Sprouts Farmers Market: A Stock for a High Inflation Environment (NASDAQ: SFM)

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Investors and consumers are right to be very concerned about the potential effects of inflation on businesses. Some sites, like ShadowStats.com, tracked inflation rates as being much higher than the results reported by the government for many years. This effect is now visible in data produced by the government likewise, with food inflation close to 10% year-over-year and projected to be between 5 and 6% in 2022. Unlike discretionary items, food is not something people can live without, so this level inflation is very disconcerting to most people. If the cost of goods exceeds income, it becomes more and more difficult for people; this same effect occurs for investments and investor wealth, so it is essential to have at least some investments that cover this effect.

Cabbage growers market (NASDAQ: GDF) is a specialty grocer that sells healthy, organic foods across the United States. Sprouts currently has over 380 stores in twenty-three states. The company offers a diverse set of products that largely target the most health-conscious and affluent customers. In this article, we examine how Sprouts shares can provide some resilience in an inflationary environment as well as its relative valuation and potential risks for this thesis.

Inflationary hedge

Inflation will hit all businesses throughout their supply chain networks, both locally and globally. The key for companies to navigate an inflationary environment is the price sensitivity of a company’s customers and the riskiness of alternatives. The nature of the organic and health food market is that there is a price premium built into the business through additional health disclosure requirements and higher perceived quality. These costs have been widely accepted by customers in this space, dating back to referring to Whole Foods as “Whole Paycheck.” These customers are better off at best, and less of their disposable income needs to be spent on necessities, which allows them to better manage price increases, which also makes it easier for Sprouts to pass on the costs on its customers.

The risk is whether there are potential substitutes for these goods. There are of course plenty of other grocery and food options that customers feeling the pinch of higher cost Sprouts grocery bills could move to; Kroger (KR) and Albertsons (ACI) are publicly traded alternatives that would offer a lower cost. Those who feel these impacts could trade to these lower-cost alternatives, although this has always been a risk to Sprouts’ value proposition. These traditional grocers will also pass the costs on to their customers. In this case, Sprouts’ more affluent customer base will likely make its business more robust than those with tighter margins. Sprouts also has a decent private label base, with around 16% of its listed products being of a private label nature. These products could also serve as internal redemption options with Sprouts listings if customers aren’t quite ready to switch stores.

Evaluation

It’s worth looking at the rating over the past few years, as the trend towards healthy food alternatives has been in place for some time. From a valuation perspective, we had an excellent barometer for the valuation of grocers with the purchase 2017 of Whole Foods Markets by Amazon (AMZN) at 10.3x EV to EBITDA. In the same article, he also noted multiples paid for regular grocers at the time, including Albertsons’ acquisition of Safeway at 5.5x EV to EBITDA.

If we look at Sprouts’ performance since then, it has grown EBIT by 57% during that time, including a “bubble-like” performance during COVID due to the impact on other alternatives like dining options :

Automatically generated table description with medium confidence

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With the market turning around and the high price of sell stocks starting to see sales, EV/EBITDA multiples are probably a better metric to value Sprouts at this point. Below, we compare Sprouts’ performance on a valuation basis, on a cash flow basis and on an EBIT margin basis to that of its largest grocery competitors:

Chart
Data by Y-Charts

We can see that the company’s valuation has declined by almost four rounds of EBITDA since the time of the Whole Foods acquisition, despite the company’s continued growth. Its valuation also compares quite favorably to its competitors, especially given its significantly better profit margins. The company also has plenty of growth options to continue expanding its footprint, as it has a presence in less than half of the states in the Union.

This growth in financial performance will also be increased by a very strong share buyback program implemented while the company has been able to reduce its number of shares by 18% over the last 5 years:

Chart
Data by Y-Charts

Sprouts recently announced a new $600 million buyout, replacing the $100 million in place with a December 2024 expiry. This would represent a nearly 20% reduction in outstanding shares at its current market cap of 3, $2 billion. I think this is good capital management, given that the discounted multiple stocks continue to trade while offering an embedded put option on the stocks.

Risks

The biggest risk, as noted earlier, is whether Sprouts can pass inflation costs on to its customers; I think this is possible given the composition of the clientele. There is a risk to the supply chains themselves as we see the impacts of COVID and geopolitical tensions making everything slower and more expensive for everyone involved, but this is certainly not unique to Sprouts.

Analysts have always focused on margins, so Sprouts’ ability to maintain them will be particularly targeted; there was some movement behind this as the COVID pandemic gave a temporary tailwind to the company’s performance, which has since returned to a normalized level. Finally, Sprouts is expected to report results after market on May 4.and; with very volatile markets right now, these could act as a catalyst for the upside or downside. This is short-term in nature, but it will be interesting to see if the company updates its guidance for the year ahead based on how the first quarter unfolds.

Summary

It has been a while since investors have had to navigate an inflationary environment. Sprouts Farmers Market offers good coverage due to its target market, operational performance, and ability to pass on rising prices.

James V. Payne