Sprouts Farmers Market (SFM) Summary

Sprouts Farmers Market has been on a downward trend since its IPO in 2013, but the underlying fundamentals all improved, except operating margins.
If the company manages to keep operating margins stable at ~4%, this is a grocery stock that offers long-term returns of ~10%, which could be even higher given the strong buybacks.
SFM had a great 2020 but long-term investors will want to see that continue post-COVID. The 5-year chart is a rollercoast that tops out at $26 but there is a growth story here that is underrealized in the market.

Fundamentals Sprouting Up!

While the stock has under performed and seen negativity since since their IPO, Sprouts has more than doubled revenues, quintupled net income, and lowered the number of shares outstanding from 154 million to the current 118 million. The latter was accomplished by returning $958 million trough buybacks since 2013 and the current fundamentals look worthwhile compared to the market capitalization of $2.3 billion. The market capitalization was $7.3 billion when the stock peaked in 2013.

The issue that Sprouts is experiencing is on their operating margins. Given the margins over the last years have narrowed, there has been a management transition and the new growth strategy is to have smaller stores for higher profitability, more growth in existing markets rather than pure geographical expansion where it is hard to scale and reach cost benefits. Management wants the format to stay true to their Fresh-focused Farmers Market Heritage, prioritize categories for growth potential and continue to offer all categories to customers. Beyond 2021, the plan is to open 300-400 new stores in expansion markets (California, Texas, Georgia, Florida, Pennslyvania and New York) which would represent a minium 10% unit growth.

Sprouts is looking to create a more concentrated delivery center (DC) supply chain so it can create advantages that'll lower logistic costs and better pricing for bargining power, which will allow for better margins!

Current Supply Chain
- DCs are located within 500 or more miles of the stores
- 5 DCs serving 345 stores (Atlanta is serving Southern Florida)
- Multiple deliveries to the stores daily
Future Supply Chain
- Aspire DC to be within 250 miles of the majority of stores
- Additional FL & CO DCs in 2021
- Leverage existing DC space to reduce overall costs; cross docking more products
- Drive efficiencies and simplicity in store & DC replenishment process

Potential Headwinds

The key is to watch whether margins will start expanding or keep narrowing as analysts fear, and as has been the case with operating margins over the past years, excluding the COVID-19 positive impact. The narrowing of operating margins is what created the pressure on the stock, alongside the fear of increasing competition from Amazon through Whole Foods and online, To Wal-Mart, Kroger and others having more and more specialty and organic offerings to hard discounters doing the same.

Goldman downgraded the stock based on the following:

Less favorable outlook for food at home once COVID economy reopens
Narrowing of the customer base could result in some top line before we see the intended improvements
Survey work pointing to customers still preferring one-stop shopping
Valuation work pointing to downside to their price target of $18
Sprouts has consistently underperformed grocery peers even before the pandemic began and that has widen during the food-at-home story

The primary risk in my mind, and what everyone is watching are operating margins. If those keep declining, as the case has been since 2014, then the outlook will not be great. However, if they cna stop operating margin from continuing to narrow and execute with online sales, then the story starts to really flip.

Conclusions

While the upside is not fantastic, I think the most likely outcome is an increase to low $30s. In the most bearish scenario, the stock falls to $18 and with momentum sell off we hit $12 where it would likely be taken over by somebody for $15. Given all of that, the investing opportunity is giving a positive risk and reward situation.