Few investors follow the grocery space. Most would rather pile into sexy internet stocks (or today, maybe "artificial intelligence" companies) so they can get in with the hot new idea taking over the market. But for those looking to invest off the beaten path, grocery stocks are a great place to look for promising investments. The U.S. grocery market is inflation-resistant, has grown every year except 2009 for the last 30 years, and is closing in on $1 trillion in annual sales.
A large underfollowed industry can create the opportunity for fantastic stock returns, as long as you have the patience to buy and hold for the long haul. One grocery stock few people know about that has handily beaten the market over the past three years is Sprouts Farmers Market (SFM -0.43%), a health food chain prepping for a major expansion across the United States. Here's why this niche grocery chain has done so well for investors and why the business has a ton of growth potential.
Strong Q1 earnings show durable margins
Sprouts is a grocery chain that sells organic and attribute-based foods (think vegan, paleo, etc.) at an affordable price. It is similar to Whole Foods, but going for a more price-sensitive customer. After going public in 2013, Sprouts started expanding outside of the Southwestern states, which is where it started.
In doing so, management prioritized sales growth at the expense of profit margins, sending out coupon flyers for shoppers for cheap deals on items like fresh produce. This drove down profit margins significantly, leading to deteriorating stock performance. The CEO at the time was asked to leave, and the board of directors brought in Walmart veteran Jack Sinclair in 2019 to right the ship and turn around profitability.
Sinclair's key decision was to stop sending out unprofitable promotional coupons (he actually decided to end all physical marketing campaigns and move fully to digital), which hurt revenue growth but significantly improved Sprouts' operating margin. This continued in the first quarter of this year, with Sprouts' adjusted operating margin coming in at 7.9% versus 5.7% in Q1 2019. Adjusted operating margin has been above 7% in Q1 for each of the last four years, which shows how successful Sinclair's changes have been.
Now, after getting further away from this change in strategy, Sprouts is starting to accelerate its comparable store sales growth, a key metric for grocery businesses that show revenue growth from existing locations. Comp sales growth was 3.1% in Q1 2023 versus just 1.6% a year ago. With stable margins and accelerating sales growth, it is no surprise to see Sprouts jump 8% on the day after its Q1 earnings.
Lesson: Starting valuation matters
Looking at the chart above, Sprouts stock has performed mightily over the last three years, up almost 80%. Healthier revenue trends and a pandemic boost to grocery sales definitely helped drive some of the stock returns in the last few years.
But the key reason Sprouts stock worked was its starting valuation. Over the last few years, investors could buy shares of Sprouts at a price-to-free cash flow (P/FCF) of around 10, which is significantly lower than where the overall market was trading at the time. Readers should also note that Sprouts is reinvesting a ton of cash into growing its store count ($47 million just in Q1). If it stopped investing for growth, its annual free cash flow would likely be much higher.
SFM Price to Free Cash Flow data by YCharts
Compare that to market darling Shopify (NYSE: SHOP), which traded at a price-to-sales ratio (P/S) above 50 at several points during 2021, something unheard of outside of the internet bubble. This may be an extreme example, but Shopify is now off over 70% from its all-time high while Sprouts stock continues to march to new heights.
The price you pay for a business matters. Even though Sprouts is not the fastest-growing or highest-quality business in the world, it has performed well and beaten popular tech stocks over the last few years because investors were able to buy a piece of the company at an extremely cheap price.
Returning capital to shareholders while growing store count
There's a lot to like about the Sprouts Farmers Market business. But the best part of this story might be management's capital allocation.
Since the business consistently generates cash, the finance department and CEO need to decide what to do with that cash. In the case of Sprouts, they have decided to simultaneously repurchase stock and invest in new grocery units across the U.S. Since 2015, Sprouts reduced its shares outstanding by 39%, which greatly increases the per-share earnings for shareholders.
On store growth, the company backed off on rapid expansion during the pandemic and subsequent supply chain crisis. But it plans to open 30 stores this year and hopes to grow its store count by around 10% annually for the foreseeable future. With only 395 locations and no presence in some major population centers like the Chicago area and New England, I think Sprouts has plenty of room to grow its store count. If margins stay steady, this will drive the stock even higher over the next few years and beyond.
