Sprouts’ Turnaround and Omnichannel Efforts Are Paying Off, but Competition Looms

Equity Analyst

Zain Akbari

Sprouts has capitalized on a natural, health-oriented positioning aligned with culinary trends, but we believe it faces a competitive onslaught as conventional grocers, mass merchandisers, hard discounters, and online sellers target the same themes. Without the cost leverage of the largest grocers, we believe Sprouts will face continued intense price pressure.

We believe Amazon’s 2017 purchase of Whole Foods remains a threat, as the digital juggernaut’s procurement strength and distribution efficiency can fuel price cuts that upend Sprouts’ value proposition (a produce-oriented store featuring fresh, affordable items). Sprouts has room for store growth, but we believe the ensuing cost leverage will need to be used to keep pace with price cuts in an industry favoring larger firms that can spread fixed costs and omnichannel investments over the broadest possible sales base.

Sprouts relies on Instacart for its delivery and click-and-collect efforts. While the partnership is prudent given Sprouts’ size, it imposes costs that larger firms can mitigate by fulfilling digital orders internally. Delivery can extend Sprouts’ appeal to customers that do not regularly drive past a store, but the channel is margin-dilutive even for firms that are able to scale costs over a much larger sales base. The pandemic likely accelerated grocery’s digitization, shifting sales into a less lucrative channel long term.

New leadership began revitalization work in earnest in early 2020, attempting to stabilize declining operating margins (6.8% in 2014 versus 3.9% in 2019) and optimize an inefficient expansion strategy. While we expect management to comfortably hit its long-term low-single-digit comparable sales growth goal, we believe its low-double-digit adjusted EPS expansion target will be harder to achieve, even after considering share buybacks (our forecast averages around 10% over the next five years). Nonetheless, the efforts should provide ammunition to fight unending price battles against intensifying competition as large retailers encroach on Sprouts’ natural and health-oriented turf.

Business Strategy & Outlook

While Sprouts’ fresh, natural, and health-oriented positioning is consistent with recent consumer trends, we believe the business model is not sufficiently differentiated as to benefit from an economic moat. As conventional grocers, general merchandise stores, hard discounters, specialty retailers, and online rivals all look to fresh products as consumers shift away from the more processed foods typically found in the center of the grocery store, we anticipate Sprouts will face a significant challenge from firms that can bring their scale to bear in reducing costs, encroaching upon the chain’s health- and value-oriented positioning. As we anticipate the industry will remain intensely price competitive with customers nonetheless still demanding a high-quality store experience, we believe chains will have to rely on cost leverage to deliver value. We do not believe Sprouts has achieved sufficient scale as to insulate itself from the continuing competitive onslaught. While its recent returns on invested capital have exceeded its 7% estimated capital cost (averaging 12% over the last three years, including goodwill), we anticipate compression well within the decadelong period over which we would have to be convinced that the firm would generate economic profits in order to award a narrow moat designation. We forecast average returns near 10% over the next decade, with economic profits almost evaporating in a more pessimistic scenario than our baseline assumptions (despite efforts to simplify stores, optimize expansion strategy, and reduce inefficient marketing and promotional expenditures).

It is difficult for pure-play grocers to develop an economic moat, considering intense price competition, channel diffusion as customers look online or to more convenient physical alternatives, and limited switching costs. We believe those that do benefit from a durable competitive edge enjoy either brand, consumer data, or vendor relationship-based advantages, or a materially more attractive cost position (for example, we believe narrow-moat Kroger exhibits each of these characteristics). Despite its strong growth and recent profitability, we do not think that Sprouts has achieved such a standing.

Sprouts features a produce-centric assortment (figuratively and literally; the firm places fresh foods at the center of the store instead of at the perimeter, which is the typical layout) that focuses on drawing customers into the store by offering aggressively priced, high-quality fruits and vegetables. The company tends to eschew products from larger food producers, instead favoring smaller, more local purveyors with products that often carry organic, non-GMO, or other designations. While the chain’s approach is consistent with the culinary zeitgeist as consumers look toward foods that are perceived as healthier, the faster growth in areas such as the natural and organic sector (which we expect to grow at a mid-single-digit clip long term, relative to a low-single-digit mark for the broader food landscape) has not escaped the attention of large food manufacturers and retailers. With firms like Kroger, wide-moat Walmart, and no-moat Target devoting increased shelf space to on-trend fresh and natural items, and larger packaged food companies (with whom conventional firms have considerably more purchasing power than Sprouts) adapting to meet customer demand, we expect the currently intense competitive environment will not ease.

As such conventional retailers adapt, we expect they will be able to replicate Sprouts’ in-store experience while leveraging costs over a larger sales base. Particularly as the incremental health-oriented food shopper is more likely to simply desire a more nutritious alternative to conventional fare (in contrast to lifestyle shoppers who will go out of their way to find products that have the attributes they value, buyers who likely already shop at a specialty grocer and are Sprouts’ core customers), we believe traditional sellers’ convenience and proximity to their patrons will prove valuable. In addition to offering more fresh items, we believe moat-endowed grocers like Kroger can capitalize on their more comprehensive offering (while Sprouts has been working to build its non-perishable assortment, it is still less complete than that of a traditional grocer and often does not stock leading national brands) to offer time-starved consumers a more convenient shopping experience that can cover the entirety of their food and beverage needs. With certain food sellers (such as many Kroger and Costco locations) also offering gasoline, we believe such retailers have more opportunities to draw and retain traffic than a more focused firm like Sprouts. Although we have a favorable view of Sprouts’ recent efforts to target its core health- and wellness-focused customers more directly, we suspect a broader customer base will be required to secure its long-term growth trajectory.

