Chit Chat Stocks - Why We Own Sprouts Farmers Market (Ticker: SFM)

Episode Date: September 5, 2023

This is our monthly Arch Capital episode. About once a month we will publish an episode that covers a company in the Arch Capital Investors Fund. These episodes will be modeled after our Not So Deep Dive episodes and will also be available on YouTube. Sprouts Farmers Market, Inc. (SFM) is a grocery store chain that specializes in natural and organic foods, catering to health-conscious consumers, but also facing competition in the grocery industry and supply chain disruptions. Brett and Ryan dive through Sprouts and outline the investment thesis for why we own the company in our Arch Capital limited partnership. ****************************** What is Arch Capital? Arch Capital is a concentrated, long-only equity fund aiming to compound capital at an above-market rate. Arch managers are perpetual learners with a long-term focus that strive to build wealth with our partners through intelligent capital allocation. Learn more here: https://www.archcapitalfund.com/ ****************************** Timestamps Company Background | (3:30) History | (10:47) Unit Economics | (22:38) Risks | (41:16) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is Chit Chat Money. My name is Brett Schaefer, and I'm joined, as always, same intro as always, by Ryan Henderson. We're doing our Arch Capital episode

to close out the month. You are going to be listening to this after Labor Day weekend in the united states so at the start of september we're recording it two weeks prior since i'm going on a little vacation so if anything major happens to this company that we're talking about today i don't think it will it's not a very exciting company but if anything happens just yeah we're recording this on august 24th and we are talking sprouts farmers market i don't like like i mentioned nothing this isn't nvidia this isn't amazon there's not news on this company constantly but we're gonna talk about what it might have better returns well it had not not nvidia but maybe versus no it could it could 10 years steady compounder yeah yeah yeah of course

boring companies can provide sexy returns that is correct that is correct it doesn't have to if it's boring it doesn't mean it's going to be a bad investment but we're going to talk about why we on the stock. We're going to talk about the risk. We're going to kind of go through our back and forth interview section where one person asks a question, the other person answers, then that person asks the question back for another topic. We got a few interesting ones here. For these episodes, I will want to give another disclaimer. Again, at this time, we were talking about why we own the stock, but we're also going to talk about reasons why we'd sell the risk we're looking at to potentially get rid of the position. So in the future,

We can possibly not own it, but at the time, we may. And if you want to look at our entire portfolio for our investment fund, it is at archcapitalfund.com. You can sign up for our newsletter and get updates that we send to investors. Yeah. And one more thing I'll say, because sometimes I think people tune into our show and don't really understand the structure. This is the Sprouts Farmers Market. It's the Arch Capital episode.

Brett and I run an investment fund called Arch Capital Investors Fund, and this is a company we actually own in the fund. We do one of these every month at the end of our Not So Deep Dive theme, which we do Not So Deep Dive shows on companies we're looking at kind of for the first time throughout the month. This theme for the month was share cannibals. And I have to say, probably in terms of companies that ended up being investable, something that we'll look at more, this was probably the best theme we've done. It's the most fun one from an investable thesis. So yeah, I think we should try to come up with unique ones like that in the future. Although I am excited, a little teaser next month.

I think I'm more excited than Ryan. I've had to push him to get some of these companies to do. I am excited about covering airlines because I think that they could be undervalued. All right, let's get into it. Ryan, I think you have the first question. So why don't you ask me? Yeah. So, I mean, some people probably aren't familiar with Sprouts Farmer's Market as like a concept because it's mostly in the Southwest and Southeast US. So if you're in the North, you might not have experienced it. So what does Sprouts offer to customers and what's the in-store experience like? Yeah. So Sprouts Farmer's Market, or as we might recall or call it throughout the episode,

is just Sprouts for short, is a grocery chain focused on serving healthy and what they call attribute-based items at a reasonable price. So grocery store, healthy food focus, reasonable price. That's kind of the key three points for the overview of the business model. It has a reversed store layout compared to a traditional grocery store. So in the center, there is a large area for produce, bulk containers that you can fill up for yourself, you know, do it by weight, stuff like that. And then what it calls a quote unquote innovation center, which just means samples and unique items. That is in the middle of the store where traditionally at a Kroger type, an Albertsons type, whatever else type of Walmart, you might have the grocery aisles with the packaged goods stuff in the middle.

