Sprouts Farmers Market (SFM 3.25%) is a specialty grocery chain with a heavy presence in the South and Southwest. The grocer released its full-year 2020 earnings on Feb. 25, putting up fantastic sales and profit growth with an eye on sustainable store expansion.
Shares were up on the news, but they're still down over the last three years, even though management seems to have turned around this business. For that reason and others outlined below, investors should take a hard look at Sprouts Farmers Market as a potential addition to their portfolio.
Unique concept
While Sprouts competes in the grocery industry, its unique concept leaves it free of much direct competition. The company focuses on supplying fresh, healthy options for special diets and lifestyles (like vegan or gluten-free) at an affordable price. This gives it a competitive advantage over Whole Foods but also leaves it free from battling with Kroger or Walmart for customers. Its only true competitor is Trader Joe's, a private grocer with 530 stores scattered across the United States. However, Sprouts also competes with local concepts with the same focus on health and wellness.
Image source: Getty Images.
You can see the focus play out with Sprouts' sales mix. Sixty-eight percent of the company's sales come from produce and what it calls attribute-based products (vegan, gluten-free, paleo, etc.) with organic products making up 23% of sales. CEO Jack Sinclair, who came from Walmart's U.S. grocery division in 2019, has talked about focusing on winning these health-conscious customers instead of trying to attract every person in town.
Strong fundamentals
Sprouts saw strong financial growth in 2020. Sales grew 15% to $6.5 billion, while adjusted earnings per share (EPS) grew 99% to $2.49. The company also paid down $288 million of debt in 2020. With only $250 million in debt outstanding and $170 million in cash, Sprouts' balance sheet got materially healthier over the past year.
2020 was clearly a good year for the company. However, some of that strength was undoubtedly fueled by the fact Sprouts kept its doors open as an essential business during the COVID-19 pandemic. Management basically acknowledged this reality with 2021 guidance that called for flat or declining numbers across all of its important financial metrics. However, Sprouts still sees the potential to more than double its store count over the long term, self-funded from cash generated by operating activities. If you can see the forest through the trees, a relatively weak 2021 shouldn't scare a potential investor from this business.
Valuation
Even though the business is of high quality, the best part about Sprouts Farmers Market stock is how cheap the shares are. The company generated $375 million in free cash flow in 2020, giving it a price-to-free-cash-flow ratio of 6.8 based on the current market cap of $2.6 billion. Yes, you have to consider that cash generation in 2021 could be lower than 2020, but over the long term, with self-funded store growth, it's not unreasonable to think this business could generate $1 billion in annual free cash flow five years from now. At current levels, that looks like a bargain.
Sprouts Farmers Market had a fantastic 2020, but the market doesn't seem to appreciate it. With new leadership, a clear path to store growth over the next decade, and an attractive valuation, Sprouts is a quality investment for anyone with a long-term mindset.
