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

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Investors and consumers have every reason to be concerned about the potential impact of inflation on businesses. Some websites, such as ShadowStats.com, have tracked inflation rates much higher than government-reported results for many years. That Effect can now be seen in government-produced data Food inflation is also close to 10% y/y and is expected to be between 5% and 6% through 2022. Unlike consumer goods, people cannot do without food, so this level of inflation is very worrying for most people. When the cost of goods exceeds revenue, it becomes increasingly difficult for people; The same effect occurs in investors’ investments and wealth, so it is important to have at least some investments that hedge this effect.

Sprouts Farmers Market (NASDAQ:SFM) is a specialty grocer that sells primarily healthy and organic groceries throughout the United States. Sprouts currently has more than 380 stores in 23 states. The company offers a wide range of products, primarily aimed at more health-conscious and affluent customers. In this article, we examine how Sprouts stock can offer some resilience in an inflationary environment, its relative valuation, and potential risks to that thesis.

An inflationary hedge

Inflation will hit all companies in their supply chain networks, both locally and globally. The key for companies to find their way through an inflationary environment is how price-sensitive a company’s customers are and what the risk of alternatives is. The nature of the organic and health food market is that there is a price premium built into the deal with the additional requirements for health data disclosure and the perceived better quality. This cost has been widely accepted by customers in this space, owing to Whole Foods being referred to as the “Whole Paycheck”. At best, these customers are wealthier because less of their disposable income has to be spent on basic necessities, making them better able to handle price increases, which also makes it easier for Sprouts to pass costs on to its customers.

The risk is whether there are potential substitutes for these commodities. There are, of course, plenty of other food and grocery options that customers who feel the Sprouts grocery bills are going to cost more could switch to. Both Kroger (KR) and Albertsons (ACI) are publicly traded alternatives that would offer lower costs. Those feeling the impact may switch to these lower-cost alternatives, although doing so has always been a risk to Sprouts’ value proposition. These mainstream grocers will also pass the cost on to their customers. In that case, Sprouts’ more affluent customer base will likely make the business more resilient than those with lower margins. Sprouts also has a decent private label base, with about 16% of the products listed being private label. These products could also serve as internal trade-down options with the Sprouts offerings if customers are unwilling to switch stores.

valuation

It’s worth looking at the reviews over the last few years, as the trend towards healthy diet alternatives has been going on for quite some time. From a valuation perspective, we had a great barometer of grocery retailer valuations when we bought Whole Foods Markets by Amazon (AMZN) in 2017 at 10.3x EV to EBITDA. The same article also noted multiple payments for regular grocers at the time, most notably Albertsons’ acquisition of Safeway at 5.5x EV to EBITDA.

If we look at how Sprouts has performed since then, EBIT is up 57% over that time, including a somewhat “bubble” performance during COVID due to the impact on other alternatives such as restaurants:

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As the market turns around and high sell stock prices are starting to see sell-offs, EV to EBITDA multiples are likely a better metric to evaluate Sprouts at this point. Below, we compare Sprouts’ performance to its larger grocery peers on a valuation basis, cash flow basis, and EBIT margin basis:

diagram
Data from YCharts

We can see that the company’s valuation has fallen nearly four turns of EBITDA since the time it acquired Whole Foods, despite the company’s continued growth. Its valuation also compares fairly favorably to its peers, especially considering the significantly better profit margins. The company also has plenty of growth options to further expand its footprint as it is present in less than half of the states of the Union.

This growth in financial performance is also fueled by a very strong share buyback program, while the company has reduced its share count by 18% over the last 5 years:

diagram
Data from YCharts

Sprouts recently announced a new $600 million buyback, replacing an existing $100 million buyback that expires in December 2024. That would be a nearly 20% reduction in outstanding shares at its current $3.2 billion market cap. I think this is good capital management considering the discounted multiple shares continue to trade while also offering a built in put on the shares.

risks

The biggest risk, as mentioned, is whether Sprouts can pass the cost of inflation on to its customers; I think this is possible due to the composition of the customer base. There is a risk to the supply chains themselves as we see the impact of COVID and geopolitical tensions making everything slower and more costly for everyone involved, but this is certainly not just for Sprouts.

Analysts have always focused on margins, so Sprouts’ ability to maintain them will be of particular focus; There have been some changes as the COVID pandemic provided a temporary tailwind to the company’s performance, which has since settled back to normalized levels. Finally, Sprouts will report post-market results on May 4thth; As the markets are very volatile these days, this could serve as either a catalyst up or down. This is short-term in nature, but it will be interesting to see if the company updates its guidance for the coming year based on how the first quarter went.

summary

It’s been some time since investors have had to navigate an inflationary environment. The Sprouts Farmers Market offers a good hedge because of its target market, operational performance and ability to pass on rising prices.

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