Investors typically shy away from the grocery store industry when looking for market-beating investments. The space is highly competitive and mature, and it has commoditized products, making it difficult for operators to differentiate themselves.
But there are a few grocery concepts -- Trader Joe's and Whole Foods are two good examples -- that have built lasting brands that keep customers coming back again and again. I believe Sprouts Farmers Market (SFM 1.11%) is another promising grocery concept with tons of growth potential.
Shares of Sprouts are now up 18% in the past month after the company reported strong second-quarter earnings. Here's why the stock is still underrated and belongs in your portfolio today.
Positive comparable sales
Sprouts reported its Q2 earnings on Aug. 3. Sales were up 5% year over year, which came from a small number of new store openings and comparable-store sales growth of 2%. Comparable-store sales growth tracks sales growth from stores that have been open for 12 months or longer and is a good indication of whether a retail concept is expanding or losing popularity in a given period. The grocer has struggled over the past few years in putting up consistent comp store growth, so this number was definitely a highlight for investors this quarter.
Profitability and cash flow generation have been much more consistent, and that showed up once again for Spouts in the second quarter. Operating income grew 3.4% year over year to $86.5 million, with an adjusted EBIT (earnings before interest and taxes) margin of 6.4% through the first half of 2022 -- the exact same margin it had in the first half of 2021. With raging inflation and wage pressure going on in the U.S. economy right now, Sprouts is showing its resilience by maintaining its EBIT margin.
Through the first half of 2022, Sprouts generated $209 million in operating cash flow, up from $177.3 million from the same period last year. With this cash, it is pouring money into store count growth while also returning cash to shareholders through buybacks. In Q2, management spent $65 million on share repurchases, reducing the stock's share count by 2.4 million. This helped earnings per share (EPS) rise 10% to $0.57, outpacing sales growth.
Long runway with a unique concept
While management still plans on pouring money into share repurchases -- it has repurchased 54 million shares and reduced share count by 35% since 2015 -- Sprouts still has a huge runway to expand its store base across the United States.
At the end of Q2, the grocer had 378 stores in 23 states. It is set to open up 15 to 17 stores this year, 30 next year, and then increase its store growth to 10% annually in 2024. The slow acceleration in growth is a result of supply chain issues, which are out of management's control. If those were resolved, the executive team said the company would be at 10% unit growth already.
But what makes Sprouts Farmers Market special? Why will it steal customers from legacy competitors with all these new stores? It comes down to a few things. First, Sprouts prides itself on having fresh produce at the center of its stores (hence, the farmers market name). Second, it has large bulk and vitamin sections. Third, it focuses on serving specialty diets like keto, paleo, and vegetarian across its product assortment.
Finally, unlike Whole Foods, it sells products at a reasonable price. This strategy caters to health-conscious Americans looking for a better assortment than the traditional grocery store. While only a relatively small portion of the population is attracted to this model, Sprouts is still a long way off from serving its entire target market.
The stock is still cheap
Even after this recent pop, Sprouts shares still trade at a cheap valuation. With a market cap of $3.25 billion as of this writing and $347 million in trailing 12-month operating income, the stock sports a price-to-operating-income ratio of 9.4. Combine this cheap multiple with a growing store count, positive comp-store sales, consistent cash generation, and a shrinking share count, and Sprouts stock looks set to provide great returns for shareholders this decade.