so they have a more open layout that's part of no they're off to the side well so kroger will have it in the middle like i mean the the the produce no the dry goods okay cpg is dry good said that backwards no i said dry i thought it's dry goods the grocery items are going to be in the center okay the produce the fresh stuff the bulk for a sprouts is going to be in the center that's how they try to differentiate it make an open concept and they only hold a small amount of grocery skews which will be on the side so it's a lot different model it's a lot more open and another important note is that they have a big vitamins and supplements section so again this isn't some of these notes are not going to be game changing for the thesis but

i think it's important for people to understand what they're focused on and what the consumers they are trying to target. In the newsletter that goes along with this episode, which again, the link will be in the show notes, we'll have an example layout of one of their stores. You can kind of see it's quite different than a traditional grocery store. And then when they talk about attribute-based items, that just means food items that are focused on dietary restrictions, people focused on the diet fat of the day, or certain different lifestyle diets. They could have dairy-free stuff, gluten-free stuff, vegan, paleo, vegetarian, you name it. Overall, they want to cater to what I would call the Venn diagram of US shoppers that want to eat

healthy and at an affordable price. Ryan, something to add. Yeah. And those attribute-based items, so like you said, organic, paleo, keto, gluten-free, that kind of stuff accounts for, I believe, 70% of sales. So it really is that kind of shopper, I guess. Yep. It is a large portion of their sales. And then another example for anyone to kind of get thinking of how this concept works, if you haven't been there before, I like to think of them as a cross between a Trader Joe's, which has in-house brands, lower priced or reasonably priced unique items, and then also

crossed with a Whole Foods, which will have the healthy, organic, dietary focused stuff. Again, there will be a store layout in the newsletter. And then I think from more of an investor perspective, there are a few unique parts of the Sprouts business that I believe are underappreciated by investors because a lot of people look at it and say, okay, it's just another grocery store. What makes it special? Here are a few things. First, and this one isn't that big, but the e-commerce business has grown substantially

in recent years, driven by very profitable partnerships with Instacart and DoorDash. In 2023, e-commerce was 12.3% of sales versus 9.4% in 2020. So after the triple e-commerce sales in 2020, they've really executed at driving that as a volume for their stores. Second, the in-house Sprouts brand now makes up 20% of sales up from just 14% in 2019. And then third, and probably the most important, is that it doesn't carry any major CPG brands. You will not find Coca-Cola or Goldfish in a Sprouts store among a lot of their stuff. I think the key takeaway from an investor perspective is that Sprout has attributes as a business model that allows it to earn higher gross margins than a standard

grocery store. Again, no major CPG brands, lots of in-house brand growth, outsourcing e-commerce, and that allows it to achieve better operating leverage without selling at Whole Foods type prices. I think it gives them plenty of room to earn a sustainable margin, a lot of significantly lower price point and gives them the potential if, as we'll talk about later, if the management team can really accelerate with this new model, grow comp sales, the operating leverage should start to kick in and it's sustainable versus... There's some bear cases out there that talk about their margins being a little unsustainable because it will revert back to the normal levels of what a grocery store has. But I think that's a little bit misleading because

they don't have to negotiate with Coca-Cola. They're negotiating with local farmers. That's what I was going to say is when you have like Sprouts, let's say you've got a lot of stores in Phoenix area. If local suppliers, you've got a lot more bargaining power with them than you would with some big, big, big brand. So you're going to be able to get potentially better rates. Um, and they do that all across their entire store base.

So throughout the country, they try to localize and they even have, I think a segment that's like support local kind of thing where within the store where people can shop there. Today's episode is presented by the science of hitting investment research service. The science of hitting was founded by Alex Morris, who spent a decade working as a buy side equities analyst before launching his own service in early 2021. You've heard him here on the show a number of times, but Alex produces really, really high quality equity research. And in addition, he provides 100% transparency into all his portfolio decision-making. We were early subscribers to the Science of Hitting Research Service, and we genuinely believe that Alex produces research that is on par with top Wall Street analysts at a fraction of the cost. The fact that you also get complete portfolio transparency and 100% accountability is just icing on the cake.

Effectively, you're outsourcing a full-time equities analyst role for just $349 per year. Brett and I both pay for the service on our own, and we can tell you that it's honestly worth the money. Some of the companies that Alex covers includes Microsoft, Netflix, Meta, Roku, Costco, Match Group, Berkshire, tons of others. So if you're interested, check out the TSOH Investment Research Service today at thescienceofhitting.com. Anyways, let's talk about the evolution of Sprouts over the years. So I'm going to give a little bit of history.

