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Sprouts: A Poor Man's Whole Foods?

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February 18, 2014 – Comments (0) | RELATED TICKERS: SFM , WFM

Board: Value Hounds

Author: LeKitKat

Healthy Living for Less is the mantra driving Sprouts expansion and its position in the world of organic markets is affordable healthy eating.

Sprouts at a glance


•High-growth, value-oriented natural and organic food retailer
•Broad consumer appeal
•One of the largest natural and organic retailers
•Significant momentum
•Significant white space opportunity

Health & Wellness

•Greater focus on preventative health
•Childhood obesity
•Specialty diets (e.g., gluten-free)

Value

•Increasingly cost-conscious consumers
•Persistent shift in shopping behaviors
•Sprouts makes healthy choices affordable

When reading through company presentations, value is at the forefront and it asks investors to consider Sprouts as the “poor man’s Whole Foods”. The stores are solidly engineered to attract the middle class rather than the higher income demographic.

Sprouts opened its first store in 2002 in Arizona. Nine years later, Sprouts merged with Henry’s and grew from 43 stores at the beginning of 2011 to 103. In 2012, Sprouts acquired the Sunflower market’s 37 stores and the current total stands at 167 stores in eight states. They are targeting 1200 locations and guide to 12% unit growth per year. If organic food demand remains high, Sprouts has a fair amount of growth ahead. So far, almost all of their expansion has been by acquisition. They built 19 stores in 2013.

Because of the acquisitions, year-over-year comparisons are impossible especially since there is no data on Henry’s presented. In short, Sprouts being a recent IPO with two years of heavy merger/acquisition preceding the offering make it nightmare to evaluate. There is no long-term organic record of growth. We take what we can get at this point.

Who they are

Sprouts is a high growth (mostly by acquisition), natural and organic grocer that differentiates itself as a better value than its competitors. They sell fresh produce, bulk foods, vitamins/supplements, grocery, meat and seafood, bakery, dairy, frozen foods, body care and natural household items. They believe they have competitive fresh organic products at better pricing and enhance the in-store experience with great team members. I have seen a store in AZ—clean, well-lit, big selection and wide open. Can’t comment on staff.

Stores have positive comparable store sales growth for 26 consecutive quarters, including throughout the recent economic downturn
Highlights are pro forma with Sunflower as if it contributed for entire year

•Pro forma comparable store sales growth of 9.7% in fiscal 2012 & 5.1% in
fiscal 2011, and 14.8% on a two-year stacked basis through fiscal 2012

•Pro forma comps of 9.7% for the 39 weeks ended September 2013 and 10.1%
for the thirty-nine weeks ended September 30, 2012 -- 19.8% on a two-year
stacked basis

•Pro forma sales of $2.0 billion in fiscal 2012, for an increase of 16%
from $1.7 billion in 2011

•Net sales of $1.8 billion for the thirty-nine weeks ended September 29,
2013-- an increase of 21.0% over 2012

•Net income of $19.5 million in 2012, an increase from a loss of $27.4
million in fiscal 2011, and pro forma adjusted net income of $47.3
million in fiscal 2012

•Net income was $42.0 million for the thirty-nine weeks ended September
29, 2013, representing an increase of 99.7% from net income for the
thirty-nine weeks ended September 30, 2012 pro forma for the Sunflower stores
Sprouts is growing fast, and a large part of it has been through acquisition. From 2002 through September 29, 2013, they opened 91 new stores and rebranded 43 Henry’s and 39 Sunflower stores to the Sprouts banner. Combined, Sprouts, Henry’s and Sunflower opened an average of 16 stores per year from 2008 through 2012.

The comps are high the past two years and on that basis, growth looks solid. The comps have improved over the past 5 years. CAGR has been 17.8% since 2008 through Q3 2013.

Organic growth

It costs around $2.8 million (a recent 18,000 SF WFM is costing $3.5 million), including store build out, inventory and cash pre-opening expenses to build the typical 25-28k square foot store. Based on historical performance, they target pre-tax cash-on-cash returns of 35-40% within three to four years after opening.

Mostly because of lower pricing Sprouts thinks they can entice a wider demographic than Whole Foods to shop organic. They also make oblique references to being competitive to such luminaries as Trader Joe’s. Sprouts has been successful across a variety of urban, suburban and rural locations in diverse geographies, from California to Oklahoma. Based on their market research they believe the U.S. market can support approximately 1,200 Sprouts Farmers Market stores including 300 in the 8 states Sprouts already has stores in. They are looking for 12% or more annual new store growth over at least the next five years.

