With inflation rearing its ugly head recently, everything is getting more expensive, including the stock market. As of 10/15/21, the S&P500 is trading at a 30.5 P/E multiple. In this environment where valuations are rich, it’s rare to find good value stocks. But there’s a potential opportunity in Sprouts Farmers Market, Inc. (Nasdaq: SFM). 

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Situation Overview

Sprouts is a health-oriented grocery store mainly located in California. As of July 4, 2021, Sprouts has 363 stores across 23 states, with approximately a third of its stores located in California.

The stock price of Sprouts went from highs of $29.35 around June to $22.11 as of closing 10/15/21. The $22.11 share price yields a forward P/E multiple of 10.9, which implies a significant discount from fair value. It’s difficult to pinpoint what exactly led to the decline of the stock price, but it seems to have been due to underperformance in its most recent quarterly earnings. Q2’21 earnings reported the first half of 2021 revenue and EPS decrease from 2020:

Adding to the injury, management forecasted full-year net sales to decrease in the low low-single digits and EPS to decrease approximately 20% versus 2020. Management also announced that seven new store openings planned for 2021 may be pushed into 2022, derailing its target to open 20 new stores in 2021.

On the macro front, there has also been pressure from grocery purchases transitioning online. Many giant brick-and-mortar retailers such as Amazon and Walmart have been investing heavily in online grocery shopping. Although Sprouts is also ramping up its online presence, it does not have the same footprint and resources as the giant retailers.

Despite all of this, the beatdown of the stock price still looks like an overreaction. The analysis below goes into detail on Sprouts’ value proposition.

The Value Thesis

Trading at a Significant Bargain Relative to Peers 

Sprouts is trading at lower multiples than most of its peers but has the highest EBITDA margin and net margin out of its peers listed below.  

SpartanNash has the closest forward P/E multiple to Sprouts but has a net margin of only 0.8%. Grocery Outlet has the closest net margin to Sprouts and is trading at a 20.6 forward P/E multiple.  With the highest net margin out of its peers at 4.3%, Sprouts should command a forward P/E multiple closer to Grocery Outlet as opposed to SpartanNash. 
 

Historically Low P/E Coupled with Great Net Margins

Sprouts is also trading at a very low forward P/E multiple compared to itself. As shown below, the 5-year average forward P/E multiple from 2017 to 2021 is approximately 17.7. The current multiple is 10.9 (Note: Refinitiv P/E multiple of 11.4 was as of 10/14/21). This is also significantly lower than the industry average of 20.7

Source: Refinitiv Stock Reports Plus

As seen from the chart above, Sprouts’ forward P/E ratio has been on a consistent downward trend since 2017. Usually, there would be a material negative impact in financials to cause a Company's P/E multiples to keep trending down. But from 2017 to 2021, there hasn’t really been any material downfall in Sprouts’ top or bottom line. In fact, revenue is growing and net margins are improving. Although 2021 is estimated to have a year-over-year decrease from 2020, it still looks to be a strong year compared to 2017 to 2019.

Source: Data sourced from Yahoo! Finance. 

Illustrative Valuation and Potential Upside

So what could Sprouts be trading at? Below is an illustration of what could be a fair value for Sprouts.

The 5-year average forward P/E multiple for Sprouts is approximately 18. The mean forward P/E multiple from market comps is approximately 14. For simplicity’s sake, if we just take the midpoint of 18 and 14, we get a forward P/E multiple 16. We will assume management hits its 2021 EPS guidance of approximately $1.95 per share. Multiplying $1.95 by 16 gets to $31.20 a share, which is an upside of 41% from its closing price of $22.11 as of 10/15/2021. 

The Option Play

If a potential 41% upside doesn’t sound attractive enough, there is a way to leverage up the play using long-term call options. For example, the call option with the strike price of $22.00 expiring January 20, 2023 (expiring about one year and 3 months from the time of this writing) looks interesting. The option last traded at $2.55 per contract. Assuming that the stock price does reach $31.20 sometime before January 20, 2023, you could potentially achieve a whopping 256% return on this play ($31.20 minus $22.11 equals $9.09. Then take $9.09 divided by $2.55 and subtract by one)!

But please note that the downside is significant with this type of strategy so be very careful in using it. Essentially, you are forgoing your margin of safety when trading this way. If the stock ends up anywhere on or below $22.00 on January 20, 2023, your entire options investment will be worthless. Any macro downturn in the market could also wipe out all your whole investment.

Remember, only invest what you’re willing to lose in its entirety to options. You can refer to this article here for an introduction to long call options.

Potential Downside and Threat

Despite its attractive valuation, here are potential downside risks to Sprouts:

1. Sprouts is a grocery store gearing towards the health-conscious crowd, which means that it doesn’t focus on providing rock-bottom prices. If a downturn in the economy occurs and consumer focus shifts to buying the cheapest groceries, Sprouts will have a difficult time competing on price. 
2. As previously mentioned, the shift to online grocery shopping is a significant threat to the Company. Although Sprouts is ramping up its e-commerce presence, bigger grocery sellers such as Amazon, Walmart, and Target have a wider footprint and more resources to capture market share. 
3. Sprouts doesn’t pay a dividend and plans to continue to expand its store count. If existing stores' performance deteriorates and new stores fail to perform, share prices can decline further.

Conclusion

Despite these potential downfalls mentioned above, the current share price for Sprouts allows for a purchase of a profitable, cash-flowing business at a relatively cheap price. This could be a great long-term hold for the value investor.

 In summary:

• The first half of 2021 shows a year-over-year decline in revenue and EPS; full-year EPS forecast is 20% lower than 2020.
• Forward P/E multiple of 10.9 is low compared to market comps of 14. Sprouts also has EBITDA margins and net margins that are higher than its peers. 
• The 5 year average forward P/E multiple for Sprouts is 18. Forward P/E multiple has been trending down since 2017 despite growth in both the top and bottom lines.
• Using a forward P/E multiple of 16 (average of 18 and 14), and 2021 EPS of $1.95 yields a share price of $32.1.
• Competition in price and e-commerce could further decrease stock price as well as failure to execute growth plans.