Sprouts Farmers Market (SFM) operates health-conscious grocery stores. It specializes in fresh, natural, and organic products.
Its products include fresh produce, bulk foods, vitamins, supplements, grocery, meat and seafood, frozen foods, and more. The company was founded by Stan Boney and Shon Alexander Boney on July 11, 2002, and is headquartered in Phoenix, AZ.
We are neutral on the stock.
Measuring Efficiency
As a grocery company, Sprouts Farmers Market needs to keep inventory in order to keep its business running. Therefore, the speed at which it can move its inventory and convert it into cash is very important in predicting its success. To measure SFM’s efficiency, we will use the cash conversion cycle, which shows how many days it takes to convert inventory into cash. It is calculated as follows:
CCC = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding
Sprouts Farmers Market’s cash conversion cycle is 11 days. This means that it takes the company 11 days for it to convert its inventory into cash. In the past several years, this number has trended downwards, as its cash conversion cycle was 15 days in Fiscal 2019. This indicates that the company’s efficiency has improved.
It is also worth mentioning that 11 days is much better than the sector average. Currently, the consumer staples sector has an average cash conversion cycle of 45 days. As a result, the company can be considered to be more efficient than most of its peers.
In addition to the cash conversion cycle, we can also consider Sprouts Farmers Market’s gross margin trend. Ideally, we would like to see a company’s margin expand each year. This is unless its gross margin is already very high, in which case it is acceptable for it to remain flat.
In Sprouts Farmers Market’s case, its gross margin has expanded in the past several years. 10 years ago, its gross margin was 29.5%. Five years later, this figure increased to 33.6%, and now, it is 36.4%. This is ideal because it allows the company the opportunity to increase free cash flow or reinvest a larger percentage of revenue into growth initiatives.
SFM Creates Value for Shareholders
Great companies often have great management teams that effectively allocate capital to profitable projects. We can get a good picture of management’s effectiveness by analyzing its financials. A metric we like to look at is the economic spread, which is defined as follows:
Economic Spread = Return on Invested Capital – Weighted Average Cost of Capital
The idea is very simple, if the return on invested capital is greater than the cost of that same capital, then the company is creating value for its shareholders through well-thought-out projects. Otherwise, the company is destroying value and would be better off simply investing money into risk-free bonds.
For Sprouts Farmers Market, the economic spread is as follows:
Economic Spread = 10.8% – 6.8%
Economic Spread = 4.0%
Since SFM has a return on invested capital of 10.8%, it is creating value for its shareholders, implying that management is efficiently allocating capital.
When using its five-year average ROIC of 13%, the spread is even greater. It will be interesting to see if it can get its ROIC back to 13% within the next few years. Nonetheless, 10.8% is still a respectable figure, especially for the grocery business.
Growth Catalyst
As a consumer staples company that sells groceries, Sprouts Farmers Market can act as a hedge against inflation. Since customers will continue to need food, SFM will be able to pass on most of the costs.
In addition, higher food prices mean that going out to restaurants is becoming more expensive. Because of this, people may prefer to prepare their own food purchased from grocery stores rather than dine out.
This could potentially increase the volume of shoppers visiting the store, which, combined with higher inflation, means higher revenues for the company.
Risks
To measure Sprouts Farmers Market’s risk, we will first check if financial leverage is an issue. We do this by comparing its debt-to-free-cash-flow ratio. Currently, this figure stands at 5.8 (if we include lease liabilities as debt).
This is roughly in line with Kroger’s (KR) debt-to-free-cash-flow ratio of 5.7 and Walmart’s (WMT) ratio of 5.3. However, it is not as good compared to Target (TGT) and Costco (COST), whose ratios come in at 3.2 and 1.5, respectively.
Nonetheless, we don’t believe that debt is currently a material risk for the company because its interest coverage ratio is 29 (calculated as EBIT divided by interest expense). This means that its earnings before interest and tax can cover its interest payments 29 times over.
However, there are other risks associated with Sprouts Farmers Market. According to Tipranks’ Risk Analysis, SFM has disclosed 41 risks in its most recent earnings report. The highest amount of risk came from the Finance & Corporate category.
Valuation
To value Sprouts Farmers Market, we will use a single-stage DCF model because its free cash flows are volatile and difficult to predict. For the terminal growth rate, we will use the 30-year U.S. Treasury yield as a proxy for expected long-term GDP growth.
Our calculation is as follows:
Fair Value = Average FCF per share / (Discount Rate – Terminal Growth)
$35.83 = $1.74 / (0.078 – 0.0294)
As a result, we estimate that the fair value of Sprouts Farmers Market is approximately $35.83 under current market conditions.
Wall Street’s Take
Turning to Wall Street, Sprouts Farmers Market has a Hold consensus rating based on two Buys, four Holds, and four Sells assigned in the past three months. The average Sprouts Farmers Market price target of $28.56 implies 9.2% downside potential.
Final Thoughts
Sprouts Farmers Market is a solid company that may benefit from inflation. However, our estimated intrinsic value doesn’t really provide a large enough margin of safety for us to be bullish on the stock.
Furthermore, it appears that the analyst community thinks that SFM’s valuation is priced in, as they collectively expect over 9% downside. As a result, we are neutral on the stock.
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