Grocery store chain Sprouts Farmers Market (NASDAQ:SFM) reported results in line with analysts' expectations in Q2 FY2023, with revenue up 6.06% year on year to $1.69 billion. Sprouts made a GAAP profit of $67.3 million, improving from its profit of $62 million in the same quarter last year.
Sprouts (SFM) Q2 FY2023 Highlights:
- Revenue: $1.69 billion vs analyst estimates of $1.69 billion (small beat)
- EPS: $0.65 vs analyst estimates of $0.63 (3.59% beat)
- EPS (non-GAAP) Guidance for Q3 2023 is $0.61 at the midpoint, below analyst estimates of $0.62
- Free Cash Flow of $63.3 million, down 111% from the same quarter last year
- Gross Margin (GAAP): 37%, up from 36.4% in the same quarter last year
- Same-Store Sales were up 3.2% year on year
- Store Locations: 391 at quarter end, increasing by 13 over the last 12 months
Playing on the secular trend of healthier living, Sprouts Farmers Market (NASDAQ:SFM) is a grocery store chain emphasizing natural and organic products.
Because of this focus on health, a shopper at Sprouts can find more depth and breadth in areas like organic produce, meats free from added hormones, natural foods such as cereals and juices, and vitamins. In addition to a focus on healthy foods, Sprouts also offers reasonable prices. The company does this by sourcing directly from farmers and other producers, which minimizes middlemen and the costs associated with them. In addition, Sprouts emphasizes its private label products, which are produced by contracted manufacturers and cheaper than brand-name products.
The average size of a Sprouts Farmers Market store is around 30,000 square feet, and most stores are located in suburban areas. The stores are laid out in a farmer's market style, with fresh produce and bakery items prominently displayed at the front of the store. The perimeter and back of the store typically has refrigerators and freezers with items like milk, yogurt, frozen vegetables, and packaged meat.
Sprouts Farmers Market launched its e-commerce presence in 2020, which was expedited due to the COVID-19 pandemic. Customers can now order groceries online and either pick them up in-store or have them delivered.
Food is non-discretionary because it is essential for life (maybe not that ice cream?), and grocery stores cater to this need. Selling food is a notoriously tough business, as grocers must deal with the costs of procuring and transporting oftentimes perishable products. Plus, the costs of operating stores fit to sell everything from raw meat to ice cream to fresh fruit are high. Competition is also fierce because grocers and other peers such as wholesale clubs tend to sell very similar brands and products. While online competition threatens all of retail, grocery is one of the least penetrated because of the nature of buying food. Still, the online threat exists and will likely increase over time rather than dwindle.
Grocery competitors with a total or partial focus on healthier options include Amazon.com’s Whole Foods market (NASDAQ:AMZN), Kroger (NYSE:KR), and private company Trader Joe’s.Sales Growth
Sprouts is larger than most consumer retail companies and benefits from economies of scale, giving it an edge over its competitors.
As you can see below, the company's annualized revenue growth rate of 4.98% over the last four years (we compare to 2019 to normalize for COVID-19 impacts) has been mediocre as it's opened new stores and grown sales at existing, established stores.
Sprouts grew its revenue by 6.06% year on year this quarter, in line with analysts' expectations. Looking ahead, the analysts covering the company expect sales to grow 5.9% over the next 12 months.
Number of Stores
A retailer's store count is a crucial factor influencing how much it can sell, and store growth is a critical driver of how quickly its sales can grow.
When a retailer like Sprouts is opening new stores, it usually means that demand is greater than supply or that it has no locations in markets where it could be successful. Sprouts's store count increased by 13 locations, or by 3.44%, over the last 12 months to 391 total retail locations in the most recently reported quarter.
Over the last two years, the company has generally opened new stores and averaged 3.67% annual growth in its physical footprint, which is decent and on par with the broader sector. If a company is operationally efficient and has strong demand, an expanding store base is usually a good thing because it means that revenue growth can come from multiple vectors: sales from new stores, sales from e-commerce, or increased foot traffic and higher sales per customer at existing stores.
Same-Store Sales
Same-store sales growth is a key performance indicator used to measure organic growth and demand for retailers. This metric shows the year-on-year change in sales from a company's established brick-and-mortar stores and e-commerce platform.
Sprouts's demand within its existing stores has been relatively stable over the last eight quarters but fallen behind the broader consumer retail sector. On average, the company's same-store sales have grown by a mediocre 1.09% year on year. This performance suggests that its steady rollout of new stores could be beneficial for shareholders because when a company has demand, more locations should help it reach more customers seeking its products, boosting total revenue growth.
In the latest quarter, Sprouts's same-store sales rose 3.2% year on year. This growth was an acceleration from the 2% year-on-year increase it had posted 12 months ago, which is always an encouraging sign.