I know I usurped your question there, Brett. Do you want to just, for formality purposes, you want to re-ask it? Yeah, Ryan, what is the history of Sprouts? How has it evolved over the years to where it got to its current strategy today? Sure. Great question. the uh so let's go back to the early days the first sprout store was open in 2002 in chandler arizona there's some history that dates back to like the 40s actually and it was

kind of this um like the founders so the nephew of some guy named i think it was like henry i can't remember but the henry name will come in to play here in a second because there was It's like the Henry's Markets, which started as these kind of open-air farmer's market type concepts, and they grew in Arizona. And then the nephews, or the – yeah, I believe it was the nephews of that guy, ended up starting out at the Sprouts Farmer's Market in Chandler, Arizona. That was in 2002. Throughout the next decade, they grew stores pretty quickly. By 2011, they had 56 stores located pretty much all throughout the Southwest. um and they were acquired by private equity firm apollo global management and while under

the apollo umbrella which they were there i think for like two years they were owned by apollo they were combined with two other fresh grocery chains called henry's which had i think like base a slightly smaller store base um and then sunflower farmers market which had maybe it was slightly smaller than the other two but it kind of they retrofitted a lot of the henry's and the sunflower farmers markets into sprouts-based stores, both in the label and the layout. And so they basically supersized Sprouts by doing this. And then Apollo took the combined chain public in 2013. They ended up getting rid of any ownership stake they had by 2015. And when they came public, they were at about 157 total stores. Today, they're roughly 400. So

So it's a much larger business now, but from 2013 to 2015, so when they first came public, Doug Sanders was the CEO and he'd been there for a while. I think he was there since like the really early days for Sprouts. He did okay. He kind of ran the business the same way it had been run prior to kind of going under Apollo or even under Apollo's umbrella. But in August of 2015, Amin Meredia stepped in as the CEO. He was the CFO prior to stepping up, but his time at CEO was just really kind of rough. And I think a lot of it was self-inflicted. So when he stepped in, Sprouts was doing $3.6 billion in revenue, strong operating cashflow margins, and they had kind of minimal debt, $160 million in long-term debt.

The year he left, so he stepped in in 2015, left in 2018, so three years later, they were doing higher revenue, but lower quality revenue, which we'll talk about in a second. He basically tripled the debt load and margins compressed. So during this time, Meredia levered up to expand store count nationally, but he did it without the necessary support infrastructure. So for example, the Washington locations, there was some that were put in here around Breton Eye. They were nowhere near a distribution center, or the closest one was a ways away. and the quality of the produce was worse, fulfillment costs were higher and Meridia was using a lot of mail coupons. So like kind of attracting the bargain hunters,

which was a big driver of foot traffic, but it was bringing in low value customers, people that weren't going to come back unless they got those big coupons, which was a lower margin customer. So 2018, 2019, they bring in Jack Sinclair, Jack Sinclair came over from Walmart Grocery Division, and he really made it his focus to improve the Sprouts brand to be a fresh, healthy specialty retailer and to optimize the store base. So he cut stores that weren't working.

He added distribution centers where they needed so that every store was within 250 miles of a distribution center. And he also cut out all the mail coupons. So, and that kind of took a hit to the comp sales because even though they're lower value customers, they're a big chunk of the revenue. So when you cut those out, people stop coming in, suddenly it looks really bad. However, he was willing to kind of bite the bullet on that. And he really did a good job shifting the focus to fresh, unique, high quality groceries. And so far, he's done a really good job of that. Margins are higher, comp sales are growing again. Granted, inflation's a little bit of a nice help there. and they've continued to open stores in the right areas. The store expansion has been a little slow. Some of the supply chain problems throughout COVID kind of slowed that as well, but really they've opened distribution centers

in the right spots so that all the stores are now within a 250 miles of a distribution center. And then they are now forecasting 10% store count growth from here on out. This year, they've started to pick up the pace on their store count expansion. and they expect it to kind of continue from there. So that's been the role of Jackson and Clary.

He's done a really good job, in my opinion. Brett, am I leaving anything out there in terms of who they were over the last 10 years versus who they are today? I would say, no, you were leading right into the next question on the supply chain. One note is that they've customized their distribution centers.

