EUR 850.00 For Business Accounts Only

Morningstar | Despite a Differentiated Concept, Sprouts Faces Intensifying Competition; Shares Trade Fairly. See Updated Analyst Note from 20 Jun 2019

We are reducing our valuation for no-moat Sprouts to $21.50 per share from $26.50, reflecting a revised long-term profitability outlook in light of intense competition. Although the chain’s health-oriented positioning is consistent with culinary trends, we believe other grocers, mass merchandisers, hard discounters, and online sellers are also striving to offer more health-oriented, natural, organic, and other specialty items. As larger firms use their cost leverage to reduce prices, we believe smaller chains like Sprouts will be at a disadvantage.

Sprouts features an aggressively priced, high-quality produce assortment that is consistent with customers’ shift toward fresh foods. However, its rivals are adjusting accordingly, with larger grocers increasingly featuring fresh items. The ensuing price competition comes at a time when customers’ service expectations are rising. Amazon’s 2017 purchase of Whole Foods accelerated the grocery industry’s digital transformation, and particularly affected Sprouts as the digital giant cut prices at the larger natural grocer (Sprouts has positioned itself as a more affordable alternative). While we believe standing is weakening as competition rises for both firms, Sprouts does not benefit from the local market scale, robust data capabilities, or private-label strength that narrow-moat Kroger enjoys.

The intense competitive environment is reflected in our updated long-term profitability outlook that now calls for operating margins to fall to a little more than 3% over the next decade from 4.5% in fiscal 2018 (as opposed to our earlier 5% long-term mark). We continue to believe store network expansion should hold annual percentage revenue growth in the mid- to high-single-digits over the same period, with the chain approaching 600 stores over the next decade (from 313 at the end of fiscal 2018). With the shares trading near our valuation, we suggest investors wait for a more attractive entry point before building a position.

Our moat trend rating remains negative, reflecting persistent competitive pressures that should result in ongoing price headwinds and necessitate continued investment to deliver a strong omnichannel experience. Although increasing scale and customers’ focus on health should serve as long-term tailwinds, competition should remain fierce, particularly as Amazon drives prices lower at Whole Foods and hard discounters build their American presence. We believe the need to match price cuts to keep its value proposition intact (Sprouts features an aggressively priced produce lineup meant to drive traffic) will hold profitability in check despite improving cost leverage and procurement strength, with top-line pressure augmented by the need to offer a robust menu of higher-cost fulfillment options in an increasingly omnichannel grocery landscape.