Gross Margin & Pricing Power
Gross profit margins are an important measure of a retailer's pricing power, product differentiation, and negotiating leverage. They also show us how much money a retailer gets to keep after paying for the goods it sells, and if the gross margin is high, it increases the likelihood of more operating profits.
As you can see below, Sprouts has averaged a decent 36.8% gross margin over the last eight quarters. However, when comparing its margin specifically to other non-discretionary retailers, it's best in class. This is because non-discretionary retailers have structurally lower gross margins as they compete to provide the lowest possible price, sell products easily found elsewhere, and have high transportation costs to move their goods. We believe the best metrics to assess these types of companies are free cash flow margin, operating leverage, and profit volatility, which take their scale advantages and non-cyclical demand characteristics into account. 
In Q2, Sprouts's gross profit margin was 37%, marking a 0.6 percentage point increase from 36.4% in the same quarter last year. These steady margins for a retailer like Sprouts, which will always be less profitable than the typical retail business for the reasons mentioned above, could stem from its efforts to keep prices consistently low or signal that it has stable input costs (such as freight costs to transport products).
Operating Margin
Operating margin is an important measure of profitability for retailers as it accounts for all expenses that keep the lights on, including wages, rent, advertising, and other administrative costs.
This quarter, Sprouts generated an operating profit margin of 5.41%, in line with the same quarter last year. This indicates that the company's costs have been relatively stable.
Although it's not burning cash, Sprouts has struggled to manage its expenses efficiently over the last eight quarters. Its average operating margin of 5.65% demonstrates subpar profitability for a consumer retail business.
In addition to operating profitability, the change in a company's margin is just as important (especially for stock market returns). During that same time, Sprouts's operating margin has stayed more or less flat, showing that the company's operating expenses have been stable.
EPS
These days, some companies issue new shares like there's no tomorrow. That's why we like to track earnings per share (EPS) because it accounts for shareholder dilution and share buybacks.
In Q2, Sprouts reported EPS at $0.65, up from $0.57 in the same quarter a year ago. This print beat Wall Street's estimates by 3.59%, a welcome development that should delight shareholders. 
Between 2020 and 2023, Sprouts's adjusted diluted EPS grew 28.2%, translating into an unimpressive 9.4% average annual growth rate. This EPS growth is materially higher than its revenue growth over the same period, indicating that Sprouts has excelled in managing its expenses (leading to higher profitability), bought back a healthy chunk of its outstanding shares (leading to higher PER share earnings), or did some combination of both.
Cash Is King
Although earnings are undoubtedly valuable for assessing company performance, we believe cash is king because you can't use accounting profits to pay the bills.
Sprouts's free cash flow came in at $63.3 million in Q2, up 111% year on year. This represents a 3.74% margin.
Over the last eight quarters, Sprouts's free cash flow margin has been well above its consumer retail peers, averaging 4.37%. This solid cash profitability gives it the flexibility to reinvest in growth initiatives, pay down debt, or participate in shareholder-friendly schemes such as share buybacks or dividends.
Meanwhile, Sprouts's free cash flow margin has stayed more or less flat during the same time, showing that the company's cash flows are relatively predictable.
Return on Invested Capital (ROIC)
Sprouts's subpar returns on capital may signal a need for future borrowing or capital raising to fund growth. Its five-year average return on invested capital (ROIC) is 14.3%, low compared to the best retail companies that consistently pump out 25%+.
We like to track ROIC because it tells us how much return (profit) a company makes on the money it invests into its business, shedding light on its prospects and its management team's decision-making prowess. ROIC can also be used as a tool to benchmark a company's performance versus its peers, and just like how we focus on long-term investment returns, we care more about analyzing a company's long-term ROIC because short-term market volatility can distort results.
Key Takeaways from Sprouts's Q2 Results
With a market capitalization of $4.04 billion, Sprouts is among smaller companies, but its $259.5 million cash balance and positive free cash flow over the last 12 months give us confidence that it has the resources needed to pursue a high-growth business strategy.
It was comforting to see Sprouts decrease its full-year capex guidance this quarter. That really stood out as a positive in these results and should help its free cash flow margins. Furthermore, the company slightly topped analysts' EPS expectations. Zooming out, we think this was a decent quarter, showing that the company is staying on target. The stock is up 1.99% after reporting and currently trades at $39.03 per share.
Is Now The Time?
Sprouts may have had a bad quarter, but investors should also consider its valuation and business qualities when assessing the investment opportunity. We cheer for everyone who's making the lives of others more convenient but in the case of Sprouts, we'll be cheering from the sidelines. Its revenue growth has been mediocre, but at least that growth rate is expected to increase in the short term. And while its strong free cash flow generation allows it to invest in growth initiatives while maintaining an ample cash cushion, the downside is that its mediocre same-store sales growth has stunted total revenue growth and its operating margins are below average compared to its consumer retail peers.
While it's trading at a reasonable price and we've no doubt one can find things to like about Sprouts, at the moment, we think there might be better opportunities in the market.
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