They spend a good amount of money since a lot of their assortment is produce and a lot of people go for the fresh produce they've made them specifically for keeping things fresh they had two examples in some youtube video that they watched that they have the bananas and avocados it's a big problem for people that's just two examples of they're either too ripe at the store not ripe enough at the store right it's a big issue for not a giant issue but it can be an issue when you're shopping and if you can find something that's about to be ripe or kind of in that golden period that's a value you know increase and they're trying to make it much

better than say a kroger in that regard so i think that's a small note it's not going to be a game changer for them but it shows that they're doing the little things now to actually put the meat behind their what they market to consumers all right let's talk about maybe some of the tailwinds. So I think part of our thesis is that we believe Sprouts is going to be a long-term compounder. They've got a replicable model. In order to do that, I think they need some tailwinds or maybe they need to be operating in a good industry. Are there any long-term tailwinds that Sprouts benefits from? How large do you think this business can really get? Yeah. So the numbers out here are typically not going to be rock solid. A lot of it's built on

surveys, but I believe, and I think Ryan believes as well, that there is a steady tailwind of healthier eating in the United States that should continue over the next decade. If you look back, thinking more from a common sense perspective on kind of what people ate on average on a decade by decade basis, looking backwards, I think there's clearly a growing cohort of people looking to eat healthy food. Now, half the population might not care, but that's okay because Sprouts is only targeting that growing maybe 10, 15, 20% of the population, depending on what region you're in, that wants to eat healthy food. And I will also say as a side note, there's a lot of talk about Ozempic and weight loss drug risk for CPG brands, grocery stores,

restaurants, whatever. I'd say Sprouts is definitely in the small category of food-based companies that are not at risk and perhaps will maybe even benefit from these weight loss drugs, but that's not really part of the thesis. Here are some quotes from studies done by the Food Institute. Maybe I'll read them all. The full quote will be in the newsletter, but basically what it says is that high quality fruits and vegetables remain a top attribute for choosing a primary store among supermarkets for people. And then health and wellness is still one of the few purchase drivers that have stayed consistently strong through the recent inflationary period. So that's very recent, the last couple of years.

84% of people say they want to eat healthy. Three out of four people want to see to now use food as quote unquote medicine. You know, that's a big trend. And there's also a lot of need to help identifying what foods are best for them. And that I think is what sprouts and sprouts type stores, whole foods, whatever, that's where they kick in or come into play because they can help say, okay, hey, you're trying paleo. You're trying, you want to eat organically.

Okay, we got everything for you here. At our store, if you go to a Kroger, you're going to have a bunch of Coca-Cola, whatever that stuff, you know, all the other CPG brands that everyone knows already. Now, if we look at, let's say, the actual store count, which is way more important for the investment thesis, Sprouts has 391 stores and it's spread across the southwest Texas and the southeast of the United States. over the next few years, they will be focused on the southern part of the country, as well as the greater regions around New York City. And from 2024 onward, as Ryan mentioned, they plan on growing store count by 10% a year. Now, I want to share the screen just for a map for anyone watching the video here, which will be nice, I guess, just to kind of look at. They have a map that they put in all their IR presentations, and they have two different highlights for states

here where you have expansion markets, which are highlighted in dark green, and that's our California, Texas, Florida, Georgia, and the greater New York area. And then they have existing markets, which are really the Southern belts, except for they have those strange stores in Washington that are kind of an outlier. Now, I don't have an exact number on how many stores they can have, but I don't know. I think they could do well north of double its current store count and likely more than 1,000 just in the United States. I think this is a store count that can succeed in the entire country, given there are healthy eaters everywhere. And I think looking at their current map, looking at that they only have 391 stores, it's clear to me that if they can continue executing with their strategy,

the store count can grow not indefinitely but from an investor perspective for for us who kind of focus on a three to five year time horizon there's no concern on any sort of market saturation like with a something like a starbucks a mcdonald's a dollar general whatever anything else there ryan no i think i agree it's always hard to forecast how many stores some a concept like this can have i think in terms of tam i think probably similar tam to a trader joe's like concept yeah maybe a little lower but i agree something like that you're not going to have a ton of stores and they're not going to be big stores as we'll talk about in the next section but there's there's room for probably at least a thousand of these across the whole country especially and they can also

move into canada pretty easily as well but that leads into the next question we're going to talk about the unit economics of this business. Get into the numbers. In Toronto, every arrival is a statement and nothing says it better than this. Cadillac Optic was the number one selling luxury EV in Canada for 2025. Find your rhythm across a seamless 33-inch display

and an immersive 19-speaker AKG surround audio system. This city demands agility and Optic delivers with precision to make every drive extraordinary. Let's take the Cadillac. Find out more at cadillaccanada.ca. Luxury sales claim based on S&P Global Mobility Canadian new vehicle total registrations for calendar year 2025 for the Cadillac definition