Larger retailers also benefit from a more extensive private-label offering, which can be used to spur traffic by differentiating the assortment while also boosting margins. Firms like Kroger have invested heavily in building in-house manufacturing capabilities to ensure product quality and responsiveness to customer trends, spending that is difficult for a smaller chain with less cost leverage to justify. Similarly, Whole Foods has long offered an assortment that favors private and exclusive brands. While Sprouts’ produce-heavy orientation skews its private-label penetration potential, its sub-20% mark at the end of fiscal 2022 nevertheless pales in comparison with Kroger’s roughly 30%.

While the competitive environment has always been difficult for Sprouts, we believe wide-moat Amazon’s 2017 purchase of Whole Foods further roiled the landscape. We believe Amazon will continue to price more aggressively than legacy Whole Foods, using its purchasing and distribution leverage, strategic importance to vendors, and desire to build a leading, comprehensive omnichannel grocery platform to justify progressively more attractive stickers. As affordable healthy food has long been Sprouts’ main calling card, we believe the acquisition materially changed the smaller chain’s long-term relative standing, as legacy Whole Foods’ pricing left ample room for a value-oriented rival to remain strongly profitable while targeting a somewhat different, less affluent customer. We also believe Amazon’s digital strength enables it to better leverage costs in that channel, allowing it to keep order fulfillment in-house rather than incurring third-party costs (which Sprouts incurs through its partnership with Instacart for home delivery, though the absolute dollar impact of the profitability pressure is offset to some extent by Instacart’s delivery radius, which management believes drives incremental traffic by serving customers for whom driving to a Sprouts location would otherwise be inconvenient).

The competitive threat does not end with incumbents. Although European hard discounters Aldi and Lidl have not had a linear upward path in the United States (with Aldi’s low-single-digit market share coming despite a presence in the country since 1976 and Lidl struggling in the early stages of its first foray into the market), they have prioritized value, particularly in produce, as they expand their American footprint. Their aggressive pricing has put relentless pressure on incumbent conventional grocers in Europe and (in Aldi’s case) Australia, where they are more established. We anticipate they will contribute to an emerging race to the bottom in grocery pricing in the United States, a dynamic we believe strongly disadvantages firms without the scale needed to leverage costs (necessary fuel for price cuts).

Sprouts’ size is at the heart of our view that it does not enjoy a durable cost advantage. While its ongoing growth should allow it to better leverage advertising, supply, and distribution costs, we do not believe its standing is materially better than that of its conventional rivals, particularly in its newer markets (though we are encouraged that the new leadership team indicates that boosting density around existing stores will take near- to midterm priority over entering new areas). Furthermore, we anticipate that the price differences between organic and conventional produce will fall as supply of the former rises, and that traditional retailers should be able to replicate Sprouts’ sourcing opportunities. This is particularly true in areas where Sprouts does not already have a dense presence, where it will be competing for local supply with larger, more established participants that can offer greater volume (particularly as conventional retailers also look to boost the quality of their fresh offering, an area where Sprouts has attempted to distinguish itself). Additionally, as packaged food firms incentivize farmers to convert to organic production, we anticipate established firms (with long-tenured relationships with conventional grocers) will benefit from incremental supply. That said, management’s increasing focus on flexibility in sourcing, including working with farmers of more esoteric produce to acquire stocks of limited time-only items destined for select stores only, could provide differentiation that resonates with its core customers.

Although conventional retailers have been able to use customer transaction data to inform the assortment, stocking levels, and promotional activity (in addition to emerging efforts from grocers like Kroger to monetize data insights externally), Sprouts is in the early stages of collecting such information. We believe it will take years before the data set is sufficiently deep as to provide a comparable level of insight as those enjoyed by larger peers.

None

Economic Moat

Sprouts Farmers Markets

Sprouts Farmers Market, Inc. engages in the operation of healthy grocery stores. The firm specializes in fresh, natural and organic products. Its products include fresh produce, bulk foods, vitamins and supplements, grocery, meat and seafood, deli, bakery, dairy, frozen foods, body care and natural household items. The company was founded by Stan Boney and Shon Alexander Boney on July 11, 2002 and is headquartered in Phoenix, AZ.

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Sprouts Farmers Market, Inc. engages in the operation of healthy grocery stores. The firm specializes in fresh, natural and organic products. Its products include fresh produce, bulk foods, vitamins and supplements, grocery, meat and seafood, deli, bakery, dairy, frozen foods, body care and natural household items. The company was founded by Stan Boney, Shon Alexander Boney, and Kevin K. Easler on July 11, 2002 and is headquartered in Phoenix, AZ.

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