Can Sprouts Survive?

Sprouts Farmers Market (NASDAQ: SFM) is in an interesting and unpleasant place for a retailer. The discount supermarket’s revenues are growing but it is not making that much money.

This means that Sprouts’ future is just as uncertain as SUPERVALU’s (NYSE: SVU). The most bothersome occurrence at Sprouts has been a share value collapse. Back on March 24, 2016, Sprouts’ stock hit a high of $29 that fell to $20.71 on September 19, 2016.

This indicates that Mr. Market is losing faith in Sprouts. He actually paid much more fora slightly smaller supermarket operator: Weis Markets (NYSE: WMK). Weis which is about the same size as Sprouts; it reported $2.915 billion in revenue on June 30, 2016, but it was trading at $53.01 a share on September 19, 2016.

It bodes ill for Whole Foods Market (NASDAQ: WFM); a former Wall Street darling, which saw its share price drop to $28.61 on September 19, 2016, the lowest price in years. As recently as June 7, 2016, Whole Foods was trading at $35.17 a share.

Whole Foods has a very similar business model to Sprouts selling organic and premium foods and prepared meals. The difference is that Sprouts engages in a lot of deep discounting. Both brands have been doing quite well in a highly competitive grocery market, yet their financial reports reveal some serious problems.

Why Sprouts is not a Value Investment

Growth investors are interested in Sprouts and Whole foods because they have a lot of momentum. Over the past two years, Sprouts’ revenues grew by $1.15 billion or nearly one third; rising from $2.708 billion in June 2014 to $3.858 billion in June 2016.

Whole Foods also displayed quite a bit of momentum, its revenues grew from $13.91 billion in June 2014 to $15.67 billion in June 2016. That made for an increase of around $1.76 billion in just two years.

The growth is very impressive but it is not leading to additional money at Sprouts. On June 30, 2016, Sprouts reported a net income of $143.62 million, A free cash flow of -$950,000, and $78.44 million in cash and short-term investments.

Sprouts is generating very little money and creating very little float; it only had assets of $1.44 billion and generated $266.9 million in cash from operations at the end of second quarter 2016. This chain is much closer to the death spiral than you might guess.

Who Would Buy Sprouts?

These figures indicate that Sprouts can run out of money at any time. That might mean it will have to start closing stores or simply sell the entire chain like Roundy’s and the Fresh Market did. Nor would it get that much for the entire operation, Ycharts reported that Sprouts had a Market capitalization of $3.072 billion and an enterprise value of $3.063 billion on September 19, 2016.

These figures alone will reignite the speculation that Kroger (NYSE: KR) might buy Sprouts. Kroger has a lot of resources and it is on the hunt for additional revenue. Kroger reported $112.41 billion in revenues, $34.66 billion in assets and $319 million in cash and short term investments on July 31, 2016.

Kroger’s assets in particular have grown dramatically over the past few years it had $29.08 billion in assets in July 2014. Much of this growth has come from the acquisition of brands like Roundy’s (which operates Marianos, Copps, Pick n’ Save and Rainbow Foods) and Harris Teeter.

There is of course a much better potential deal for Kroger out there in the form of Supervalu. Supervalu reported revenues of $17.32 billion on May 31, 2016, but it had an enterprise value of $3.469 billion and a market capitalization of $1.228 billion on September 19, 2016. Supervalu also owns at least one major grocery brand; Cub Foods, that would fit well into Kroger’s operations.

Why would Kroger spend $3 billion to get $3 billion in revenue, when it can get $17.32 billion in revenue for the same price or less? More importantly buying Supervalu would expand Kroger’s footprint; and get it into some new markets including Minneapolis.

Why Whole Foods will survive and Sprouts will not

Another company that might be in a position to takeover Sprouts would be Whole Foods. Unlike Sprouts, Whole Foods is actually making money it reported a net income of $476 million, a free cash flow of $104 million, cash and short-term investments of $625 million, assets of $6.275 billion, and $896 million in cash from operations on June 30, 2016.

Whole Foods might want Sprouts in order to expand its discount grocery operations and ward off the growing competition from Trader Joe’s. Whole Foods also faces growing competition from Kroger which is quietly duplicating most of its capabilities including organic foods and precooked foods.

That means Whole Foods will probably survive but Sprouts’ future is in serious doubt. Seriously I don’t see how it can survive as an independent organization. My guess is that Sprouts will collapse and get acquired like the Fresh Market (which had a similar business model) did.

Why Investors should stay away from Sprouts and Whole Foods

Naturally investors will want to know which grocer they should buy. My recommendation is once again, Kroger. Kroger is a real bargain; it was trading at $30.88 a share on September 19, 2016. Yet it reported $112.41 billion in revenue, $2.05 billion in net income; $5.11 billion in cash from operations and $34.66 billion in assets on July 31, 2016.

My take is that Kroger is the only major publicly traded grocer with the sheer size and sales volume to compete with mass discounters like Walmart Stores (NYSE: WMT), Amazon (NASDAQ: AMZN) and Costco Wholesale (NASDAQ: COST). That gives it the ability to match their discounts and undercut their prices. It also gives Kroger the resources to experiment with net generation solutions like click and pull and same-day delivery.

This offers future growth but it also means that Kroger’s 12¢ dividend, 1.41% dividend yield and 32.03% return on equity are fairly safe. Kroger will not only survive it will make money for years to come, that makes it a value investment in the grocery sphere.