of luxury. Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it. I'm Siaia and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently that's how I roll. So bundle up and come along for the bumpy ride stream a new episode of north of north tuesdays on cbc gem what are the unit economics for sprouts how much do they generate in revenue and profits i would say uh as a side note here this is the numbers section quote unquote and we will have some charts in the newsletter that highlight a lot of the different trajectories of these earnings

we'll have operating income per store, comp sales, all that stuff in the newsletter for free. All right. What do you got first, Ryan? Yeah. Today Sprouts has 400 stores, give or take. I don't think they have the updated store count, but- 391. 391. It's hard to find. They don't brag about it, but yeah. Sure. Oh, you're talking about that on August 24th, 2023? Yeah, because they had 386 at the end end of the year last year and then year to date they've opened 14 they may have closed some but it's 391 i believe at the end of q2 because they did close some and i think they said opening 10

in q3 but again yeah we don't know exactly so roughly 400 that's all that matters anyway like brett said they're located throughout the southwest and the southeast us um and to get a new sprouts farmers market store up and running in in the newer format i guess we should talk about this The typical store kind of prior to Sinclair coming in was about 30,000 square feet. Sinclair has basically said, we can shave off 7,000 of that. So he thinks they can generate the same sales, same level of sales in a 23,000 square foot format. And so to get a format like that up and running, it costs Sprouts about $3 million up front.

um and sinclair's based on kind of his numbers or his guidance they you can estimate that each store at maturity which it takes some years for a store to kind of mature for a surrounding area to become aware of a store and kind of get to a level of sales that's durable at maturity each store could do about 16 to 18 million dollars in revenue per year keep in mind i mean you probably here, $3 million upfront costs versus 16, $18 million in revenue a year. That's great. But it's a low margin business. It's a grocery store, not that low margin, I guess, but they think the stores can have about 8% EBITDA margins on their own. So that means that maturity, which I think I've seen estimates that it takes about four years to get to maturity. Each location can generate

about 40% of its initial upfront costs in a given year, in cash in a given year. So I think you really do get pretty good returns. They estimate that they generate mid-teens returns on invested capital, but really you can kind of see it in the results. These stores are profitable when they're mature and when they're up and running. Across the whole business, though, Sprouts generates $6.6 billion in revenue over the last 12 months, which on its current store base and the current average square footage of each store, which is about 28,000 right now, that implies $592 in annual sales per square foot. That is relative to the bigger box retailers like Kroger and Walmart. That's really good.

Now, obviously, it's a smaller store format. You can kind of expect that. um the only one that really trumps it that i can think of is whole foods um creator joe's probably too but private we don't have the numbers yeah and that number is even higher for their new smaller store format i believe um sinclair's estimates estimates that he could that the smaller store formats could do 700 plus in sales per square foot um but beyond the better footprint efficiency because Sprouts focuses on that fresh, unique items segment. It allows them, and because they go with local suppliers, it allows them to win without having to be the

low cost provider. And so this helps Sprouts generate 37% gross margins, which is best in class for a grocer relative to Walmart, Kroger, natural grocers, and Weiss markets, which were all kind of the grocery comps that I could find publicly. Let's see here. Natural grocers is 28%, Walmart, 24, Weiss Markets, 24, Kroger, 21, and Sprouts at 37. So it's significantly more profitable on a per store basis than your big box retailers. A lot of that gross margin trickles through to the operating line. They get 6% operating margins. They've been able, I remember people saying this coming out of COVID, like there's no way their operating margins are going to be sustainable, but they've really done it. I mean, they've sustained kind of 5.7, 5.8% operating cash flow margins.

Even with a lot of wage inflation. A lot of wage inflation. Yeah. So over the last 12 months, they've generated $457 million in operating cash flow. They've used about 37% of that for capital expenditures. That includes new stores, retrofitting old stores into potentially the new type of layout, although that hasn't been a huge part of it. And then just general maintenance CapEx. And then whatever's left, they basically plow into buybacks.

And I'll say this on a go-forward basis, and Brett's probably going to talk about this, a larger chunk of that cash flow is going to start moving to capital expenditures because they're going to start to ramp up that store pace. Yeah, that's a good tease. and I would mention, so Ryan talked about the high gross margins and then the operating margin at 6%. We don't know what comp sales are going to be. We think they're going to be sustainably in the low to mid single digits. It's not going to be a crazy comp grower like Costco, but that difference or the gross margin, operating margin difference means that if they're driving more volume and traffic and unit volumes at each of these stores, they can achieve steady operating leverage over the long term, which could see the operating margin get higher to 7%, 8% now.

