do these posts in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

Since attending the workshop with Phil Town, I have decided to make some changes to the layout of my analyses. I will perform additional calculations and also provide a brief explanation of why the company is significant to me. If you want to learn more about my company evaluation process, please visit the "MY STRATEGY" section on my website.

For full disclosure, I should start by mentioning that at the time of writing this analysis, I do not own any shares of Sprouts Farmers Market. If you would like to view the stocks in my portfolio or copy my portfolio, you can do so on eToro. Instructions on how to do so can be found here. I don't own any stocks in Sprout Farmers Market's competitors either. Thus, I have no personal stake in Sprouts Farmers Market. If you want to purchase shares (or fractional shares) of Sprouts Farmers Market, you can do so through eToro. eToro is a highly user-friendly platform that allows you to start your investment journey with as little as $50.

Sprouts Farmers Market was founded in 2002 in Arizona, United States. In 2011, it acquired Henry's Sun Harvest and Sunflower in 2012. Sprouts Farmers Market conducted their IPO in 2013. Sprouts Farmers Market focuses on selling fresh, natural, and organic foods, which they mainly buy locally. The Sprout Farmers Market shops represent a blend of farmers markets, natural foods stores, and smaller specialty markets, which is what distinguishes them from their competitors. Another thing that distinguishes Sprouts Farmers Markets from their competitors is that they dedicate 20% of their selling space to produce, specifically fruits and vegetables. 58% of their sales are perishable foods (produce, meat, dairy, etc.), while 42% of their sales are non-perishable (vitamins, frozen foods, body care, etc.). Sprouts Farmers Market also has its own private label, which contributed to 19% of revenue in 2022. By the end of 2022, Sprouts Farmers Market had 386 stores in 23 states in the United States. Their customers are usually higher-income consumers who focus on health and selective products. I believe that Sprouts Farmers Market has built a brand moat because they distinguish themselves from their competitors through the unique vibe they create and their focus on providing fresh produce.

Their CEO is Jack Sinclair. He joined Sprouts Farmers Market in 2019 as the CEO. Prior to joining Sprouts Farmers Market, he served as the CEO of 99 Cents Only Stores. He has also held the position of Executive Vice President of the U.S. Grocery Division of Walmart experienced substantial growth under his leadership. He has earned a bachelor's degree in Economics and Marketing from the University of Strathclyde in Glasgow, Scotland. He also serves as a board member of The Food Industry Association. He has been credited with making Sprouts Farmers Market a more efficient, profitable, and innovative retailer. In an interview, he mentioned that being transparent is very important as a leader. This allows everyone to understand the reasons behind the leadership's actions, creating a positive working environment where everyone feels heard. I believe this is a great point. We don't have much information about Jack Sinclair, but he has shown great leadership during the pandemic and has more than 35 years of experience in the industry. I am confident in Jack Sinclair's ability to lead Sprouts Farmers Market moving forward.

I believe that Sprouts Farmers Market has a brand moat, and I also have a positive opinion of their management. Now, let us investigate the numbers to determine if Sprouts Farmers Market meets our criteria for having a strong competitive advantage. In case you want an explanation about what the numbers are, you can have a look at "MY STRATEGY" on the website.

The first number we will investigate is the return on invested capital, also known as ROIC. I would like a 10-year history with all figures exceeding 10% for each year. The ROIC (Return on Invested Capital) of Sprouts Farmers Market has consistently been above 10% since 2014, which is always a positive indicator. It is very encouraging to see that the Return on Invested Capital (ROIC) has been above 20% every year since 2020, which represents the first three full years with Jack Sinclair as CEO. Seeing numbers like these is very encouraging, as not only are the numbers well above the 10% requirement, but the ROIC has also reached a new level in the last three years. ROIC did drop slightly after 2020, but it is not something I am worried about. This decline can be attributed to the unique circumstances of the pandemic in 2020. Hopefully, Sprouts Farmers Market will continue to deliver a return on invested capital (ROIC) above 20% in the future.

The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. The numbers have been a bit mixed, and 2019 marked the lowest equity in the last 10 years. However, ever since Jack Sinclair became the CEO of Sprouts Farmers Market, the equity has grown every year and reached a new milestone in 2022. Thus, I'm encouraged to see numbers like these.

Finally, we will investigate the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. Levered free cash flow is the amount of money a company has remaining after paying all of its financial obligations. I use margins to enhance clarity and improve understanding. Free cash flow yield refers to the amount of free cash flow per share that a company is projected to generate in relation to its market value per share. Sprouts Farmers Market has consistently generated positive free cash flow over the past 10 years, which is always encouraging to observe. It is also encouraging to see that Sprouts Farmers Market has experienced an increase in free cash flow since Jack Sinclair assumed the role of CEO. Levered free cash flow margin may appear low, but this is due to the industry in which Sprouts Farmers Market operates. In fact, Sprouts Farmers Market has consistently delivered higher levered free cash flow margin compared to most of their competitors. The free cash flow yield suggests that Sprouts Farmers Market is trading at a cheap valuation, but we will discuss this further in the analysis.

Another important aspect to consider is the level of debt. It is crucial to determine whether a business has manageable debt that can be repaid within a three-year period. We calculate this by dividing the total long-term debt by earnings. After performing the calculation on Sprouts Farmers Market, I found that the company has 0,96 years of earnings in debt. Thus, debt is not an issue for Sprouts Farmers Market.

