Sprouts Farmers Market SFM

Transcription

1 Sprouts Farmers Market SFM Buy Target: $24.00 Current Price: $18.66 Investment Thesis We believe that Sprouts Farmers Markets (SFM) is one of the top long term investments in the food retailing industry. Food deflation has significantly impacted the entire food retailing industry as participants have engaged in price wars in an attempt to gain market share. In doing this, retail deflation has outpaced price deflation hurting profit margins. This presents our opportunity, buy when others are fearful. Food price deflation appears to be improving and although we expect it to be mid 2017 before its impact hits the income statement, we believe that the fundamental improvements that Sprouts has made to their customer base will more than compensate for this past year s pullback. Now looks like a good time to follow management and buy the stock (recent buybacks discussed below). Catalysts Price Deflation Improving: SFM is down 22.57% over the past year primarily due to the deflationary pressures on inventory costs (really it s the price wars from these pressures that hurt). It now appears that the food at home - consumer price index (CPI), the measure for food inflation/deflation, has recently shifted to the positive (figures 1 & 2). This can be seen in the recent price shift upward of milk, cattle and hogs. Deflationary pressures remain on produce (a staple of SFM s offerings), but we believe that the totality of their offerings will move away from deflation over the coming year. Source: Bloomberg, JWC Research Weekly Chart Solid Long-Term Growth: One of our favorite buy recommendations are companies with long term growth potential that are temporarily out of favor. SFM fits that model perfectly. Management has actively positioned the company for long term growth in the face of compressed margins and price wars with competitors. They have continued to increase the number of stores towards their stated target of 1,200. (continued on next page ) Source: Stockcharts.com *Please see disclaimer at the end of this report JWC Research. All rights reserved. No part of this report may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying or by any information storage and retrieval system, without permission in writing from JWC Research. Page 1 February 16, 2017

2 Additionally, SFM has maintained their position as a cost leader, especially in produce, they are ~25% cheaper than Whole Foods and even a bit cheaper than Walmart. This will continue to drive new customers to their growing brand. Figure 1. CPI (food at home) Company Buybacks: Through October 31st, 2016 SFM had repurchased 11.1 million shares a total investment of $249 million (avg cost of $22.43). This is in line with our belief that this company is a good long term holding at this level. This also supports our belief that management has done a respectable job of building shareholder wealth in a difficult economic environment. Additional Food for Thought: SFM currently has million shares outstanding and 134 million in their float. Current short interest: 16.4 million shares or 12.25% needing ~5 days to cover. We believe that this will eventually support our other catalysts as SFM begins to climb higher. With an effective tax rate of ~37%, a decrease in the corporate tax rate by the Trump administration will go straight to their bottom line as they are exclusively in the United States. The counterpoint here is that if President Trump also goes forward with a border tax on Mexico, a large supplier of SFM, will that hurt them. We don t believe it will in the long run as food tends to be inelastic and retail prices should adjust rather quickly. Source: Bureau of Labor Statistics, Bloomberg Figure 2. CPI (food at home) 10 yr On 2/23/2017 SFM reports year end numbers. We know that customer discounts have been in full swing during the 4 th quarter and we expect this to put pressure on their Q4 EPS, hence our underperformance expectations vs consensus (see figure 6). We view a potential pullback after the earnings announcement as a further opportunity. Barring any material changes to their outlook, we expect limited downside to SFM s stock price next week thanks to the overwhelming bullish catalysts in place. Source: Bureau of Labor Statistics, Bloomberg Page 2 February 16, 2017

