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Unless you live in the Southwest United States, you have probably never been to a Sprouts Farmers Market (NASDAQ: SFM  ) . However, if the company's ambitions are fulfilled, the company will soon be as recognizable as grocery giants Whole Foods Market (NASDAQ: WFM  ) and Kroger (NYSE: KR  ) .

Sprouts targets health-conscious shoppers on a budget -- sort of a lower-priced Whole Foods. The company's origins date back to 1969 when Stan Boney opened Boney's Marketplace in California. Boney's, later renamed Henry's Farmers Market, focused on selling natural food at affordable prices. After selling the company in 1999, the Boneys opened Sprouts in 2002 as an affordable provider of natural foods, vitamins, and other products.

In 2010, the company had 54 stores and $517 million in sales. Riding the wave of enthusiasm for organic food, the company has since tripled its size -- expanding to 163 stores in eight states with $1.7 billion in sales.

A different model

Like many other grocers, Sprouts offers a wide variety of fresh and natural foods. Unlike most grocers, Sprouts accepts razor-thin margins on its fresh produce. The stores' inexpensive -- yet high-quality -- produce draws customers in, and the stores make money on the high-margin products that surround the produce on the store floor: vitamins, meat, bulk foods, beer and wine, baked goods, seafood, and similar items. In addition, about one-quarter of Sprouts' items are on sale on any given day.  Sprouts is sort of like Whole Foods with Wal-Mart prices (or, as close to Wal-Mart prices as a natural grocer can get).

The model has worked extremely well for Sprouts; it earns a 30% gross margin, compared to 35% for Whole Foods and 22% for Kroger. Meanwhile, Sprouts' operating margin is similar to that of Whole Foods, while both stores' margins are much higher than Kroger's. This is impressive because Sprouts has a smaller store base than its upscale rival: Sprouts has 163 stores, compared to Whole Foods' 355.

Whole Foods has tremendous brand recognition for a company that may still triple in size before it is done growing in the United States. The company's stature as the largest business in the organic food market affords it significant bargaining power over suppliers, particularly organic farmers.

Moreover, its stores are about 40,000 square feet -- double that of smaller rivals like Sprouts. This allows Whole Foods to take advantage of its high store traffic and burn through its inventory faster than traditional grocers; Whole Foods turns its inventory over about eighteen times per year, whereas Kroger's inventory turnover is about twelve times per year. As a result of earning higher margins and a higher inventory turnover, Whole Foods earns much higher returns on capital than almost any other grocer.

Sprouts is not nearly as profitable as Whole Foods, however. Its items sell for less, which means slightly lower margins. But its inventory turnover is much lower -- about equal to that of traditional grocer Kroger. This is due to the company's relatively low profile, which makes it difficult to generate substantial store traffic.

But there is an important distinction between Kroger and Sprouts: whereas Kroger's inventory turnover has improved as its gross margin has declined, Sprouts continues to earn a higher margin than Kroger despite turning its inventory over at an equal rate. In other words, Sprouts is able to earn a higher profit on each round of inventory than Kroger can.

Kroger's lower profitability reflects the decline of traditional grocers. The grocery business is extremely cost-competitive, with many in the space resorting to substantial loss-leaders to keep store traffic numbers up. As Kroger continues to let its margin fall -- and compete based on price -- it will continue to become less attractive than grocers like Sprouts -- which competes in the gray zone between quality and price.

Bottom line

Sprouts is a fast-growing organic grocer that benefits from the massive trend in organic eating. While its ambition to outgrow Whole Foods may be excessive, its profitable business model in a growing niche will be more than enough to put a smile on shareholders' faces.

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  • Report this Comment On September 05, 2013, at 7:07 PM, ellen76 wrote:

    I live in the Southwest and I've been to Sprouts, but I don't plan to return. The place is woefully understaffed. The last time I went there, late one afternoon, they had one cashier open and a long line of customers. When it was finally my turn to check out, the computer scanner said my one-item purchase was $35. The tag on the shelf said $28. When I pointed this out, the sole cashier accompanied me to verify the shelf price. I felt like I was going to be attacked by the angry mob of customers who had to wait even longer.

    In contrast, my local Whole Foods is always very well staffed. There are no lines. That is where I spend my money.

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