It's not going to get that much higher, but there is room given they're already selling stuff at reasonable prices. If you go to a Sprouts Farmer's Market, it'll cost probably half of what it is at a Whole Foods. So they can keep those prices steady. If they drive more volumes, there's really room to gain operating leverage without screwing over your employees or screwing over your supply chain. So I think it's a win-win scenario given the model of avoiding stuff like Coca-Cola as we use as our example there. Okay. Let's talk capital allocation. What is the capital allocation strategy for Sprouts? What do we think about it? Yep. And as this is the share cannibal month, you're going to guess, any listener will know

by now that they are buying back stock. But I think a great thing about Sprouts and one of the big reasons why we like the company is that they have a simple stated capital allocation strategy that management has followed through with. So they've done it consistently. They've done what they say they're going to do. Part of our thesis is that Sprouts can continue with this capital strategy over the next three to five years and probably much, much longer. So there's two parts to it. Generally, Sprouts plans to take its operating profits and cash flow and first reinvest to build more stores and improve its supply chain. Its guidance for 2024 onward as it increases its new store count or yeah, increases its store build out is to spend about 3.5% of

sales each year on capital expenditures, around half of which is for new stores and a half of which is for company infrastructure, which includes supply chains, distribution centers, offices, et cetera. So over the last 12 months, they've generated around $6.6 billion in sales, which would equate to $230 million in capital expenditures. Like I mentioned before, the company spent less on that. I'll have a chart in the newsletter. They have a nice graphic of what their plans are, which I think is great.

And they put it out with what's going to be new stores, what's going to be sales and infrastructure, and what's going to be maintenance as we go from the pandemic period where they spent less on new stores into this kind of 2024 and onward period. So that's a great one. Definitely take a look at that.

they do have a very nice IR presentation that they just updated in August. If we go back to the numbers, though, like Ryan mentioned before, over the last 12 months, cash flow from operations was $457 million. So what do they do with that excess $457 million minus the $230 million in capital expenditures? They pour the money into share repurchases and a lot of them. So since 2016, Sprouts has shrunk its share count at a 5.2% annual rate, bringing its shares outstanding down from $148 million to $102 million. And with a market cap of about $4 billion today, and hundreds of billions, or excuse me, not billions, hundreds of millions in cash available to repurchase shares each year, Sprouts will

have the ability to continue producing shares outstanding in the years to come, or at least we think so. And again, this is one of the key parts of our thesis for the stock, along with new store openings, durable comp sales, and the potential for operating leverage. Of course, if the share price rises, the buyback becomes less valuable. But I think as shareholders, that would be a good problem for us to have. I'll have a chart of the share count in the newsletter. They paused it during 2020. So it makes it even more impressive that they were able to keep reducing at a 5% rate. And I would note, looking at some of the long-term compounders that we looked at that our share cannibals for this month, AutoZone, Lowe's, our two prime examples,

the 5% to 6% annual rate of decline is kind of in line with those. So I think it sets up sprouts. They're on the same trajectory of getting that share count down 70% cumulatively, 80% cumulatively. And eventually, if they do it long enough in that AutoZone level of declining by a cumulative level of 90 percent anything else to add there ryan before we move to the next section no i mean share counts down 40 since 2015 roughly we think i'll just spoil it now you know we when we talked about autozone we talked about lows the hope was or our conclusion i think for both of them was yeah this is great they've done such a good job allocating capital but it would have been awesome if we could have come across them 10, 15 years ago. We feel like Sprouts is hopefully a younger

version of that where it's a steady compounding story in terms of the top line and management has a rational capital allocation strategy. That is a great tease. And now let's move into our thesis part. Ryan, you had that section, so valuation discussion. How much do we think Sprouts can earn? What kind of numbers that we look at it? Why do we think generally that it's attractive investment at the price that we bought which i should reference was we we had owned this in kind of the 20s we had sold it but then we re-bought earlier this year at a price of around 33 to 34 dollars i don't have the exact cost basis so it's lower than today but i'm sure ryan will talk about kind of the difference between the buy and the current price um but yeah what do you what

are the numbers you got for us yeah so around some of the numbers and it really i mean when you have a concept like this it really depends what they choose to grow their store count at in terms of what you know what free cash flow is going to be um and it sounds like sinclair wants to get a little more aggressive and they're targeting that 10 store count growth that we've talked about so if that's the case management estimates that they'll be spending about three and a half percent of their revenue on capex each year in that case free cash flow probably wouldn't look quite as good because right now they spend significantly less than that. But I've got a couple of assumptions that get basically to a 15% annual return. So let's assume they grow store count

