Editor's Choice

This IPO Sprouted Too High

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After the 123% gain following the IPO, Sprouts Farmers Market (NASDAQ: SFM) appears to have sprouted too far for new investors. The company offers a compelling shopping experience and attractive pricing, but can it grow fast enough to justify a market cap exceeding $6 billion with revenue of only $2 billion last year.

Sprouts competes in the fast growing and suddenly competitive natural and organic grocery sector against the likes of The Fresh Market (NASDAQ: TFM), Natural Grocers by Vitamin Cottage (NYSE: NGVC) and Whole Foods (NASDAQ: WFM). The sector has become pricey so is the stock or any of the stocks worth buying now?

Basic details

Sprouts now operates 163 stores in only eight states with plans to grow the store base at a 12% annual rate. The company will open 19 stores for the year and 20 stores in 2014 with the eventual goal of reaching 1,200 locations in the U.S. Quarterly revenue has recently topped $600 million with Q1 adjusted net income growing from $16.6 million to $19.6 million or roughly 18%.

The company raised $344 million in net proceeds by selling 20.5 million shares at $18. The proceeds from the offering will be used to pay down debt and allow for a reduction in the interest rate on a credit facility. Apollo Management is a large shareholder that could provide selling pressure in the future with the stock at these levels.

The stock is valued at over $6 billion or roughly 3 times the trailing revenue base. As an example, Whole Foods only trades at 1.5 times expected revenue. Fresh Market has been public for a while and it trades at only 1.7 times revenue.

Sector potential

With the massive store growth of the smaller firms of The Fresh Market, Sprouts, and Natural Grocers, the sector has the potential to grab a larger portion of the overall $600 billion U.S. supermarket industry. According to Nutrition Business Journal, spending on the natural and organic sector has been growing at a rate of 10% annually with sales only reaching $43 billion in 2011. With less than 10% of the total supermarket sector, the natural and organic industry will benefit from the greater access to the produce that the new stores bring.

Rich valuation

Investors paying more than double the IPO price of $18 must be salivating over the growth potential of Sprouts with locations in only eight states. This compares favorably to Natural Grocers in 13 states and The Fresh Market with locations in just over 20 states. Ironically, all three grocers have recently ventured into Oklahoma with plans for multiple locations in Tulsa. This state and the metro areas of Oklahoma City and Tulsa could provide the ultimate research as to which operation will ultimately succeed in dominating the plans for nationwide rollouts.

As mentioned above, Sprouts trades at market value exceeding $6 billion with revenues of $2 billion in 2012. The company reported revenue of $622 million for the quarter ending June 30 with growth of 22%. This compares to a sector that generally trades at 2 times trailing revenue making Sprouts the most expensive in the group. Especially considering the company isn’t overly profitable with razor thin profit margins in 2012 of around 2%. Hard to fathom that adjusted earnings of $45 million could justify a valuation of $6 billion in the grocery sector no matter the strong growth potential. The Q1 results provide some hope as adjusted profit margins hit 3.4%.

Bottom line

Based on recent shopping experiences at a new Sprouts store in my metro area, it was shocking to see the IPO price above the range. The surprising part was the magnitude and valuation afforded the stock compared to other industry players. Sprouts appears a top notch operator, but razor thin profit margins make the current valuation difficult to swallow. Sure the $6 billion stock has all the makings of competing well against sector leader Whole Foods down the road, but investors need to wait for a discount on the stock to justify buying. Remember that Whole Foods has mentioned more competitive pricing and that could impact competitors such as Sprouts.

Mark Holder and Stone Fox Capital Advisors, LLC have no positions in any stocks mentioned. The Motley Fool recommends The Fresh Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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