Investing in the biggest players in the grocery market doesn't seem too appealing to me. Companies like Kroger already operate thousands of stores, and balance sheets are often loaded with debt thanks to long histories of acquisitions. Run-of-the-mill grocery stores with no real differentiation are low-margin affairs, forced to compete on price with Walmart and every other generic grocery chain.
Sprouts Farmers Market (SFM 3.25%) is different. The company operates just a few hundred stores, many of them much smaller and more focused than those of its competitors. Produce, and increasingly local produce, is put front and center. Beyond produce, Sprouts fills its stores with attributed-based products – organic, paleo, keto, gluten free, etc. These types of products account for 70% of what Sprouts sells.
Growth from all angles
Sprouts can grow by increasing sales at its existing stores, and it can grow by expanding its store footprint. While the pandemic provided a tailwind to grocery stores as consumers shifted spending from restaurants, Sprouts' results have held up even as that shift has unwound. Comparable sales rose 2.2% for Sprouts in 2022, and total sales jumped 5%. The company opened 16 new stores during the year, bringing its total store count to 386.
Sprouts is ramping up store openings this year. The plan is to open 30 new stores, all of which will be in the company's new smaller format. These new stores will feature 23,000 square feet of floor space, while the old format included 30,000 square feet. These smaller stores are more productive, generating higher returns on investment.
Sprouts is also closing 11 stores this year, but these store closings are a one-off. The company was exploring closing these larger, unprofitable stores prior to the pandemic, but it held off to ensure the communities served had access to groceries. Now that the pandemic has largely faded away, Sprouts is finally shuttering these stores this year.
For the full year, Sprouts expects comparable store sales growth in the low single-digits, along with total sales growth between 4% and 6%. Adjusted earnings per share should come in between $2.41 and $2.53, up from $2.39 in 2022.
A buyback machine
Sprouts is investing in increasing its store count, but it's still generating plenty of free cash flow. The company has been using this free cash flow, backed by a solid balance sheet, to greatly reduce its share count via share buybacks.
Sprouts spent just shy of $200 million on share buybacks in 2022, adding to the $187 million it spent in 2021. Between 2015 and 2022, the company was able to reduce its share count by 37%. Sprouts has another $412 million authorized for additional share repurchases, so the share count should continue to decline over the next few years.
Sprouts can certainly afford this spending. Free cash flow in 2022 was roughly $247 million, so these buybacks aren't jeopardizing the balance sheet. Sprouts is sitting on $293 million in cash and just $259 million in debt. Free cash flow will likely be lower in 2023 as the company ramps up its store opening activity, but there should still be plenty left over for buybacks. Sprouts expects to spend as much as $230 million on capital expenditures this year, about $100 million more than it spent in 2022.
An attractive valuation
Sprouts' gross and operating margins were boosted by the pandemic, and those margins have largely remained elevated even as the pandemic tailwinds have faded. Sprouts believes these higher margins are here to stay, driven by changes in the promotional strategy, and improved product mix, operational improvements, and new distribution centers.
While Sprouts may be right, investors shouldn't assume that these higher margins are permanent. Thankfully, Sprouts stock price offers a decent margin of safety to account for this uncertainty. Based on the high end of Sprouts' guidance range for 2023, the stock trades for just 13.5 times earnings.
This is a company capable of increasing its store count dramatically over the next decade. The plan is to increase the store count by at least 10% annually beyond 2023. The company believes there's room for 300 to 400 new stores in its expansion markets, which would effectively double its current store count. Combined with low single-digit comparable sales growth, Sprouts is anticipating sales growth of around 25% over the next 4 years.
Sprouts' growth story is compelling. Margins could contract in a tough economy as consumers pull back, but the valuation seems attractive enough to offset that possibility. For long-term investors looking to benefit from a small grocery chain aiming to become a large grocery chain, Sprouts looks like a solid investment.
