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Sprouts Farmers Market - Patience And Discipline Will Win Out In The End

Summary

If anyone is looking to invest in the grocer industry, the word deflation is something to familiarize one's self with.

This word alone has led some analysts to take a cautious if not pessimistic approach to where Sprouts is going over the near term.

Analysts have also been somewhat conflicted internally as Goldman Sachs recently recommended Sprouts as a sell from neutral, and back to a buy a couple weeks ago.

What is clear is that SFM has outperformed its peers in the grocer industry by far; average analyst target prices reflect a premium based on further potential.

But the stock has been stuck around $22.50/share recently; patient long-term investors can profit from current deflation headwinds and near-term uncertainty.

Overview

Sprouts Farmers Market (NASDAQ:SFM) performance after the company reported its second-quarter earnings on August 4th was telling. The stock immediately shot up over 4 percent, only to close down over 1 percent for the day. The company missed revenue estimates by roughly 2 percent, but was able to beat earnings estimates for the fourth consecutive time.

For Sprouts, the second quarter of 2016 was a record for revenue at over $1 billion, as well as a record for second-quarter earnings at nearly $40 million. Despite these results, analysts quickly focused on deflation, competitive promotional activities, and the company's near-term growth potential.

Deflation has been a tangible headwind that has not only impacted Sprouts, but also Whole Foods Market (NASDAQ:WFM) and Kroger Co. (NYSE:KR), as well as all traditional grocers and others exposed to this market including the likes of Wal-Mart Stores (NYSE:WMT) and Target Corporation (NYSE:TGT).

Deflation has led to strong promotional activity and many perishable goods have witnessed substantial price declines at grocery stores over the past year. Regular and savvy shoppers tend to know when the promotions hit and pay strict attention to them, ensuring that their personal buying expenses meet their preferences.

This explains why Sprouts and its competitors have invested heavily into mobile applications to target existing and potential customers, and also partnered with e-commerce platforms from Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and Amazon.com (NASDAQ:AMZN). As customers become more digitized, new platforms need to reach them.

But even with a competitive pricing environment, Sprouts has continued to grow comparable stores sales while others have witnessed slower growth or flat out declines. The company has grown both top and bottom lines by 15 and 24 percent, respectively, year over year (YOY) through June. By year-end, the expectation is that Sprouts will have grown revenue and diluted earnings per share (EPS) by 15 percent, outperforming both Whole Foods and Kroger.

All three peers have been impacted by deflation this year as might be expected, but despite Sprouts' stronger performance, the company is currently trading at a valuation in line with Whole Foods' 2017 expectations. Companies like Whole Foods and Kroger have been around much longer than Sprouts, with substantially greater scale. Sprouts is currently in an earlier growth phase and judging by the 26.5 times earnings premium afforded the company by average analyst price targets over the next year, investors would expect to gain a higher return for this growth versus peers.

Some inconsistencies with respect to Sprouts' expectations for investors can be recently illustrated by the actions of Goldman Sachs, which, in May of this year, downgraded the company from neutral to sell. Just this past late July, Goldman upgraded Sprouts from sell to buy. During May, Sprouts was trading about 6.5 percent higher than last Friday's close, so a 6.5 percent decline led to a two-point upgrade while the stock continues to encounter weakness whenever it approaches the $23/share level. Analysts seem to be getting more skeptical despite the positive results.

Since Sprouts' IPO date, the stock traded above $30/share the majority of the time until mid-2015. Recently, the stock price has settled below $23/share. The company has recovered twice over the past year above the $25/share level, pushing back to the $30/share in March 2016. Since the peak in mid-March, Sprouts' stock price is down over 23 percent.

It is definitely debatable regarding the Sprouts valuation before mid-2015. During this time, investors were paying anywhere between 30 and 50 times diluted EPS. But today, Sprouts' 2017 estimated valuation is approaching 20 times diluted EPS, or over 30 percent below the low end of the company's higher valuation days. This current valuation that the market is placing on Sprouts' performance for 2017 puts the company nearly at par from a valuation perspective with Whole Foods, whose growth phase has declined substantially due to scale, namely a smaller percentage of new stores being opened from the total.

Deflation is a strong factor, which has impacted the grocer industry holistically, but analysts' skepticism for Sprouts is also being driven by the competitive environment. Not necessarily from traditional grocers or the likes of major retailers diversified into the grocer market, but more from existing direct competitors like Whole Foods and smaller private players. The 365 stores by Whole Foods are clearly an example to gain market share at the expense of Sprouts. Whole Foods is attempting to transition into a lower-cost side and lower retail price business, a model that Sprouts has already perfected.

Overall, Sprouts' business remains strongly positioned to continue to take market share from traditional grocers, and more costly competitors, as well as grocery stores that cannot keep up with investor preferences. The current valuation is at a level that is substantially below the company's past and future growth trajectories. If Sprouts were to remain at highly depressed levels, or become even further discounted, buyout attempts from private equity could intensify. Once the deflationary cycle reverses, the company will be poised to experience accelerated growth for both top and bottom lines from investments being made into the business today.

The combined macro environment and competitive uncertainties have presented investors who have the ability to be patient and manage their position in Sprouts, a great opportunity for potential consolidation and/or long-term returns.

Deflation Is Currently Biggest Headwind, Which Is Cyclical

During 2016, the deflationary environment has begun to weigh more on grocers as evidenced by the chart above. Aside from the market declines in January/February, all three companies above are at or near lows set during the year while the broader indices have pushed higher.

Inflation and deflation are part of the grocery store equation impacting revenue and profits. Simply put, grocery stores rely upon traffic, transactions and the number of products purchased per transaction, typically expressed as basket size and/or tonnage at aggregate levels. While traffic, transactions and average basket size or...


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