The term "value stock" often refers to companies that trade at cheap valuations in relation to their annual earnings or cash flows. While many of these companies are valued cheaply due to slow or declining growth, occasionally, high-quality and growing businesses simply get mispriced by Mr. Market. Two of those companies are Sprouts Farmers Market (SFM 0.43%) and Nelnet (NNI -0.84%).
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Sprouts Farmers Market
Sprouts operates 363 health-focused grocery stores located across 23 states. However, unlike its peers in the ultra-competitive grocery industry, Sprouts has carved out a bit of its own niche by targeting health enthusiasts and diet-specific consumers. Since these customers are often focused more on quality than price, they're typically willing to pay slightly higher prices in exchange for locally sourced and organic food.
As its name entails, Sprouts' stores are designed to invoke the feeling of attending a traditional farmers' market. The company helps cultivate this atmosphere by putting its fresh produce at the center of the store and having an open format with low-shelf displays. Additionally, Sprouts' stores are much smaller than competitors', which helps the company spend less on leases. The company's average store size ranges from 28,000 to 30,000 square feet, with its newer stores expected to be between 21,000 and 25,000 square feet. For comparison, Kroger and Walmart average well above 60,000 square feet per store.
Thanks to these smaller store sizes and higher-value customers, Sprouts generates greater profit margins than nearly all of its peers.
| Metric | Kroger | Walmart | Natural Grocers | Weis Markets | Sprouts Farmers Market |
|---|---|---|---|---|---|
| Gross margin | 23% | 25% | 32% | 27% | 37% |
| Operating income margin | 2% | 5.2% | 2.3% | 3.5% | 5.9% |
Data source: Listed companies. Calculations by author.
Over the last 24 months alone, Sprouts has generated roughly $526 million in free cash flow and used that cash to make several improvements to its operations. For example, during the most recent quarter, Sprouts built out two new distribution centers in Colorado and Florida, which will help improve the overall quality and freshness of its produce at the surrounding stores. Sprouts has also reduced its outstanding long-term debt by more than 50% over that same 24-month span. With this improved balance sheet, Sprouts' management team stated that the company is in a great position to start adding new store locations, and in 2022 Sprouts is planning to begin growing its store count by 10% per year.
But despite Sprouts' expected store growth and better profit margins than that of competitors, the company trades at a dirt-cheap valuation. At its current market cap to operating income ratio of roughly seven times, Sprouts trades at a significant discount compared to peers like Kroger and Walmart, which trade at 12 and 14 times, respectively.
Nelnet
Nelnet is a Lincoln, Nebraska-based conglomerate that garners very little attention from investors. Likely due to its nonpromotional nature and unique corporate history, not many people seem to have taken notice of Nelnet's impressive blend of assets.
After getting its start in servicing and originating federally guaranteed student loans, Nelnet has since morphed into a variety of businesses and assets that continue to accrete shareholder value. Before diving into some of these promising subsidiaries under Nelnet's umbrella, it's probably worth mentioning the company's main cash generator.
Nelnet's Asset Generation and Management (AGM) business consists of a massive pile of student loans that continue to get paid off by borrowers. Though new originations under this student lending program were officially halted in 2010 by the federal government, Nelnet continues to collect plenty of interest from these remaining loans. In fact, according to the company's latest quarterly report, Nelnet expects AGM to generate roughly $1.6 billion in cash flow by the end of 2026.
But since the cash from this loan book continues to gradually decline, management has been prudent about reallocating capital to its other operations. Two of those include Nelnet's loan servicing and education technology businesses. Though I won't go into too much detail on both of these segments, it's worth explaining the basics.
The loan servicing segment administers and services different types of loans primarily on behalf of the federal government. While this operation doesn't grow much, it generates a good amount of steady earnings for the company. The education technology business, on the other hand, consists of nine different businesses that provide various software and payments processing solutions for the education sector.Unlike loan servicing, this segment, which Nelnet refers to as Nelnet Business Services (NBS), has grown its earnings before taxes by more than 20% annually over the last five years reaching $75 million for the last 12 months.
But it isn't just its operating businesses that should have investors excited. Nelnet has several other investments, including a private stake in a performance analysis company called Hudl, partial ownership of a fiber optic cable business called Allo Communications, and various venture investments, which in aggregate Nelnet has invested $1.2 billion in over the last eight years.
At Nelnet's current market cap of $3.2 billion, its valuation stands at about eight times the company's trailing 12-month operating income and free cash flow. With the growing and profitable businesses under its umbrella and the steady cash flow from its loan book, Nelnet's dirt-cheap valuation should make for strong shareholder returns over the coming years.
