Sprouts Farmers Market’s Stock Momentum Has Space Left (NASDAQ:SFM)

Sprouts Farmers Market (NASDAQ:SFM) operates grocery stores in the United States. The company’s store concept differentiates itself from most of its competitors with an offering based on organic, fresh produce and other more health-conscious products. SFM has a long history of growing the grocery store network throughout the country.

After a weak long-term stock performance, investors have picked up on the company’s underlying value in the past year – in the past year into the market close at 7^th of June, the stock has returned 129%.

Due to the recent year’s rally, the ten-year appreciation now stands at 154%, making the ten-year performance fairly good at a CAGR of 9.8%. SFM doesn’t pay out a dividend, as operational cash flows are spent on growth investments and share repurchases, such as the recently announced $600 million repurchase program replacing the older program.

Growing with Great Financials and Significant Targets

SFM has a great history of revenue growth, growing in a stable arithmetic manner as the company has continued to open new units – revenues have grown at a CAGR of 10.9% from 2013 to 2023 with an average annual revenue increase of $440 million. From 2019 to 2023, total units have grown from 340 to 407 at a CAGR of 4.6%, with SFM currently identifying potential for over 300 new stores in growth markets. For 2024, around 35 new units are targeted.

Borrowing a graphic from my recent article on Albertsons (ACI), SFM has grown revenues well in the sector. Compared to Albertsons, Walmart (WMT), and Kroger (KR), the company’s revenues have grown more impressively by 69.0% from 2016 compared to the mentioned competitors’ total growth of 32.8%, 33.4%, and 30.1% respectively in comparable fiscal years. SFM experienced more turbulence in 2020 and 2021 than competitors but has now returned back to highest growth of the companies.

Over the long term, SFM targets even more significant growth, with 10% in annual unit growth and low single-digit comparable store sales growth with stable EBIT margins. Currently, the operating margin trails at 5.8%, and has already been stable over the past few years.

I believe that investors should take the growth target with caution for the time being – previous years haven’t shown unit growth quite at the targeted level, as the target implies over double the rate of new openings compared to the 2019-2023 period.

Also, aggressive growth would require expansion into new markets, and could potentially fail. SFM’s strategy involves a high degree of local sourcing and closely located distribution centers, making expansion into new markets a more heavy strategic decision. In my opinion, SFM’s store concept has been well proven and should be able to be copied into growth markets, but investors should still note possible friction in achieving such a high revenue growth target.

Improved ROIC Could Position SFM For More Aggressive Growth

Most significantly, in my opinion, the cost of new units is targeted to be reduced, having a positive impact on SFM’s ROIC if successful. The company already has quite a good return on total capital with a current 9.1% and return on equity of 26.2%, compared to the consumer staples sector’s average of 6.8% and 11.2% respectively in the low-risk, and ultimately, low cost of capital sector. A higher ROIC could also allow for more aggressive unit openings as cash flows are able to finance more openings.

Smaller store sizes, improved efficiency as new stores ramp up operations, and reductions in building costs are intended to improve new stores’ returns. SFM targets capital expenditures of just $3.8 million to open up a new unit, and with revenues ramping up over the next four years following a unit opening, EBITDA margins are targeted to scale to 8% with only a breakeven result in the first year resulting in a targeted cash on cash return of low- to mid-thirties by the fifth year.

I don’t expect too much of an impact from the ROIC initiatives yet. A smaller store size and cheaper build costs should also lower revenues, making the total effect on ROIC quite modest. Yet, if the initiatives are successful, SFM’s economics would be positioned for more aggressive growth, making the metric important for investors to keep an eye on.

Margins Could Have Underlying Upside

As SFM has continued to open up new stores and the current store base isn’t entirely mature, the company’s underlying current profitability is also slightly higher than current financials show.

In addition, SFM could scale margins through the Sprouts private label brand, which should be able to generate greater margins. The company’s fresh produce focus doesn’t rely on very strong brands, and as such, I believe that the company’s brand could perform very well on store shelves. A good performance from the Sprouts brand has already been demonstrated in terms of growth, as the sales penetration has increased by six percentage points to 20% in 2023.

Still, SFM only targets stable EBIT margins. The more aggressive unit targeted growth could eat away profitability as the unit base becomes less mature on average, but underlying margins have catalysts for some expansion in the long term. SFM already achieves higher margins than most competitors seem to report.

Stock Momentum Has Some Space Left

After a significant stock rally in the past year, SFM still has some moderate upside left in terms of the valuation. To demonstrate the valuation, I constructed a discounted cash flow model (DCF model).

In the model, I estimate continued unit growth, although not at quite the level that SFM targets, as I believe that caution around anticipating the target is justified. After a 2024 revenue growth of 8.0%, I estimate a very gradual slowdown into a perpetual growth of 2.5%, representing a CAGR of 6.4% from 2023 to 2033.

The company targets stable margins, but I estimate very slight leverage into a 6.0% EBIT margin in later years as the growth slows down. SFM’s capital expenditures are relatively low even with unit investments, and the company’s good working capital management also makes for a relatively good cash flow conversion with potentially improved ROIC, potentially improving the conversion even more.

The estimates put SFM’s fair value estimate at $98.02, 27% above the stock price at the time of writing – the valuation still has upside left despite the significant rally and estimates below SFM’s growth targets. Rising competition could deteriorate a bullish long-term scenario as the relatively high ROIC could attract competition, but it seems that SFM is well positioned to continue the growth with a greatly built distribution network.

A weighted average cost of capital of 6.93% is used in the DCF model. The used WACC is derived from a capital asset pricing model:

SFM has an irrelevant amount of interest-bearing debt, and as such, I estimate no debt used in financing over the long term. To estimate the cost of equity, I use the United States’ 10-year bond yield of 4.43% as the risk-free rate. The equity risk premium of 4.60% is Professor Aswath Damodaran’s latest estimate for the United States, updated on the 5^th of January. Yahoo Finance estimates SFM’s beta at 0.50. Finally, I add a liquidity premium of 0.2%, creating a cost of equity and WACC of 6.93%.

Takeaway

SFM’s stock momentum still has room to continue for some time. Investors should start to be more cautious about the valuation if the stock rises too much more, but for the time being, SFM’s growth strategy still poses upside even when estimating a slightly worse growth performance than the company’s significant long-term targets would imply. The company’s profitability could also have underlying upside that the company doesn’t seem to target for with more aggressive growth plans. As upside still exists and the great stock momentum could well continue, I initiate SFM stock at Buy.