Sprouts Farmers Market: SSS Growth Is Positive But Not Good Enough

Thesis

Sprouts Farmers Market (NASDAQ:SFM) maintained its recent pattern of reporting strong results. I continue to applaud the company's efforts to emphasize health and wellness in its advertising and to shift its focus to smaller stores rather than a more promotion-oriented strategy. However, I continue to remain neutral on the stock as I am still wary about the extent of SFM comps growth momentum – which is positive, but not great given the inflationary environment. The risk to reward ratio today does not seem very appealing either. Upsides from today’s share price level is mostly to be driven by increase in valuation multiple that is hard to underwrite given the SSS growth profile.

Comps growth

SFM's 1Q SSS growth of 3.1% exceeded the original projections of 1.5 to 2.5%, thanks to higher AUR inflation, higher traffic volumes, and some offset by a decrease in basket size. That's seven consecutive quarters of rising comparable sales. Given the high rate of inflation, my calculations suggest that the recent decline in basket size is significant. Therefore, while the upbeat news of 7 consecutive quarters of SSS growth is encouraging, I am concerned because I know that current levels of pricing cannot be maintained indefinitely (deflation will inevitably occur). As price-conscious customers abandon ship, there is a danger that business will not recover. The good news is that private label sales now account for 20% of all business. Looking back, I have to give props to management for getting this number where it is today. Since the company's product mix includes more produce, management has previously stated that increasing private label penetration will be challenging. But they surprised even themselves by exceeding expectations. Private label's value, in my opinion, lies less in increased profits and more in higher rates of repeat business. Those who are interested in purchasing this private label item can only do so at SFM. As they step into the store, it is very likely they will purchase something else also since they are already here. This will improve basket size, and also margins (private label) together. Hence, this improvement is really something to be positive about. In addition, e-commerce penetration continued to step up to 12.2% from 11.5% a year ago. With this increase, SFM reached its fourth consecutive quarter of e-commerce double-digit growth. The integration with DoorDash, I believe, was a major factor in the expansion. That said, while the e-commerce channel does help diversify SFM revenue stream away from its core, I am not sure how lucrative it can be from a margin perspective given the unit economics are being share with the partners now (i.e. DoorDash take rates). I guess the saving grace for SFM is that it offers a differentiated product that consumers, according to management, can't readily find at more traditional grocers.

Gross margin

Additionally, category mix shift and promotional optimization contributed to a 23-bps increase in gross margin, bringing the total to 37.5%. SFM reaffirmed its FY23 gross margin guidance of flat to slightly up, citing the continued sanity of the promotional climate and the expectation that its unique product offering will provide some buffer against inflation. I expect gross margin to gradually increase and stabilize as I see the competitive environment becoming more rational (management mentioned this in the call). Management has also made it clear from the outset that they do not anticipate a price drop this year, which bodes well for the gross margin. Moreover, as SFM expands its distribution centers across different areas, I anticipate that the company will enhance its ability to efficiently deliver fresh produce to stores nationwide. This, in turn, will lead to increased gross margin leverage by optimizing logistics routes and reducing waste.

Valuation

I lay out two scenarios in my model below.

The first scenario is what consensus is pricing in today, where revenue growth will accelerate in FY23 and FY24 due to strong SSS growth and margins to decline modestly – which I believe is due to reduce in pricing. This scenario is pretty much my base case to given how things are developing (SSS will face headwinds from lower price next year but volume will recover). If we assume that SFM is going to trade at the same multiple today, the stock is at best fair valued. Which means, for the stock to go further up, it is likely that we need to see multiples going higher. I don’t think SFA deserves a further premium here given that its SSS growth is not super fantastic.

The second scenario is what I am worried about, in that volume does not recover as much as expected (I talked about this above), as such revenue growth will be lower than what consensus are expecting. The lower-than-expected volume and pricing decline will impact margins disproportionately (back to the low 3% that it used to print). In this scenario, I think the market will punish the stock by rerating it lower in terms of valuation.

Conclusion

In conclusion, while SFM has continued to deliver strong results, I maintain a neutral stance on the stock. I am cautious about the extent of SFM's comps growth momentum, especially in the face of the current inflationary environment. The risk-to-reward ratio does not appear favorable at present, as the potential upsides from the current share price level rely heavily on an increase in valuation multiple, which is difficult to justify considering the SSS growth profile. Considering the potential scenarios, SFM's valuation appears fair at best if revenue growth meets consensus expectations, while a lower-than-expected recovery in volume and pricing decline could lead to a reevaluation and lower valuation by the market.