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Morningstar | Sprouts Is Poised to Deliver Strong Top-Line Gains, but Falls Short of a Competitive Edge

Sprouts Farmers Market is a grocery store concentrated in the southern and western U.S., with 90% of its products natural or organic. The firm strives to drive traffic to its stores by offering attractively priced produce (23% of sales) compared with conventional peers (10%-20% lower prices on average), which we believe is the key reason comparable-store sales have been positive for more than 40 quarters, including during the recession in 2008 and 2009. We think this impressive performance is reinforced by its self-distribution and partnerships with farmers in the region, which enable better-quality produce and better align supply with demand, reducing shrink and improving margins for both parties. With this focus, the firm has inverted the conventional grocery model, offering produce in the center of the store and a complete grocery offering at the perimeter (dry goods are typically center-store at traditional retailers) including private-label items (13% of sales) and non-nationally branded items (as it avoids stocking traditional CPG brands, like Pepsi, which aids profitability). The firm has strong store economics and cash flow generation, which has enabled it to grow at an above average rate over the last five years (double-digit top-line growth versus peers at mid-single digits or less). But Sprouts has maintained an eye on growing profitably, as pre-tax cash-on-cash returns are 35%-40% within three to four years, which is the second-highest on our coverage list behind the dollar stores which boast payback periods of two years or less. Helping drive these unit returns are its small box units at 30,000 square feet (grocery stores typically are closer to 50,000 square feet) which enjoy strong new unit productivity (roughly 80% in 2018). Given these unit economics and white space opportunities, we believe the firm can double its footprint over the next 10 years, approaching 570 units. Still, we contend Sprouts lacks a competitive edge and remain wary that heightened competition could lead to faltering returns to scale and/or quality standards as it grows its footprint, calling into question the sustainability of such results long term.