Projected store growth

Year 1 187
Year 2 209
Year 3 234
Year 4 263
Year 5 294
Year 6 329


In six years there is the real potential for Sprouts to double in size. If projected 6% comps are realize, CAGR will be around 18% and close to the past 5 years growth. They will need $453 million in capex to build the stores. Three years cash flow from operations was $160 million (2010-2012) but was accelerating rapidly with the addition of acquisitions. For 2012 CFFO was $84 million and if that can be maintained and accelerate, the store builds will be paid for out of cash.

Can they build them and pay for it without more debt?

Looks likely that Sprouts can afford the 12% in number of stores and still have maintenance capex available.

[See Post for Tables]

It’s important that Sprouts avoid more debt right now. They are treading on being overleveraged now and have managed to pay down the debt to tolerable levels with proceeds from the IPO

Debt/capital was 52.3% at the end of 2012 and with the proceeds from the IPO it was paid down to 42%. Interest expense went from a comfortable and margin-friendly 29x in 2008 down to an ugly 2x in 2012 as interest expense ate up 50% operating income. For the quarter ending in September, the ratio was up to 4x as operating income increased and debt was paid down. Debt is now $346 million. The company borrowed to buy Sunflower in 2012 leveraging up to $434 million from $294 million in 2011.

The IPO

In June 2013, there were 125.6 million shares outstanding and in September there are 139.7 million. The company sold 20.4 million shares and existing shareholders sold over 797k shares with none of those proceeds accruing to Sprouts.

Sprouts earned $341 million from the sale of the company issued shares most of which went towards paying down debt. Existing shareholders were prevented from selling more shares for 180 days until January 27 2014 – the lockup period. There was also a transfer restriction in place until October 2014 and it’s not clear if that expired with the lock up.

Apollo and other insiders were set to sell 26 million shares in a secondary offering at $37-$38 representing a doubling of the IPO pricing in November and the date was pushed forward 5 days when The Fresh Market delivered bad news and the sellers feared a sympathetic crash for SFM shares. The only substantial crash came when the sale of Apollo shares was announced November 7. By the time of the sale in late November, shares were at $37 where insiders sold and the price has since failed to recover. Plans for the sale were made public November 7 starting the slide from $48.

Insiders and equity groups have a knack for making money and the $37-$38 floor may signify getting out a good price and not a great entry price for new shareholders.

Warts and relationships with insiders

It’s not all good at Sprouts and insiders have profited from Sprouts transactions over the years.

Shon A. Boney has been involved in a few deals. He is on the board of directors and was Chairman from August 2012 until March 2013. Mr. Boney co-founded Sprouts in 2002 and was CFO from 2002 to 2005 and CEO from 2005 to August 2012.

Stephen D. Black is another insider that has benefitted from Sprouts transactions and is Chief Marketing and Information Officer. Black was VP at Sunflower Farmers Markets.

Apollo Global Securities, LLC, was an underwriter for the IPO and is an affiliate of Apollo, a sizable shareholder. Apollo Global Securities, LLC raked in 5% of the net proceeds of the IPO.

Sunflower Transaction

Stephen Black was a stockholder of Sunflower and made $589,000 from the Sunflower Transaction, on the same terms as all Sunflower stockholders.

Corporate Aircraft

During fiscal 2012, they purchased an aircraft from CJ Leasing Service LLC, an entity controlled by Shon Boney, for $3.2 million. I think they could get by without a jet. It’s a small geographically concentrated company and they could easily fly Southwest coach if they were more like the common man and their employees. I don’t like companies that buy private jets for corporate purposes because they usually end up being used for private flights and corporate fun and vacations. This is an extravagance and cost a lot to fly and keep maintained.

Volcanic Red

They buy coffee from Volcanic Red a company Shon Boney (and family) and Kevin Easler, a former director, own 15% and 7.5% interests, respectively.

Notes

During 2013, management held Notes -- J. Douglas Sanders (CEO), Amin N. Maredia (CFO) and James L. Nielsen (COO). Principal amounts were $500,000, $175,000 and $175,000, respectively. Notes were repaid on May 31, 2013.

Transactions with Apollo Affiliates

They paid an arrangement fee of $760,000 to Apollo Funds and Apollo Global Securities was an underwriter of the IPO and received a fee of $1.1 million. Apollo Global also reaped 5% of the proceeds from the IPO. Apollo Funds is still a major shareholder at over 30% of shares. I would be expecting some more Apollo shares to hit the market. They have around 50 million shares.