by 10% each year. Let's assume comp sales is at 3% annually. Currently 3.2. Yeah. Operating margins are steady. Gross margins are steady, although it's not super meaningful here. And then CapEx jumps, like management has estimated, and they continue to reduce shares outstanding by 5%. Obviously, that can fluctuate depending on where the stock's at. And then here's kind of the, I guess, crazy assumption if someone wants to call it that, 20 times free cashflow multiple in three to five years. Now people are probably going to say 20 times, okay, well, you're just underwriting a bunch of multiple expansion. However,

it's not that different on an operating cashflow basis. Basically this is- Oh yeah. Or an operating earnings basis. Yeah. It's basically just what do they do with their excess cash? And so it would come out as a 20 times free cashflow multiple, but because they're spending three and a half percent of their revenue on CapEx, if they were to cut that, it would not look nearly as expensive on a free cashflow basis. So all that gets you about a 15% return from here, annualized. And I guess one of the things I like about this is that buying groceries is not going to go away in a recession.

You're not going to get some of the fluctuations that we've had with many of our other businesses that we own. It's more durable. Margins might compress, but at the end of the day, it's going to basically shine through no matter what the macro environment is like. So I think it's sticky. I think it's a simple concept. And the more stores that they add, the more people start to become aware of the brand, start to know what Sprouts is selling. Hopefully that can drive comp sales a little bit higher. Or really, even if they don't grow stores that fast, as long as they maintain those gross margins and those operating margins and comp sales are positive, it should be a pretty good investment from here, especially when you throw in the buyback. Yeah. And two things before we get to our closeout on management and risks. One, there's more juice left, I guess, in the returns if operating margins expand. Remember, Ryan is underwriting no operating margin expansion. I'd say they'd probably expand if comp sales grow at 3% a year, but again-

And if their Sprouts label grows too as a percentage of revenue. Right. Correct. And then second, they are probably even more recession-proof than a typical grocery store as they have a wealthier clientele. They have some numbers on that in their investor presentation. But let's move to the management team. It's kind of clear we think that the management team is good and has executed well over the last four years since Sinclair joined and brought in the new people. But what do we think of them generally before we close out the episode i think yeah i mean i like jack sinclair um judging by his record at sprouts he's done a really good job on everything that he's talked about so pivoting sprouts from being seen as a

discount grocer to more of a health focused specialty chain he's done a good job of that that's kind of the customers they attract nowadays from what i understand he's been a little slow on store count growth but the existing stores are improving so it feels to me like you know i'm content waiting for store count to kind of come in as he sees fit as for the cfo chip what's his last chip malloy uh he's stepping away um he's retiring and this has been kind of planned for a long time apparently he's tried to retire a number of times and basically ends up coming back So they are currently searching for a new CFO. This is maybe a bit of a risk just in the fact that Chip Malloy has done a really good job balancing CapEx and Sherry purchases. I think most CFOs will be able to do that pretty well, hopefully. So hopefully it isn't that pivotal. The other thing I'll mention here, this maybe doesn't have to do that much with the management team, but they've done a really good job delevering or deleveraging where they were in a lot of debt, especially relative to their earnings EBIT, when the previous CEO left.

Now, they are sitting with more cash than debt on hand. They have really a minimal amount of debt. I think it's like $150 million out of a revolving credit facility that they use. But basically, they've gone to zero debt. Honestly, if they're getting good returns on capital that they deploy into new stores, I would say, feel free to add a little bit of leverage, assuming that it's a reasonable interest rate. Yeah, of course.

I'll go to mine. I think, again, if we own the stock, we typically think that the management team is strong, especially if it's one we think is in kind of our never sell or hopefully compound or S category. And yeah, I think highly Jackson, Claire's manager, he's executed very well in expanding margins after joining in 2019, has a consistent strategy that the team really doesn't deviate the fresh air versus a lot of the tech CEOs that we may follow and own from time to time that just talk a big talk, but the underlying income statement doesn't look as strong. Sprouts does. And then they have a fantastic capital allocation strategy. It's one of the

