Hispanic
Overview
My recommendation for the Bean Sprouts Farmers Market (NASDAQ: SFM) is a Hold rating as I am concerned about potential gross margin compression, continued volume decline and SG&A growth outpacing revenue growth.That’s because, despite strong second-quarter results As a result, it faces the headwind of falling sales behind its peers. In addition, selling and administrative expenses are expected to continue to rise due to the rapid expansion of new stores, which will have a negative impact on profit margins, which are growing faster than revenue. Finally, SFM’s profit margin is at a higher premium than its peers, and its room for decline is also much greater than that of its peers. In the event of a price war, SFM could suffer significant losses given the decline in sales.
Business
SFM offers a unique grocery shopping experience characterized by an open store layout centered around fresh produce.Their Their carefully selected wellness products reflect their commitment to promoting natural health and are supported by a team of professionals with a common goal. They continue to introduce innovative, healthy products made with lifestyle-friendly ingredients such as organic, plant-based and gluten-free.
Over the past five years, SFM has grown at a CAGR of 4.2%.However, it’s worth noting that its revenue growth has slowed from double digits to low single digits [LSD] Percent range. For reference, its revenue grew as high as 11.6% year-over-year in 2018, in sharp contrast to 5% in 2022. This shift indicates that SFM’s growth momentum is slowing down, marking the entry into a mature growth stage. Still, despite the economic slowdown, its EBITDA margins have remained at a healthy average of 7.18%. This margin performance does emphasize management’s effective cost management.
Recent results and updates
Although SFM reported strong results for the second quarter, there are concerns that volume challenges could affect future quarters.In the second quarter, SFM delivered strong same-store sales growth of 3.2%, with net sales of $1.69 billion, up 6.1% year over year, driven primarily by average unit retail sales [AUR] inflation. However, this positive performance was offset by lower sales. As a result, the company reiterated its outlook for fiscal 2023, projecting growth in the +2% to +3% range, indicating slower growth in the second half. Specifically, SFM expects third-quarter LSD compound sales to be in the 1% to 3% range, indicating a slowdown from the 3.2% compound growth rate in the second quarter. This slowdown is mainly attributed to weak sales.
This further amplifies my negative view on the business as SFM’s gross margins are 860 basis points higher than peers, implying that there is more room for margins to decline. For example, peers such as Grocery Outlets have gross margins of 30.5%, Kroger 21.4%, Village Super Market 28.12%, Albertsons Cos 28%, Natural Grocers By Vitamin C 28%, Wets Markets 25%, and Ingles Markets 25 %, overall moderate 28%. My concern is that SFM has not faced significant price competition recently, and this large margin differential puts it at risk of increasing price competition in the grocery industry, especially given its position as a retailer that balances high- and low-priced products. If a price war breaks out, SFM could face significant repercussions, especially given its continued decline in sales. Additionally, SFM’s sales volume declines have consistently lagged industry norms, amplifying the potential impact of a price war on the company.
Since entering 2021, inflation has continued. As of August 2023, the inflation rate was 3.7%, still above the Federal Reserve’s 2% target interest rate. Consumers are frustrated by the huge budget holes created by inflation. Food sellers are actively trying to change their stance in response. Positioning yourself as a friend in the fight against high pricing is becoming increasingly common. Retailers such as Aldi, Wegmans and Kroger are already preparing to lure customers with price cuts to help customers save money. As a result, the likelihood of a price war among grocery store retailers is increasing.
Additionally, selling, general and administrative expenses grew at a faster rate (7.8%) than net sales (6.1%) in the second quarter, a trend expected to continue into the coming quarters, with an increase expected in the third quarter. As SFM plans to rapidly expand its store network, the increased expenses may impact net profit margin in fiscal 2024.
Valuation and risk
Author’s valuation model
According to my model, SFM is valued at $35.84 in fiscal 2024, down 12%. This price target is based on my expectation of decelerating revenue growth in FY24 after meeting management guidance in FY23. This deceleration reflects my conservative view that SFM’s sales will continue to decline given weak consumer confidence and that SFM’s new stores are not yet at a mature stage. Additionally, my model predicts flat margins as SFM sees an increase in SG&A expenses that exceeds any operating leverage seen by its business.
SFM currently trades at 15 times forward earnings, compared with a median of 13 times for its peers (listed above). While I acknowledge that SFM’s gross margins are higher than those of its peers, I am concerned (as mentioned above) that SFM could collapse from any potential price war. When this happens, the premium multiple may shrink. I believe SFM can find a way to protect gross margins in a price war, so my model assumes 15x forward earnings. In other words, even at 15x, the upside is not attractive at all.
risk
If SFM’s product elasticity increases, it means that consumers become more sensitive to price changes. In this case, even a small increase in price could result in a significant decrease in demand, which could lead to a decrease in comparable sales. Although sustainable forest management has been subject to favorable input cost conditions, there is always the possibility that this trend may be reversed. If input costs start to fall, margins could be affected, especially if SFM is unable to adjust its pricing strategy to maintain profitability.
Upside risks include increased consumer preference for healthier eating and tailwinds for home-based food, which will drive demand for sustainable forest management. In addition, new store growth plans perform better and faster than expected, which may result in revenue growth exceeding sales and administrative expense growth. If cost pressures such as wages and promotions are reduced, it will lead to better-than-expected profit margins.
generalize
Overall, my recommendation for SFM is a Hold rating due to concerns about potential gross margin compression, continued volume decline, and rising SG&A expenses outpacing revenue growth. Despite SFM’s strong second-quarter results, it faces the challenge of declining sales volume and a substantial gross margin premium over peers, leaving it vulnerable to price competition in the grocery industry. In addition, the rapid expansion of new stores is expected to increase expenses, which may affect net profit in fiscal 2024.
