Sprouts Farmers Market: A Stock For A High Inflation Environment

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Investors and consumers alike have reason to be very concerned with the potential effects inflation will have on businesses. Some sites, such as ShadowStats.com, have been tracking inflation rates as being much higher than government reported results for many years. This effect is now being seen in government-produced data as well, with food inflation running at close to 10% YoY and forecasted at between 5-6% over 2022. Unlike discretionary items, food is not something people can do without, so this level of inflation is very disconcerting for most people. If the cost of goods outpaces income, it becomes more and more difficult for people; this same effect happens to investments and wealth for investors, so it is key to have at least some investments that hedge this effect.

Sprouts Farmers Market (NASDAQ:SFM) is a specialty grocer selling largely healthy and organic food throughout the United States. Sprouts currently has more than 380 stores through twenty-three states. The company offers a diverse set of products which largely target more health conscious and affluent customers. In this article, we look at how Sprouts shares can provide some resilience in an inflationary environment as well as its relative valuation and potential risks to this thesis.

An Inflationary Hedge

Inflation will be hitting all companies throughout their supply chain networks, both locally and globally. The key for companies to make their way through an inflationary environment is how price sensitive a company’s customers are and how much risk there is to alternatives. The nature of the organic and health food market is that there is a pricing premium built into the business through the extra health disclosure requirements and perceived better quality. These costs have largely been accepted by customers in this space, going back to the reference to Whole Foods as “Whole Paycheck.” These customers are more affluent at the best of time with less of their disposable income needing to go to necessities, allowing them to handle price increases better, which also makes it easier for Sprouts to pass costs on to its customers as well.

The risk to this is whether there are potential substitutes to these goods. There is of course a lot of other grocery and food options that customers who feel the pinch of higher cost Sprouts grocery bills could move to; both Kroger (KR) and Albertsons (ACI) are publicly traded alternatives that would provide lower cost. Those that feel these impacts could trade down to these lower cost alternatives, though this has always been a risk to the value proposition for Sprouts. These mainstream grocers will be passing on costs to their customers as well. In this case, Sprouts’ more affluent customer base will likely make its business more robust than those with tighter margins. Sprouts does have a decent private label base as well with roughly 16% of its listed products being private label in nature. These products could serve as internal trade-down options with the Sprouts listings as well if customers are not quite ready to switch stores.

Valuation

It is worth looking at valuation over the last several years as the trend to healthy eating alternatives has been in place for quite some time. From a valuation perspective, we had a great barometer for the valuation of grocers with the 2017 purchase of Whole Foods Markets by Amazon (AMZN) at 10.3x EV to EBITDA. In the same article, it noted multiples paid for regular grocers at the time as well, notably Albertsons’ acquisition of Safeway at 5.5x EV to EBITDA.

If we look at Sprouts’ performance since that point, it has grown EBIT by 57% during this time, inclusive of a somewhat “bubble” type performance during COVID due to the impact on other alternatives like dining out options:

Seeking Alpha, Company Filings

With the market rolling over and high price to sales stocks starting to see sell-offs, EV to EBITDA multiples are likely a better metric to value Sprouts at this point. Below we compare Sprouts’ performance on a valuation basis, a cash flow basis and on an EBIT margin basis to its larger grocery competitors:

Data by YCharts

We can see the valuation of the company has come off by almost four turns of EBITDA from the timing of the Whole Foods acquisition, despite continued growth from the company. Its valuation also compares quite favorably to its competitors, especially considering its substantially better profit margins. The company also has a lot of growth options available going forward to continue to expand its footprint as it has a presence in less than half the states in the Union.

This growth in financial performance will also be augmented by a very strong share buyback program in place while the company has been able to reduce its share count by 18% over the last 5 years:

Data by YCharts

Sprouts recently announced a new $600m buyback, replacing a $100m one in place with an expiry in December 2024. This would be a reduction of almost 20% of the shares outstanding at its current market cap of $3.2B. I believe this to be good capital management, considering the discounted multiple shares are continuing to trade at while providing a built-in put on the shares.

Risks

The largest risk as noted earlier is whether Sprouts can pass the inflation costs on to its customers; I believe this to be possible given the make-up of the customer base. There is risk to the supply chains themselves as we are seeing the impacts of both COVID and geopolitical tensions making everything slower and more costly for all participants, but this certainly is not unique to Sprouts.

There has always been a focus on margins by analysts, so Sprouts’ ability to maintain them will be of a particular focus; there has been some flux behind it as the COVID pandemic gave a temporary tailwind to the company’s performance, which has since settled back to a normalized level. Finally, Sprouts is set to release earnings after-market on May 4th; with the markets very volatile right now, these 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 Q1 goes.

Summary

It has been some time since investors have had to navigate an inflationary environment. Sprouts Farmers Market provides a good hedge due to its target market, operational performance, and ability to pass on escalating prices.