Can Sprouts Farmers Market Survive without Acquisition?

There is only one question that comes to mind when I look at the financials for Sprouts Farmers Market (NASDAQ: SFM): why hasn’t this company been acquired? That question is logical because Sprouts’ larger; and better known, competitor Whole Foods was gobbled up by Amazon (NASDAQ: AMZN) over the summer.

For those of you unfamiliar with it, Sprouts is a sort of poor man’s Whole Foods Market that operates around 285 grocery stores around the United States. Sprouts concentrates on natural and organic sales but is more like a traditional supermarket with a focus on low prices and vegetable sales.

Can Sprouts Compete with Amazon or Kroger

The Amazon-Whole Foods acquisition is problematic for Sprouts because Amazon wants to make Whole Foods more like a regular supermarket. Amazon’s plans for Whole Foods include lower prices, digital coupons, and a rewards points program similar to that at Kroger (NYSE: KR) and Safeway.

Amazon plans to add amenities including pop-up electronics stores and lockers for pickup of online orders to Whole Foods Stores. Both Whole Foods and Sprouts have had a hard time competing with larger amenity-loaded grocers such as Walmart (NYSE: WMT) and Kroger.

Almost all Kroger stores boast pharmacies and an increasing number now offer such draws as filling stations, banks, cafes, dry-goods sections, pizza parlors, wine bars, clinics and even jewelry stores. Such one-stop shopping is a major menace to Whole Foods and Sprouts because Kroger has been aggressively expanding its organic and natural foods offerings.

Sprouts Farmer’s Market is one of the few pure grocers left that offers only food and a few household items. Its stores lack pharmacies and many of the other amenities consumers have come to expect. Although the Sprouts locations I have seen are competitive in prepared meals and delis.

Is Sprouts Making Money?

The acquisition might be in Sprouts’ future because the supermarket is not making that much money.

Sprouts reported a net income of just $135.75 million on September 30, 2017. Nor is that money growing much, it was up slightly from $135.52 million in September 2016.

Beyond that Sprouts reported limited amounts of cash on September 30, 2017. There was a free cash flow of just $38.38 million, $18.89 million in cash and short-term investments, and $317.28 million in cash from operations. Those figures indicate a retailer that’s operating at a very narrow margin.

They also indicate that Sprouts’ revenue growth is not paying off. Sprouts reported revenues of $4.506 billion on 30 September 2017, up from $3.991 billion in September 2016. As at Kroger, expansion is not necessarily leading to additional cash even as revenues rise. Kroger reported a free cash flow of $311 million on revenues of $118.05 billion on July 31, 2017.

How close is Sprouts to the Death Spiral?

 All this indicates that sprouts is far closer to the retail Death Spiral than you might think. The Death Spiral occurs when a company’s revenues can no longer cover the cost of operations.

Whole Foods’ management sold the company to Amazon to avoid the Death Spiral. Just as Roundy’s, a large Wisconsin grocer, sold itself to Kroger to avoid the Death Spiral in 2015. One sure sign of a potential Death Spiral at Sprouts; was a low earnings per share (EPS) ratio of .97 on 30 September. In contrast, the ailing grocer Supervalu (NYSE: SVU) reported an EPS ratio of 14.61 on 31 August 2017.

A likely scenario is that Sprouts management would sell the company to a competitor or to a private-equity fund to avoid the Death Spiral. That raises the question who would buy Sprouts?

Who would Acquire Sprouts?

The most obvious buyer for Sprouts would be Kroger, which has been aggressively trying to attract more organic and high-end grocery business.

One reason Kroger bought Roundy’s was to get its hands on the upscale Chicago grocer Mariano’s; a Roundy’s subsidiary. Kroger also bought the upscale Harris Teeter and has opened a number of fancier stores including Main & Vine in Seattle.

Other potential suitors include Walmart which has been in the acquisition mode recently. Like Kroger, Walmart has been in a push to acquire more affluent customers to offset its working-class shopper base; which has been hard hit by wage stagnation.

There’s also Amazon which would need to expand its footprint to become a major player in the US grocery market. Whole Foods currently operates around 450 stores in the United States. Kroger operated around 2,796 stores in the United States in January 2017 by contrast, Statista reported. Other contenders the private equity fund, Cerberus Capital Management; which owns Safeway and Albertsons.

Is Sprouts a Good Investment?

Sprouts stock is a mixed bag; at $23.60 on December 1, 2017, it was cheap. There was a good return on equity of 20.29% on 30 September 2017, but no dividend.

In contrast, Kroger shares were selling for $25.69 on 1 December 2017, but they offered a 24.12% return on equity on 30 July 2017. Kroger shareholders received a 12.5¢ dividend on 14 November 2017, that was a slight increase over 12¢ paid in May.

If you’re looking for a cheap grocery stock to buy, Kroger is a better deal than Sprouts. Sprouts stock is simply too risky, and pays no dividend. Kroger offers a better return on equity, a dividend, and far more value ($118.05 in revenue) for a similar price. Instead, expect Sprouts to be acquired by somebody in the near future.