Sprouts Farmer Market (SFM)

Organic Ideas

Sprouts Farmers Markets was an investment thesis that unglamorously plopped into our lap.  Often, colleagues will send their ideas our way just for a glance over or review.  Many are fairly easy to write off due to insurmountable debt, poor management, or corporate malpractice, but Sprouts made us doubletake.  When we initially begin our research, the prospect of future stellar returns can cause us to miss threats to investment ideas that otherwise should have been seen.  It only stands to reason that to combat this fallacy, we ought to research from a standpoint of trying to find something that could go wrong with this idea, rather than seeking rewarding returns.  After researching Sprouts Farmers Market, I almost ashamedly can say I am not too worried about this business in the long run.  

To begin, this company thrives off its mission statement which primarily includes offering an “unwavering commitment to providing customers with affordable, healthy foods.”  Creating a company that offers healthy foods to its consumers has been done time and time again.  You likely need to travel less than twenty miles in any direction to find a local grocery store that specializes in niche, local foods.  Or rather, maybe you are the type of person who enjoys strolling through the Saturday morning farmers’ markets so that you can support local businesses.  Either way, it is not so much what Sprouts offers that sets it apart from the competition, but rather how it cultivated its business to benefit all parties involved as best they could.

Suppose a business sets out to capture the exact nature of a farmer's market.  It would need to accomplish a litany of benchmarks to pass for the real thing such as having the neighborhood aesthetic, natural foods that originate from the surrounding community, superbly fresh quality products, and above all else being affordable for any passerby on the street.  Rather than reinvent the wheel, Sprouts simply set off from the get-go to mimic precisely what it is that draws the public to their community farmer’s market.  While the task itself is an incredibly simple concept to grasp,  the execution of the above is seemingly quite complex.

Natural Implementation

Boasting a mission statement that encourages health, Sprouts Farmer’s Markets across the nation post that at a bare minimum, ninety percent of all food products within the store are either completely organic or made with natural ingredients.  The secret within this claim comes from the process by which stores are opened.  To open their doors in a new location, Sprouts must have adequate suppliers in the area, decent farming conditions year-round, as well as a health-conscious culture in the surrounding community.  To tackle this issue, Sprouts simply begins scouting where they ought to build a distribution center before opening any stores.

Vendors are vetted by an internal team that peeks at the ethical risks of their farming practices, and how well the vendor fits into their proposed supply chain, a third party conducts an audit on the potential candidate’s business, and finally, all vendors must meet a lengthy list of criteria to receive the certification of being affiliated with Sprouts.  In short, the business relationship between vendors and Sprouts is somewhat interesting.  Once chosen, vendors can offload a majority, if not all, of their products to one individual buyer.  This alleviates the stress of needing to source multiple buyers to maximize profit on one year’s crop.

Once vendors have been identified, the difficult challenge of distribution rears its ugly head.  How can we safely bring organic foods to potential new stores that remain fresh, flavorful, and above all do so at an inexpensive price?  While the question is no doubt daunting, the solution is incredibly simple: establish a distribution center beforehand.  Having a central distribution within one day’s drive of all stores is precisely how Sprouts can provide a fresh product to their consumers, and not needing to travel cross country distances to deliver obscure product cushions their bottom line by not partaking in egregious shipping costs.  New storefronts can only begin conducting business if they are within a 250-mile radius of these distribution centers.  Within these stores, Sprouts has a warm, friendly appeal but operates its business with such precision that one cannot help but notice the similarities to successful counterparts.

Familiar Business Practices

Without being blunt, and operating with tact, Sprouts has effectively cloned a multitude of businesses with which it is directly competing.  Yet, rather than embody one entire business model, it has specifically cherry-picked what works best for each business in an attempt to better serve its customers.  Before we delve into the subtle familiarities, we ought to mention that there is no shame in shameless cloning.  When researching investments, often we are wary of a company that is best in class for a short period.  We are looking for long runways of growth that spawn multiple ideas, can constantly be refined, and deliver on their promises.  We would rather invest in a company that can consistently be second in the race rather than try to discern who might be the sporadic winner that year.  This idea is best summed up in one simple phrase, “let the pioneers take the arrows.”

Now then, let’s dive in.  The nature of this business is such that consumers primarily only travel to stores to mission shops.  If you need a product other than food, most folks do not directly think to pay a visit to their local grocery store.  Recognizing this, Sprouts has implemented a process directly akin to Costco.  To effectively bring more revenue into the business, Sprouts has placed all of their lowly priced, frequently bought items near the back of their stores.  Things like highly perishable items, on-sale deals that may have been advertised, and anything that may be in high rotation in the household such as toilet paper.  While all of these items require a longer distance to travel, higher-margin items and impulsive products are advertised along the trek.  The idea is not necessarily to have a consumer create a one-off purchase on their way to grab tomatoes for dinner.  Rather, if you consistently see products with one-off uses on your way to grab tomatoes, the next time you may need these products the hope is that Sprouts immediately comes to mind.  In short, this practice plays an immense role in Sprouts’ profitability as a whole.

Yet another practice that Sprouts employs is the idea that if money is saved by the company, this should be passed along to the consumer, not to the business itself.  If through innovation apples are suddenly six cents cheaper, rather than pocket the extra margin Sprouts will reduce the price of their apples.  This practice, coupled with a well-organized promotional campaign, is no doubt eerily similar to Amazon.  Stories of how Jeff Bezos removed lightbulbs from warehouse worker vending machines to decrease costs to consumers come to mind.  While many short-term investors love to see margins increase, it seems that businesses that are capable of passing through their improvements to their customers tend to not only grow quicker but last longer than their competitors.

Lastly, the type of supply chain Sprouts employs is near a direct clone of that of the well-known burrito maker Chipotle.  High-quality organic items and wallet-saving low costs seem almost mutually exclusive.  Yet by partnering with local farmers, Chipotle was able to precisely do this.  While there are subtle differences, there’s no doubt that Sprouts seems to have been inspired by the humble restaurant.

Key Risks

With strong management currently at the helm and with a business model that operates well under any possible near-term inflation, the lack of long-term threats holds.  That being said, there are no doubt a few concerns that will prove to be a challenge for Sprouts Farmers Market should they arise.

1. Stagnation 

Management currently has a goal set in place to expand at a rate of twenty to thirty stores per year across the nation.  With this precise supply chain model, businesses will have difficulty being opened in the northern climates as winter would hinder fresh produce from being produced.

1. Whole Foods

The Amazon-owned grocer has been dubbed, “Whole Wallet.”  The cost of shopping at Whole Foods far outweighs the cost of products in Sprouts at the moment.  Yet as we’ve seen from Amazon in the past, the company culture is obsessed with cutting costs and becoming as efficient as possible.

1. Climate

With being tied to local farms, drought, and other natural disasters could play a role in the amount of fresh produce available to consumers.  Sensitive crops such as many salad greens may run in short supply should there be a continuous drought in the coming years.

Conclusion

Sprouts Farmers Market is a type of “boring business” that has a strong model of operation and consistent growth.  Virtue Capital has established a position as we feel as though there is a potential long runway for the business.  The company’s cloned practices produce incredible financial metrics which will offer security as well as a consistent upside.