New addition to the portfolio: $SFM

Differentiation drive value

Grocery stores are one of the least sexy businesses in an investor’s universe. Low returns on capital, thin margins, stagnant revenue growth, and it’s hard to see why I would be interested in the sector. However, I think one name stands out above the rest: Sprout Family Markets.

Differentiated Product

Sprout Family Markets is a regional retailer that focus on providing organic foods and produce. The company’s stores can be found in Southwest, Mid-Atlantic, and Southeastern United States, with a heavy concentration in Texas and California.

Sprout Family Markets tries to differentiate itself in a couple ways from traditional big box grocers. For starters, their store footprint is roughly half that of an average big box grocery. This model allows them to employ less assonates per location and further leverage their high fixed costs. This leverage has resulted in superior gross and operating margins compared to others in the space. Conceptually, SFM also differs themselves from other retailers. SFM takes a unique approach to arranging their stores. They start by creating an open layout with produce being in the front of store, surrounded with promotional items. The grocery, meat, and frozen products can be found in the back end of the store. Not only does this open layout help create a “farmer’s market-esque atmosphere”, it also makes it easier to find items, creating a more convenient experience for customers. SFM frequently brags in their earnings calls and press releases that over 90% of their SKUs are unique. This differentiation drives repeat customers who otherwise can’t buy this product from other stores.

The stock debuted to much fanfare in 2013 but has largely floundered since then. By 2019, The company had already cycled through 3 CEOs since going public. Same store sales struggled to keep up with competitor and capital allocation strategies were inconsistent amid constant change at the top. In June of 2019, the company finally found a suitor to fit its ambitions.

Management

Unlike my last pick, SFM has beyond capable management. More specifically I am talking about their CEO Jack Sinclair. Before taking over the top job, Sinclair had already established a world class resume in the grocery business. He spent 7 years as the head of Walmart’s Grocery Division and worked another 4 years managing over 400 Safeway stores in the United Kingdom. When it comes to groceries, the man knows the game.

Ok enough talk about Sinclair’s prior work experience. Those won’t move the stock in our favor. Let’s talk about what he’s accomplished since taking over the company two years. Since taking over, he’s spent much of his time trying to right the ship from his predecessors’ mistakes.  The most immediate change can be found in the marketing department. He’s transitioned the company away from relying on archaic print ads and coupons found in newspapers to a fully digital strategy. This has allowed Sprout Family market to double its email list, collect more data on its customers, and increase brand recognitions. On the merchandise side, He’s invested in two brand new distribution centers for existing and future stores. Now, all Sprout Family Market stores will be within 250 miles of a distribution center. Not only does this ensure that SFM’s stores will have consistent access to fresh produce, but it also lowers the operational costs of distribution over the long run with shorter delivery routes.  When it comes to competition, Sinclair has been steadfast on one principle: Differentiation. Sinclair knows he won’t be able to beat the Walmarts and Costcos of the world on pricing. He wants to beat them at providing differentiated products and produce. Sprout’s moat won’t be created because of its pricing, but rather because of its unique array of produce and organic foods. This will drive repeat visits from already loyal customers and bring in new ones who can’t find these products anywhere else. On a side note, inflationary concerns are largely non-existent for grocers. If inflation continues to persist throughout the broader economic, this should actually improve sales and margins. Most grocers operate best in a 3-4% inflationary environment, due to the high fixed costs associated with their business model.  

Last May, Sinclair unveiled the most ambitious growth plan in the company’s history. Starting in 2022, SFM plans to increase their store count by 10% per anum. These new units will not only be smaller than their current stores, but also 20% cheaper to build. Management believes that these smaller units will be able to generate revenue on par with its bigger stores while delivering a 40+% return on investment in 4 years. Not too shabby for a low margin low return on capital type business.

 However, the street has taken a much more skeptical view of Sinclair’s growth plans. Analysts have been indifferent at best about Sinclair’s ambitions. Most seem to doubt that the firm can hold sales constant at each new store, while shrinking its footprint. Since unveiling these ambitions, Sinclair has asserted time and time again that these unit economics work, and already Sprout’s smaller stores are able to generate revenue on par with their larger units. This makes sense as Sprouts will be largely cutting space from their less profitable deli and meat sections, leaving more space for their more robust vitamins and produce sections. Now let’s see if the math work outs for our investment:

If Sprouts starts 2022 with 380 stores and grows their unit count 10% from then until 2024, they will have 460 stores. If those stores can hit Sprout’s revenue and EBITDA margin goals, then Sprout will have generated roughly $600M in EBITDA for fiscal 2024. Whole Foods was bought out for 10x EBITDA, so being conservative and using 9x has our multiple yields us a valuation of $5.4 billion, or about 70% upside from its current levels. Not too bad for a boring grocer if I do say so for myself.

I’m going purchase 380 shares for our portfolio.