Sold Sprouts

I sold my entire SFM position today at the open.  Although SFM was the smallest of my three remaining holdings, I did have strong conviction in it and thought it was a position I would be holding for many years.  So I would like to go a little more in depth into why I decided to sell.

To show why I sold, I first have to recap why I bought SFM and why I had strong conviction in it.  I believe that the move towards natural and organic foods is a strong trend which will continue for a long time. I felt that there was room for a grocer focused specifically on that niche, and I thought Sprouts was ideally positioned with its focus on value pricing and its smaller store format. I felt that a grocer that provided value yet still felt like a specialty retailer would be a winning concept. I thought smaller stores had several benefits. 1) Consumers seem to be turning away from superstore formats, 2) smaller stores have more flexibility in location selection, and 3) smaller stores are cheaper to build, lease, and operate.

I felt that Whole Foods (WFM) had limited appeal due to its expensive prices and its large store format was not flexible.  Other smaller publicly traded grocers focused on natural and organic like The Fresh Market (TFM) didn’t seem to be gaining traction. I wasn’t too concerned about the likes of Walmart and Target getting into selling natural and organic foods because I didn’t think they would garner much mind share in that space. I thought Kroger (KR) was doing a decent job offering more natural and organic selection, but again I thought that their bigger stores and lack of focus wasn’t as attractive. Actually my favorite in the space would be Trader Joe’s, but they are not public.

So, I thought SFM was the most attractive publicly traded option. I felt they had the best format. They had massive room to grow.  At the time I initiated my position they had around 150 stores and projected they could ultimately grow to around 1200 stores.  They also had the best comps, with same store sales comps at or above 10%, roughly double WFM and TFM.

The biggest downside I saw in SFM was the valuation.  It was on the high side based on both trailing and forward earnings.  However SFM had consistently been exceeding their guidance, which I felt was overly conservative.  In past years they were guiding to 8-9% and 7-8% same store sales comps and were delivering 10-13% instead.  They would guide to 25% EPS growth at the beginning of the year and end up delivering 50% EPS growth.  So at the price I was building my position (around $30), even though that was 40x forward earnings, I felt SFM would continue to exceed guidance and quickly grow into its valuation.

If SFM continued to deliver on its 14% annual store growth plan, and continued to deliver at least high single digit same store sales growth, then the resulting leverage in operating margins could drive sustained 30% EPS growth.  SFM would soon become a 30% grower trading at 30x earnings, which is very attractive if it can be sustained over the long term.

So what changed?  Several things.

1) SFM reported earnings yesterday and although they were only very slightly below guidance, the trends were worrying.  Same store sales growth was 4.8%. Although SFM had guided to only 5-6%, I was used to SFM exceeding same stores guidance by a couple points instead of falling short. 4.8% same store sales growth is about half what they had been delivering over the past couple years. It was also not impressive compared to the competition.  It was barely better than Whole Foods, and it was actually worse than Kroger. I didn’t find management’s explanations very satisfying either.

2) Whole Foods announced that they will be launching a new chain of smaller stores focused on value. While I think this confirms Sprouts’ model, it will also be a direct competitor to Sprouts. It will be a direct competitor for locations and a direct competitor for mind share. If Sprouts growth is already slowing, how much worse will it be with this new competition?

3) Consumer Reports annual supermarket survey for 2015 was recently released, and Sprouts slipped in the rankings. Sprouts got a score of 83 compared to 84 last year. The difference was small, but in the wrong direction. And other supermarkets increased their scores from last year, so Sprouts ended up slipping from around 4th last year to around 8th this year. Sprouts wasn’t even named as one of the stores scoring highest for fresh produce, supposedly its strength. Wegmans, The Fresh Market, and Whole Foods scored highest there.

4) Insiders, particularly the CEO, have been selling a lot of shares. I do not let insider sales deter me if I believe strongly in the fundamentals. But if I am conflicted about fundamentals, insider sales can tip me towards selling. The CEO has not only sold a lot of shares recently, the amount of sales has left him with a very small ownership position.

5) The valuation and risk/reward was looking less attractive. With declining same store sales growth and increased competition on the horizon, the probability of sustained 30% EPS growth seemed less likely. Now the probability of only 20% sustained growth seemed more likely. At 30% EPS growth I thought SFM had only a couple dollars of downside risk while having the potential to become a 2 or 3 bagger.  At 20% EPS growth I think SFM could trade down to $17 (20x 2015 EPS of $.85) while upside potential is much reduced. So the risk/reward profile is far less attractive now than I had thought before.

6) At around $28 where SFM opened this morning, it was in the region of 5-10% down from my average cost basis. I do not have any hard and fast rules about cutting my losses at a fixed percentage, but I do have some ‘mental stops’ where I will heavily scrutinize whether my reasons for owning a stock are still valid. I tend to give more leeway to the ideas I have stronger fundamental conviction on, but I do have respect for the market’s judgement. Cutting my losses quickly saved me quite a bit on past positions such as Zulily and Yelp. If I felt the fundamentals and valuation were still strong on Sprouts I would have held my position or added more. However the worsened fundamentals and valuation in this case caused me to go with the decision to cut my losses while they were still small.

So all the above reasons contributed to my deciding to sell. Obviously I would have been better off selling a couple months ago when SFM was at $38. However it wasn’t until recently, in particular SFM’s earnings report, that the preponderance of the evidence convinced me it was time to sell. Prior to that I tended to think that SFM was simply trading down along with WFM and the sector, and that was actually presenting an attractive buying opportunity in SFM. Fortunately I decided to wait until after Sprouts earnings before doing anything.