Sprouts Farmers Market (SFM) (hereafter ‘Sprouts’ or ‘SFM’) is a grocery chain focusing on healthy, fresh, natural and organic food. This doesn’t just remain limited to produce, but also includes frozen food and household items. The company has been on an impressive growth trajectory, but the share price went south in 2016.
Another year of double-digit revenue growth
Sprout has recently reported on its financial results in 2016, and this gives us a great opportunity to check up on its performance. The company has been able to continuously increase its revenue, and 2016 was no different.
Source: SEC filings
The full-year revenue came in at $4.05B, which is an increase of 12.6% compared to the full-year revenue in the previous financial year. That’s an excellent achievement, taking the ‘weaker’ performance of the fourth quarter into consideration. Indeed, the revenue growth in the fourth quarter was just $55M, whereas the average quarterly revenue increases were in excess of $130M per quarter. So there definitely was a slowdown in the final quarter, and it’s not really surprising to see the company being ultra-careful in its 2017 guidance as it now expects the comparable store sales growth to come in at just 0-1%.
Due to the weak performance in the final quarter, the operating income actually plummeted from almost $48M to just $30.2M. Even though the decrease in operating income was very noticeable in the fourth quarter, there very clearly was a lot of pressure on the company’s margins. The operating margin decreased from 6.37% to 5.26%, and that’s the best way to show the substantial slowdown.
But does this make the company cheap?
Indeed, it’s not because your revenue is continuously increasing, you are an excellent buying opportunity. That’s clearly the case at Sprouts Farmers Market as the operating income and net income actually Decreased, despite the impressive revenue growth. Increasing revenues are great, but not if it hurts the bottom line.
With a full-year EPS of $0.84 (of which $0.72 was generated in the first three quarters), Sprouts is pretty expensive based on pure net income (although the adjusted EPS based on the effective share count at the end of the year instead of the weighted average amount of outstanding shares will be higher than the reported EPS), but perhaps the cash flow statements are showing us reasons to be bullish on this company?
The operating cash flow was approximately $254M in 2016, but there are a few non-recurring events we’d like to highlight. First of all, this amount includes a $21M deferred tax and whilst this tax bill indeed hasn’t been paid in 2016, it will eventually have to be paid and is just a postponed expense. On top of that, there are quite a few changes in the company’s working capital position ($14M), and after taking these two things into consideration, the adjusted operating cash flow is approximately $220M.
$181M was spent on capital expenditures, and this was very likely almost completely related to the opening of new stores. This means that the sustaining capex is probably just a fraction of the $181M, and we would guesstimate the adjusted free cash flow to be approximately $175-190M. Based on a current share count of 137 million shares, the FCF/share is very likely coming in at approximately $1.3-1.35, so at a share price of $18, the current free cash flow yield is 7.2% which isn’t outrageously expensive for a growth company.
But that’s also the problem. Yes, Sprouts is still increasing its revenue, and will be able to boost its revenue by another double-digit percentage this year, but pretty much the entire revenue increase is related to opening new stores, as the comparable store sales growth might even be 0% this year.
It’s great to see the company investing in new stores, but the continuous focus on share buybacks is causing a massive cash outflow. In 2016, the company spent almost $300M on share buybacks which is almost twice as high as the sustaining capex. Granted, the shares aren’t terribly expensive right now and a well-timed buyback might make sense, we would prefer Sprouts to take a step back and re-think its capital allocation plan (which we do think will happen).
Disclosure: the author has no position in Sprouts Farmers Market