best we've seen and probably the best out of a company we own, I'd say, at least out of the operating businesses. There's a lot of stuff they're doing around the edges, including the lower store size, bringing in a better checkout experience. They didn't really even have self checkout before Sinclair came and then improving the supply chain stuff like we talked about. He had a great track record of growing Walmart's grocery business, which has grown tremendously over the last 15, 20 years. He was a big part of that. And I think as we get away from the pandemic bullwhip, I think they can play offense now instead of defense by pushing for more store growth with these better unit economics, the smaller store format, the better distribution

centers and improving that customer value proposition. That's a long ways away from when they were in 2019. And it's only been four years they had the pandemic to deal with two. it's a big testament to this team. All right. To close things out, we've got to talk about the risks. What are we watching here? When will we add to our position? When will we sell? Closing thoughts here, Ryan. Well, I share one of the same risks as you, which is comp sales only at 3% is a little bit of a concern for me because inflation has been, I think that's basically in line with inflation, maybe a little bit lower, especially if we look at it over the last two years, comp sales versus inflation.

So it worries me a little bit that foot traffic isn't growing much at all, which is not the end of the world if you're generating higher operating income per square foot every year. It doesn't really matter if your existing customers are sticking around and they're spending more, that's great. But I worry that maybe that's what the previous CEO saw and may have encouraged him to go after those low value customers with those mail coupons, I don't think Sinclair will go back to that. But if they do something to start to try to boost foot traffic and it compromises gross margins, I'd be a little concerned. When would we add? I think it would need to be at a cheaper multiple, assuming our estimates for the business don't change. But if we start to think that the

business can grow store count at 10% and maybe comp sales are closer to 5% or 6%, I'd be willing to add at this multiple. The difficulty is that's not the reality right now. So I don't know if we're necessarily adding shares today, but I think you pegged a specific multiple on it. I think that's probably reasonable 12 to 13 times trailing earnings seems like an attractive price to add shares. When would we sell? I would say if we notice something fundamentally wrong with the business, if we start to see margins contract, I'm not talking about free cashflow margins, but operating margins, because everything below the operating cashflow line is kind of up to management's discretion. Or if it got up north of 25 times trailing earnings, I'd be

maybe a little reluctant to continue owning it. Yeah. Now I might push back on the valuation part there. For me, it might be a little bit higher. It's just, again, it all comes down to what your other opportunities out there are, but with such a long runway for reinvestment, I would worry that it's a mistake to sell, even if it got to, you know, quote unquote, a mark in multiple or an extent in multiple or some other kind of arbitrary reason. Obviously, buying at 25 times earnings for a business like this does not seem smart, but I don't know. I guess that's something we can debate. It's a good problem to have if it ever occurs. You talked about the inflation risk. I think that's the number one thing for me,

it's not the inflation risk of getting hurt by inflation. It's just that inflation is masking their weaker traffic. Traffic hasn't been that strong recently. Their comp sales are still weaker than the mass market merchants like Kroger, and we need to see comp store growth continue. Now, the key metrics I'm going to be looking at to see whether the business is deteriorating or improving are comp sales, operating margin, and operating income per store. They all relate together, but I believe those are the key drivers of the long-term of cashflow growth. If one or all these took a hit, which again, if one of them takes a hit, they're probably all going to take a hit. I would be looking to sell sprouts and not just for a quarter, but over a

multi-year period. And yeah, I think to close things out, we would want to make this a significantly large position or not maybe not significantly larger, but up it to a large position in the portfolio. If the trailing PE gets closer to 12 to 13 times, that'll really make the formula of unit cap growth, comp sales, margin expansion, and buybacks work wonderfully. And given the numbers that Ryan laid out, if the stock gets closer to that 12 to 13 times earnings, I think the forward returns could be at 20% CAGR over the next five years, give or take, if we get down there. I mean, we, not to pat ourselves on the back here, but when we first bought this position, I think we made it a 10% position. It was trading at six or seven times

operating income so yeah it's not it's not as easy the margin of safety is a little uh not as good here but we still think it's a good opportunity yeah i mean that was one of the maybe the only fat pitch that we've been comfortable with in the last two three years probably the best what do you think probably the easiest it's it was aside from maybe some like other smaller positions it nominally it's been the best investment we've made yeah and it was probably i think one of the easier ones we've made too yep all right well that close things out again full disclosure on this episode we do own shares today we could easily sell them in the future there are risks to this company but we do own

it today and we think it's an attractive uh price at these levels again check out the show notes we'll have the charts and all that good stuff when the newsletter comes out as we release this on tuesday after labor day full disclosure here we are not financial advisors anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you everyone for tuning in. Hope you enjoyed our thoughts on Sprouts, and we'll see you next time.