Henry’s Transaction

In 2007, Whole Foods Market purchased Wild Oats and sold the Henry's stores to Smart & Final Holdings Corp., which in turn was purchased by Apollo Management, one of the world's largest private equity firms.
In 2011, Apollo bought a controlling interest in the 63-store Sprouts, and Smart & Final sold Henry's to Sprouts...effectively reuniting two companies that had been founded by the same family, years apart. At the time, Henry's was operating 43 total store locations, comprised of 34 stores in California and nine stores in Texas operating under the Sun Harvest banner.

Henry’s was merged with Sprouts in 2011 and Apollo was a shareholder in Sprouts from 2011. Did Sprouts get a great deal or did Apollo get their pound of flesh?

It was a somewhat convoluted payment but in the end $274.6 million was distributed to Smart & Final and shares to Apollo. Of the total tab of $379 million, $144 million was goodwill and $188 million was paid for intangibles. It was paid by issuing debt both for cash and as shares to Apollo. There is no filing for us to evaluate Henry’s business and work out a price to EBITDA.


The other acquisition

Sunflower was acquired in 2012 and on board at the end of July 2012. The price was $219.5 million and the price to EBITDA was 12x. That’s maybe a tad high, but not outrageous. Sunflower brought I $400 million in revenue in 2011 and $9 million in operating income with 2.2% operating margins. Since the acquisition, Sprouts margins have been rising and it’s possible the goodwill of $169.6 million might have been worth something. They claim goodwill was paid for synergies and economies of scale and maybe that was not just company boilerplate BS

Five years performance

Growth was supercharged in 2011 from Henry’s and in 2012 it was pushed by Sunflower. Beyond that no trends are notable because the history is too short except we see 2009 was respectable for a recession. Whole Foods slowed to 1% revenue growth in 2009. Margins improved by 2012 after two acquisitions. In 2013, they were even better.

Margin improvement is encouraging year-over-year and is necessary to make Sprouts worth considering as an investment. The 2010 and 2011 margins were dismal and started expansion after the Henry’s and Sunflower acquisitions. Would really like to see them approach Whole Foods 4% net rather than scrape the bottom like mainstream grocers who always seem to struggle with raising margins. Whole Foods manages a 4% net margin that is 4x what a Safeway of Kroger’s can do. Whole Foods also manages to sell $900/SF of merchandise –absolutely phenomenal. Sprouts is down around $440 after hitting a high of $527 in 2008.

Sprouts is the value organic market and is sacrificing margin for traffic. More stores will help. Comps seem to support the idea that shoppers will support value. Sprouts comps are better than WFM.

Growth in the third quarter is still not a comp of the Sunflower acquisition completed July 31 2012 and lacks one quarter in 2012—means growth is not all organic for 2013 as reported.

The 39-week margins are trending the right way in 2012 and are better than the reported numbers would lead us to believe. Those improvements continue in the third quarter. I am looking for margin improvement and sustainable growth and Sprouts looks OK as of September.

Same store sales

Sprouts comps are good for a grocer but not great if you compare them across other retail like Chipotle and Michael Kors. Groceries are a tough way to make a living with low margins and low growth for mature non-organic grocers. Whole Foods has been the exception to the rule proving grocers can be sexy and have high growth great margins and incredible comps. In Whole Foods most recent quarter it became much less super power and more mortal as comps and margins both declined with mediocre growth. Sprouts as a value oriented relatively younger retailer seems to have connected with the average income shopper and growth and comps are holding their own.

Sprouts is not entirely out of the question as an investment candidate. The balance sheet has manageable debt and cash flow is positive and looks like it will cover expansion plans without taking on more debt. With 12% in store growth and a 6% comp projected, growth around 20% looks probable.

It’s not a value with a trailing PE of 117 and forward PE of 60. Price to sales is 2.2x and price/book is 10.5x—all too high to be a value. Whole Foods forward PE is 26 and NGVC is at 48.

Sprouts is near a 52-week low and there is the overhang of Apollo sales of shares keeping them there. Even at the low, Sprouts sells at a premium to the competition. The growth is part of that and it’s not just acquisition activity—pro forma results are good and comps are impressive. New announcements of sales by Apollo are almost sure to send Sprouts down more and there is no question that this large equity investor is going to want to take profits—just a matter of when. These investment stories are a Dirty Harry moment for me always—do you feel lucky? I do like the company –not sure I feel lucky.

 

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