3 Company Description SFM operates as a retailer of fresh, natural, and organic food in the United States. The company's retail stores offer fresh produce, bulk foods, vitamins and supplements, grocery, meat and seafood, deli, bakery, dairy, frozen foods, body care and natural household items, beer, wine, and dairy alternatives. As of November 3, 2016, it operated 252 stores in 13 states. Sprouts Farmers Market, Inc. was founded in 2002 and is headquartered in Phoenix, Arizona. Industry Overview State of the Industry: The food retailer industry is large, highly fragmented and competitive. It has been beaten down over the past year as food deflation has spurred price wars putting pressure on margins. Eggs, Meats and Dairy Products were hit the worst during 2016 and each are forecasted to have a much improved 2017 according to the U.S. Department of Agriculture (see figure 4). The street has known this, and in response the industry as a whole is up slightly more than 10% from its bottom. Except for SFM, currently sitting near all-time lows. Figure 3. SFM Store Count Source: Bureau of Labor Statistics, Bloomberg The explanation is logical. Produce, the centerpiece of SFM s offerings, has recently turned deflationary. Each of the major food retailers have driven prices even lower with promotional events. Produce: The most recent food to turn deflationary is produce, the cornerstone of SFM s offerings (accounting for ~25% of sales). We believe that this is what has kept SFM near its historic lows (see weekly chart on page 1). This has already started promotional events from traditional food retailers and healthy living retailers in the produce department. This is expected to be a short term problem. The average deflationary cycle for produce is about 3-4 months, which is in line with the average growing cycle for many U.S. producers. Healthy Living: The competitive landscape for all natural and organic products has intensified. Traditional food retailers have begun offering more products of this type and stores dedicated to this have popped up both online and in brick and mortar locations. As with many price wars we expect this deflationary period to squeeze some of the weaker players out of the market and those who were able to maintain a cost advantage and therefore drive in more customers will fare the best when the dust settles. Page 3 February 16, 2017

4 Wrap Up: 2016 was a tough year for food retailers and we expect it to improve over the next few quarters. Pressure is likely to remain on SFM as produce has temporarily turned deflationary. SFM has responded with promotions which has the effect of attracting more customers but also amplifying margin pressures during promotional times. Figure 4. United States Department of Agriculture Forecasts Page 4 February 16, 2017

5 A Quick Look at Operations As of November 3, 2016 SFM had 252 stores in 13 states. Their stated goal is 1,200 stores. Their approach to business is fresh, natural and organic products at compelling prices. We have taken a closer look at the possibility of SFM attaining their stated goal of +15% a year growth until they can reach that 1,200 store mark and their ability to maintain their position as a price leader. Locations: They have opened 19, 24, 27 and 36 stores in 2013, 2014, 2015 and 2016 respectively. The average store size is between 28,000 and 30,000 sq. ft. Compare that to the avg Whole Foods 38,000 to 40,000 sq. ft. and the avg Walmart Supercenter ~178,000 sq. ft. These smaller store sizes work to SFM s advantage as it seems to help with location selection. New Stores have an average cash cost of $3.1 million and pre-opening expenses of $0.5 million. Target net sales during the first year is $12-$14 million. Through the 3 rd quarter of 2016, sales growth was largely due to new store productivity. We expect a similar situation in the Figure 5. Map of Current Locations coming quarters as deflation begins to turn and free cash flow continues to fuel additional expansion. Expansion: SFM recently took over a 260,000 sq. ft. warehouse in Georgia to serve their expanding market into southeast United States. This will lower delivery times and costs as this area had previously been served from their Dallas warehouse (they also have one in Phoenix, AZ). SFM has plans to expand into Florida and North Carolina, followed by Arkansas, Mississippi and Louisiana (see figure 5 for current locations). Many are likely to be served from this new distribution warehouse. Pricing Position: Produce is at the core of SFM s offerings. They claim to be the lowest price retailer, so we had a look at their prices in two of SFM s major markets, Phoenix, AZ and Atlanta, GA. When comparing promotional items to promotional items, SFM had slightly better prices than Walmart, and significantly better prices than Whole Foods (+25% better). Management seems committed to growing market share via promotions in an attempt to build customer loyalty. Thus far they have succeeded and we expect this type of success to continue. Source: Company Presentation Page 5 February 16, 2017

6 Management Our View: Management has done a fine job in a year of immense competition and increasing deflationary pressures. We believe they can maintain new store growth in the low double digits while improving their same store sales at a midsingle digit pace (4%-5%). Combined this is likely to keep them in the range of 14% sales growth over the next few years. Figure 6. Estimates & Key Data Through October 31st, 2016 SFM had repurchased 11.1 million shares a total investment of $249 million (avg cost of ~$22.43). This also supports our belief that management has done a respectable job of building shareholder value in a difficult economic environment and appear to be good asset allocators. We expect this trend to continue. JWC Valuation Management s primary goal is to grow the top line. They have been tactfully pushing modest same store sales and aggressively pushing new store openings. The goal: Growth. The food retailing industry (which includes companies like Whole Foods, Kroger and Weis Markets) has grown sales over the past year at an average rate of 6.57%, Sprouts has grown 17.46%. If we were comparing it to just Whole Foods Markets (WFM) which is more of a pure competitor to SFM, WFM has grown its top line just short of 2%. It is under this pretense that we choose a premium multiple when calculating our valuation. SFM is a growth company and should be valued accordingly. Growth has been largely funded by free cash flow and we expect that to continue. SFM currently has $265 million drawn on their $450 million credit facility. They have a current ratio of 1.47 (Q3 2016). Given their $3-$4 million new store cost, they have plenty of available capital to meet their stated goal of 14% annual growth for the foreseeable future. Valuation: Our 12-month price target of $24 comes from our 2018 EV/EBITDA valuation (figure 7). Much of Wall Street is utilizing a 2018 P/E valuation, we did this calculation as well (figure 7) and we ultimately elected to go with the more conservative EV/EBTIDA price target. Source: Bloomberg, JWC Research Figure 7. JWC Valuation Calculations Source: JWC Research In Millions except Per Share Page 6 February 16, 2017

