This Underfollowed Grocery Stock Should Continue to Crush the Market

Very few stocks have escaped the carnage in the market over the past year. The S&P 500 is down roughly 16%, the Nasdaq 100 Index is down 30%, and many individual stocks that used to be high-flyers are down 80% over the past 12 months. But not grocery stocks. Due to high inflation on food prices and the durable nature of the industry, stocks like Kroger are actually up while the rest of the market is down.

But Kroger isn’t the top-performing grocery stock of the past year. Enter Sprouts Farmers Market (SFM -0.94%) a small grocery chain that is crushing the stock market right now. With that said, here’s a closer look at why this stock should be on your radar.

SFM Total Return Level data by YCharts.

What is Sprouts Farmers Market?

Sprouts got its start 20 years ago when its first grocery store was opened in Arizona. With a focus on targeting health-conscious consumers with fresh foods and diet-focused items, it has steadily grown a following in California, the Southwest, Colorado, and Texas. It currently has more than 370 stores in 23 states and is planning to expand across Florida and the Atlantic coast over the next few years.

The company went public in 2014, but over the next few years, it struggled to grow comparable store sales and saw decreasing profit margins. Then, in 2019 the board of directors brought in Jack Sinclair from Walmart‘s grocery division to turn things around. Over the past three years, the stock has been up 67% vs. the S&P 500’s 33.8% total return. Sinclair and his team have been able to achieve such strong performance and turn around this business by revamping Sprout’s advertising strategy and building a more efficient distribution chain. This has helped improve profit margins and helped the company generate consistent cash flow.

In 2019, before Sinclair took over, Sprouts had an adjusted operating margin of 4%. From 2020-2022, that margin has jumped to just over 6%. 

New stores are how this business will grow

Sinclair has helped Sprouts get back to generating solid unit economics, but the next five years and beyond will be about store count growth. Sprouts is a viable grocery concept in all major markets around the United States and has plenty of room to expand its presence across the Atlantic Coast, Midwest, and the Pacific Northwest. Management is targeting 10%-plus annual unit growth after 2022 and thinks it can eventually hit over 1,000 stores in North America.

The grocery model is simple. New stores mean more shoppers, and more shoppers mean more revenue for Sprouts. If Sprouts can double its store count over the next five to seven years, it should be able to more than double its revenue as long as same-store sales grow as well. For reference, same-store sales growth was 2.4% last quarter.

Over the last 12 months, Sprouts has generated $6.3 billion in revenue. Multiply that by two, and the company should be generating at least $12.5 billion in revenue around five years from now. At a 6% operating margin, that equates to $750 million in operating income.

The key: A low starting valuation

Sprouts Farmers Market is a good business, but it hasn’t and won’t put up hypergrowth in the future. So why did the stock outperform the market? Because a year ago, investors could purchase shares at a highly discounted valuation. A year ago, the stock had a market cap of $2.8 billion and no net debt on its balance sheet. Over the previous 12 months, the business generated around $250 million in net income, giving it a trailing price-to-earnings ratio (P/E) of 11 at that time. 

For a company with a steady runway to grow, a P/E of 11 is very cheap. This, along with consistent profit margins, is the main reason why Sprouts Farmers Market is up while the market is down in 2022.

But what about the stock today? At a market cap of $3.46 billion and with trailing net income of $252 million, shares of Sprouts now trade at a P/E of 13.7, which is only slightly more expensive than what shares were trading at a year ago. With the runway for store growth still intact, now could still be a smart time to own shares of Sprouts Farmers Market if you plan to hold for many years.

Brett Schafer has positions in Sprouts Farmers Market. The Motley Fool has positions in and recommends Walmart Inc. The Motley Fool recommends Sprouts Farmers Market. The Motley Fool has a disclosure policy.