Please ensure Javascript is enabled for purposes of website accessibility

Why Sprouts Farmers Market's Q3 Could Lead You to Greener Pastures

By Brett Schafer – Oct 31, 2020 at 9:14AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The company is growing sustainably and trading at a discount to industry peers.

Sprouts Farmers Market (SFM -0.80%) just reported strong third-quarter results -- another period of steady top- and bottom-line growth that shows again why the company is a lot hardier than the majority of investors give it credit for.

The good and the bad from the quarter

Sales were $1.6 billion for the quarter, up 9.5%, with comparable-store sales up 4.2%. This growth is not as strong as Costco's (COST 0.15%) 12.4% sales growth last quarter, but it's still impressive when you consider that Sprouts doesn't sell many of the non-perishable or non-food items like paper towels that have gotten a boost during the coronavirus pandemic.

Two people chopping fresh produce on a table

Image source: Getty Images

Looking at the bottom line, Sprouts had $60 million in net income compared with $26 million a year ago. However, it had to spend $34 million in extra expenses because of the pandemic, driving operating expenses to grow faster than sales for the quarter. This could dampen its ability to increase its profit margins over the long term, a concern for investors if those expenses keep growing in future quarters. To be clear, this doesn't mean that the company cannot grow its net profits over time, but its ability to grow its profit margin may hit a wall in the near term.

How the company can grow

Sprouts opened six new stores in the third quarter and now has 356 stores in 23 states. This is in line with its oft-stated goal to increase store count by 10% a year. This will allow the company to grow sustainably without having to take on outside funding or more debt.

But is there consumer demand for more Sprouts stores going forward? I believe so, for two reasons:

  1. Sprouts has more room to grow in its established markets. For example, the company only has four locations in Washington state and entered the market in 2019. Compare that to Arizona, a state with a similar population (both in between 7 million and 8 million people) and urban centers, with 42 locations. 
  2. The concept can work in the majority of states. Sprouts says that it wants to provide the value of Whole Foods (fresh produce, vegan/paleo options, etc.) but without breaking the bank. This format isn't limited to certain regions. It may be tough to get a dozen stores in South Dakota, but the company doesn't have a single store in many large states, giving investors reason to believe it won't run into location growth problems anytime soon.

But what about the valuation?

Sprouts currently has a market cap of around $2.4 billion. Its trailing price-to-earnings, or P/E, is 10. Kroger (KR 0.27%), the most similar public company to Sprouts (Whole Foods and Trader Joes do not have publicly available financials), also has a P/E of 10. This indicates that investors believe Sprouts has the same growth potential as Kroger, even though the larger company already has over 3,000 stores across the United States.

One last note is that Sprouts's forward P/E, which is based on earnings estimates over the next 12 months, is roughly 12. This means that analysts think that Sprouts's expenses will grow faster than its revenue over the next year, likely because of pandemic-related costs. However, investors with a long-term mindset should be able to see the forest through the trees and understand that when the coronavirus eventually subsides, these expenses likely will as well. 

Brett Schafer has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Costco Wholesale. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.