The ability to economically source, transport and sell fresh (i.e. time-sensitive & easily spoilable) produce at scale is a deeply geographical competitive advantage involving a surprising amount of complexity.
Shoprite (SHP) only managed this in Africa by actively building up local supply chains in each of its countries to support its own retail footprint. Likewise, the challenge of reaching scale in this market is arguably one of the reasons why Amazon (AMZN) bought Whole Foods and didn’t just build it to compete in this space.
With a market cap of $2.7bn, Sprouts Farmers Market (SFM) is Nasdaq-listed small cap that flies under most investors radars. Despite this, the Group has amassed a strong store footprint (362 stores with plenty more planned) with a loyal core customer following attracted to its “open-plan” store format offering a treasure hunt-like experience for all manner of fresh and healthy goods.
Five key things, perhaps, are important to understand this business & its levers.
Firstly, Sprouts supply chain from the farmer to its individual store is superb. Both its stock turnover, steady minimizing of waste (a big deal in fresh produce) and the growing building block of Distribution Centers (DCs – Sprouts is rolling more DCs as we speak) combine into a well-oil machine. Long-standing relationships with famers combine with buyers at farm-level that have a degree of discretion to make opportunistic deals with these farmers while DC’s leverage growing volumes and push out time-sensitive products out to store with high trading density.
This all combines to produce a strong Operating Margin of 6.1% (and trending steadily higher against history). Compare this to Walmart’s (WMT) Operating Margin of 3.56% and Shoprite’s “world-class” margin of 5.36%, and the quality of this metric starts to become apparent!
The next key point is that Sprouts open-plan stores drive higher trading density (in South Africa, think of the difference between a Food Lovers’ Market and a Checkers). Trading density is basically how much revenue does each square foot generate. The open-plan nature of the stores allows a customer to see almost exactly what they want when they enter (as opposed to “isle shopping” that forces a customer to walk up and down the store), and this can speed up their shopping experience, lifting sales per square foot and stock turnover (which lowers wastage of fresh produce, which lower costs…), and so on. A virtuous cycle.
Sprouts is getting so good at this format that they are starting to roll out even smaller format stores (c.20% smaller) that they believe can generate the same turnover as the traditional sized stores! If this works, this means that c.20% less capital can generate the same revenue, thus lifting their forward returns.
Thirdly, the pandemic forced Sprouts to roll out an eCommerce solution. This solution has worked wonderfully and, indeed, c.10% of the Group’s sales are now generated this way. This has shifted the retailer into a more omnichannel retailer and online sales can both be delivered or offered as click-and-collect (utilizing existing stores). This partially future-proofs the Group’s business model (although, given the real competitive advantage that is the fresh produce supply chain, this is not a major point) while, more importantly, just adding incremental revenue to existing infrastructure and offering higher forward returns (once again).
The fourth point is that Sprouts estimates that c.68% of its products sold are “attribute-driven” products. What this means is that an attribute (for example, Organics, Paleo, Keto, Plant-Based, Non-GMO, Gluten-Free, Vegan, Dairy-free, Grass-Fed, etc) has (partially) driven the purchase decision. This portion of the market is fast-developing and has excellent tailwinds behind it as many consumers become ever more selective in what they eat. For this subset of consumers, Sprouts’ offering will have an actual destination shopping element to it, as they look specifically for items.
Finally, circling back around to my first statement, the ability to economically source, transport and sell fresh produce at scale is a geographical competitive advantage involving a surprising amount of complexity. Sprouts is (extremely) profitable and, the Group may be a small cap, but it commands clout in the regional market it operates in. Perhaps so much so that it will make an attractive acquisition target for either someone wanting to compete head-on with Amazon Fresh/Whole Foods or, indeed, for Amazon itself to bulk up and consolidate its existing offering?
Just a final note that, despite all the above fundamentals, Sprouts is currently trading on a 10.4x Price Earnings. Oh, and it has an ungeared balance sheet (if we ignore leases). While management expect FY 21 to see a single-digit decrease in sales, this is coming off a massive jump in sales in FY 20 (panic buying and stock piling by USA consumers). Far more relevant, the current financial year is tracking well against FY 19.
For more information, see Sprouts’ useful investor deck over here.