Based on my findings thus far, I believe that Sprouts Farmers Market is an intriguing company. However, no investment is without risk, and Sprouts Farmers Market also has its fair share of risks. One risk is competition. Sprouts Farmers Market operates within the competitive and highly fragmented grocery store industry, which includes a wide array of food retailers. This industry encompasses large national and regional supermarkets, small grocery and convenience stores, as well as online competitors. Some of the competitors include Whole Foods, Kroger, Target, Walmart, and Amazon. Some of these large competitors may choose to lower their retail prices and expand their promotional activities, which could reduce sales and gross profits for Sprouts Farmers Market. Another risk is general economic conditions. The retail food business is sensitive to changes in the overall economic conditions. Inflation, recessionary economic cycles, higher interest rates, high unemployment levels, higher consumer debts, and depressed home values could all affect consumer spending and confidence. This, in turn, could lead consumers to shift their spending towards lower-priced competition. Furthermore, prolonged food inflation could also lead to a decrease in sales and gross profit margins. Fluctuations in commodity prices. Many products that Sprouts Farmers Market sells include ingredients such as wheat, corn, oils, sugar, and cocoa. Commodity prices are subject to significant fluctuations, and increases in prices may cause vendors to experience price increases from Sprouts Farmers Market. If Sprouts Farmers Market cannot mitigate these fluctuations, their profitability will be impacted by higher costs.

There are also numerous reasons to invest in Sprouts Farmers Market. One reason is to open new stores. Sprouts Farmers Market expects to increase unit growth by 10% from 2024 onwards. These new stores will be smaller than the current stores (which are currently 28.000 square feet), with the new shops ranging between 21.000 and 25.000 square feet. This reduction in size will result in lower construction costs, as well as a decrease in non-selling space, occupancy, and operating costs. Management expects that the new stores will have similar sales compared to their larger stores, indicating that the cost reductions in smaller stores will result in increased profitability per store in the future. Private label brand. Sprout Farmers Market is expanding its private label brand, which accounted for 19% of revenue in 2022, up from 16% in 2021. Usually, private label brands are more profitable than external brands. According to data from CB Insights, profit margins for private label foods are significantly higher than those of external brands. Furthermore, management also expects that the private label products will enable Sprouts Farmers Market to distinguish itself from competitors and promote customer loyalty. Shareholder-friendly. Sprouts Farmers Market is very shareholder-friendly. Since their initial public offering (IPO), they have reduced their outstanding shares by more than 28%. Currently, they are reducing their outstanding shares by approximately 5% per year. Management does not expect it to change anytime soon, as they have recently mentioned that they plan to opportunistically repurchase shares. Thus, shareholders' ownership in Sprouts Farmers Market is increasing without shareholders having to do anything.

Now it is time to calculate the price of shares in Sprouts Farmers Market. I perform three different calculations that I learned at a Phil Town seminar. The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 2,39, which is from 2022. I have selected a projected future EPS growth rate of 9% (Finbox estimates EPS to grow by 9,30%). Additionally, I have chosen a projected future P/E ratio of 18, which is twice the growth rate. This decision is based on the fact that Sprouts Farmers Market has historically had a higher P/E ratio. Lastly, our minimum acceptable rate of return is already set at 15%. Doing the calculations, we come up with the sticker price (some call it fair value or intrinsic value) of $25,17. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Sprouts Farmers Market at a price of $12,59 (or lower, obviously) if we use the Margin of Safety price.

The second calculation is called the Ten Cap price. The rate of return that an owner of a company (or stock) receives on the purchase price of the company is essentially its return on investment. The return should be at least 10% annually, and I calculate it as follows: The operating cash flow last year was 457 and capital expenditures were 170. I attempted to review their annual report to determine the percentage of capital expenditures allocated for maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated for maintenance purposes. This means that we will use 119 in our calculations. The tax provision was 83. We have 102,183 outstanding shares. Hence, the calculation will be as follows: (457 – 119 + 83) / 102,183 x 10 = $41,20 in Ten Cap price.

The final calculation is called the Payback Time price. It is a calculation based on the free cash flow per share. With Sprout Farmers Market's Free Cash Flow Per Share at $2,34 and a growth rate of 9%, if you want to recoup your investment in 8 years, the Payback Time price is $28,13.

I believe that Sprouts Farmers Market is an intriguing company, and I also have confidence in the management. Sprout Farmers Market may be facing some short-term headwinds due to general economic conditions, which could put pressure on the stock price. Competition will always be a risk factor for Sprout Farmers Market, but so far they have been able to distinguish themselves from their competitors, and there is nothing to suggest that they won't continue to do so. Fluctuations in commodity prices are something that comes with the industry and will affect profitability for some periods. I'm intrigued by Sprouts Farmers Market's new store concept with smaller stores, which could potentially lead to higher profitability in the future if management can successfully execute it. I haven't been able to find the profit margins on their private label products, but I would be surprised if they were not higher than those of external brands. Thus, it is intriguing that the private label is growing. It is nice to see that companies are using approximately one third of their cash flow to buy back shares, as it increases shareholder value. Warren Buffett has praised buybacks when it comes to his investment in Apple. Furthermore, Sprouts Farmers Market consistently delivers a high return on invested capital (ROIC), which, in my opinion, is the most important metric to consider when making investments. There are many positive aspects of Sprouts Farmers Market, but personally, I prefer to have a margin of safety when making investments. Thus, I will not add shares in Sprouts Farmers Market unless it falls to the Payback Time price of $28,13.

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