Sprouts: Can this Supermarket Survive?

Can Sprouts Farmers Market (NASDAQ: SFM) buck the trends in the grocery industry and survive long enough to become a viable competitor? That’s the billion dollar question facing this discount grocer and its investors.

For those of you unfamiliar with it, Sprouts is a fast-growing discount grocery chain that specializes in organic foods. It attracts customers by selling organic and regular produce and meats comparable to those at Whole Foods Market (NASDAQ: WFM) at much lower prices.

Sprouts has been expanding fast. It operated 216 stores in 13 states (California, Nevada, Arizona, Utah, New Mexico, Colorado, Kansas, Oklahoma, Texas, Missouri, Tennessee, Alabama, and Georgia) in November 2015. The grocer also has plans to expand into six more states (Arkansas, Louisiana, Alabama, Florida, South Carolina, and North Carolina) in the near future.

The chain has signed a deal to open its first Florida location in Palm Harbor Commons in the Tampa Bay area, The Tampa Bay Business Journal reported. This will put Sprouts in yet another one of America’s fastest growing states. It also puts Sprouts square in the middle of Florida’s brutal grocery wars, which the employee-owned Publix (OTC: PUSH) seems to be winning.

A Risky Expansion Strategy

Sprouts is pursuing a risky expansion strategy that has sort of paid off. The company has seen impressive revenue growth for the past few years.

In December 2012, Sprouts reported a TTM revenue of $1.795 billion that grew to $2.438 billion a year later, $2.967 billion in December 2014, and $3.593 billion in December 2015. The company’s revenue has exploded, but it may do it little good. Roundy’s, a regional grocer with fast growing revenues comparable to Sprouts, had to sell itself to Kroger (NYSE: KR) to avoid collapse in November 2015.

Roundy’s, which operates 151 supermarkets in Wisconsin and Illinois, reported similar revenue growth to Sprout. For the record, Roundy’s reported a TTM revenue of $3.49 billion in June 2014 that grew to $4.03 billion in June 2015. Just three months after reporting that revenue, Roundy’s management was selling out to Kroger for $800 million to avoid the death spiral.

Obviously, Roundy’s had a slightly different business model; it was a regional grocer operating four chains. Yet like Sprouts, Roundy’s had made an aggressive move into the organic business with a Chicago supermarket experiment called Mariano’s.

Nor was it just Roundy’s. News reports indicate that the management team at The Fresh Market (NASDAQ: TFM), a fast-growing organic grocer that operates 183 in the South, the Northeast, and the Midwest, is also trying to sell out. Fresh had found itself unable to compete largely because of low revenue – just $1.82 billion.

Is Sprouts Making Money?

Okay, Sprouts is not the Fresh Market. It has figured out how to generate a lot of revenue from its stores, but is it making money? The experience at Roundy’s shows us that grocers can generate a lot of revenue and still make no money.

The problem is that Sprouts is not making that much money from its revenue growth. For the fourth quarter of 2015, it reported a free cash flow of $27.18 million, a net income of $128.99 million, $239.9 million in cash from operations, and cash and short-term investments of $136.07 million.

That indicates a company with little or no float, but a fast growing revenue. Like Roundy’s, Sprouts could suddenly find itself out of cash and desperately seeking a buyer or at least a savior.

A big problem at Sprouts is that its business model depends on fast expansion. If the expansion hits a roadblock, Sprouts could face flat revenues and some sort of death spiral. Another is that it is operating in the ultra-competitive grocery business and it is exposed to some of the nation’s biggest competitors.

Kroger could Kill Sprouts

The biggest threat to Sprouts survival is Kroger, which is Sprouts’ biggest direct competitor. If you take a look at the map, almost all the places that Sprouts operates are in Kroger country.

Sprouts’ biggest market is California, where it has 82 stores. California is the home of Kroger subsidiary Ralph’s. Sprouts’ next largest market is Texas (36 stores), where Kroger operates under its own name and is expanding aggressively, then comes Arizona (29 stores), where Kroger operates under the Fry’s brand, Colorado (27 stores), where Kroger subsidiaries King Soopers and City Market effectively own the grocery market, and Georgia, where eight Sprouts stores are challenging Kroger and its subsidiary, Harris Teeter.

Kroger has a large footprint in every state Sprouts operates in except Oklahoma. To add to the threat, the expansion plans call for Sprouts to enter the Carolinas, Harris Teeter’s home turf in the near future.

Why Kroger Threatens Sprouts

Kroger is a threat to Sprouts because it too is a deep discounter. News reports indicate that Kroger can sell most groceries at prices 3% to 5% lower than the industry norm. It is also making an aggressive push into the organic and natural foods segment with Simple Truth, a private label brand that reached $1 billion in sales in 2014. Simple Truth sales have been growing at a rate of around 10% a quarter.

Kroger is also experimenting with a number of high-end organic and gourmet grocery models in an attempt to counter Whole Foods and Sprouts. These include Main & Vine in Washington State, Harris Teeter in the Southeast, Mariano’s in Chicagoland, and various Kroger and King Soopers Fresh Faire stores elsewhere.

Since Kroger reported $109.83 billion in revenues on Jan. 31, 2016, it certainly has the resources to crush Sprouts. In addition to being competitive with Sprouts’ prices, Kroger can provide wide amenities Sprouts cannot, including pharmacies, in-store cafes, clinics, filling stations, clothing, furniture, and even jewelry stores.

There’s also Kroger’s growing click and pull (online grocery ordering) and delivery capabilities. Harris Teeter, in particular, has been a leader in these aspects of the grocery industry. Sprouts has not even entered that area yet.

Another weapon Kroger will deploy against Sprouts is its vaunted loyalty card program, which allows customers to save 10¢ a gallon on gasoline or diesel fuel at Kroger fuel centers and convenience stores for every $100 worth of groceries they buy.

This can come in handy for middle class families because Kroger operates 1,330 supermarket fuel centers and 782 convenience stores. Since Sprouts’ target customer is the middle-class soccer mom, you can see the uphill battle it faces.

Sprouts is Growing Too Fast

Since Sprouts lacks pharmacies, filling stations, and similar amenities, it has a major disadvantage dealing with Kroger out of the gate. Nor is it just Kroger Sprouts has to contend with; it faces an increasingly reinvigorated Safeway, Publix in Florida and Georgia, and some aggressive discounters. Both Walmart and Aldi are expanding their offerings of organic products and produce, and the privately held Trader Joe’s is growing fast.

Investors should be leery of Sprouts because it is expanding too fast and taking on far larger and aggressive rivals that have the resources to destroy it if they wish. Kroger is the most dangerous of those adversaries, but it is hardly the only one. It will be difficult for Sprouts to avoid the fate of Roundy’s and the Fresh Market and potentially harder to survive.

My prediction is that Sprouts will eventually end up as part of a larger organization, perhaps Safeway or the privately-held Aldi Sud or Aldi Nord from Germany. Aldi Nord already owns Trader Joes. Sprouts’ future is simply too uncertain for it to be a good investment.

Disclosure the blogger and writer owns shares of Kroger.