7 Risks Deflation: Deflation has been the largest single headwind for the food retailing industry we are including the price wars that derive from this macroeconomic environment. We are forecasting the recent emergence of produce deflation to only last a single growing season (3-4 months) and then move to modest inflation. We are utilizing the United States Department of Agriculture (USDA) forecasts for food inflation/deflation. If food deflation lingers longer than anticipated or worsens then this will put continued pressure on margins. Expansion: SFM has pushed hard with new store growth. New stores require proper distribution and suppliers. The majority of their inventory comes from Mexico and California, but as they grow throughout the country, inventory will likely have to be sourced from locations closer to the new stores and distribution centers. If they stumble here, this could cause a ripple effect for coming years and could be a real hurdle to our valuation. Threat of New Entrants: The threat of new entrants is low in the food retailing industry. Especially in the all-natural space that SFM lives. It would be a mistake to overlook the competitiveness if SFM is going to continue to gain market share. We believe that much of the ability to find new customers is going to be in their winning the price wars. They have been succeeding at this recently, but this will come at the cost of weaker margins. If they can continue to convert these new trial customers to loyal customers then we should expect a continued improvement in same store sales and new store success. Alternatively, if SFM is unable to attract new customers, perhaps because customer s current store began offering similar products or because a new competitor of SFM s has popped up, this will hurt SFM s growth and ultimately our valuation. Page 7 February 16, 2017

8 JWC Rating Systems Buy: The stock s total return is expected to outperform the S&P 500 over the next 12 months. Avoid: The stock s outlook and drivers are too unpredictable. This stock should be avoided. Sell: The stock s total return is expected to materially underperform the S&P 500 over the next 12 months. JWC Research Disclaimer JWC Research is an independent investment research provider and is not a member of the FINRA or the SIPC. JWC Research is not a registered broker dealer and does not have investment banking operations. The JWC Research trademark, service mark and logo are the intellectual property of JWC Research Inc. The information contained in this research report is produced and copyrighted by JWC Research, and any unauthorized use, duplication, redistribution or disclosure is prohibited by law and can result in prosecution. The content of this report may be derived from JWC Research reports, notes, or analyses. The opinions and information contained herein have been obtained or derived from sources believed to be reliable, but JWC Research makes no representation as to their timeliness, accuracy or completeness or for their suitability for any particular purpose. This report is not an offer to sell or a solicitation of an offer to buy any security. The information and material presented in this report are for general information only and do not specifically address individual investment objectives, financial situations or the particular needs of any specific person who may receive this report. Investing in any security or investment strategies discussed may not be suitable for you and it is recommended that you consult an independent investment advisor. Nothing in this report constitutes individual investment, legal or tax advice. JWC Research may issue or may have issued other reports that are inconsistent with or may reach different conclusions than those represented in this report, and all opinions are reflective of judgments made on the original date of publication. JWC Research is under no obligation to ensure that other reports are brought to the attention of any recipient of this report. JWC Research shall accept no liability for any loss arising from the use of this report, nor shall JWC Research treat all recipients of this report as customers simply by virtue of their receipt of this material. Investments involve risk and an investor may incur either profits or losses. Past performance should not be taken as an indication or guarantee of future performance. JWC Research officers, employees, agents and/or affiliates may have positions in stocks discussed in this report. No JWC Research officers, employees, agents and/or affiliates may serve as officers or directors of covered companies, or may own more than one percent of a covered company s stock. Page 8 February 16, 2017