Sprouts Farmers Market, Inc. — Q2 2013 Form 10-Q
Business and period. Sprouts operates a specialty grocery chain focused on natural and organic foods. The filing covers the 13 and 26 weeks ended June 30, 2013; the prior periods ended July 1, 2012. The company had 160 stores at quarter-end and reported 165 by the filing date. Figures below are in U.S. dollars; financial amounts are rounded to millions unless noted.
Comparisons with reported 2012 results are affected by the May 2012 Sunflower acquisition, which was included in Sprouts’ results only from May 29, 2012. The filing also presents unaudited pro forma 2012 results assuming Sunflower had been acquired at the start of fiscal 2012; these are illustrative, not actual historical results.
Key financial results
| Metric | Q2 2013 | Q2 2012 reported | Q2 2012 pro forma | First half 2013 | First half 2012 reported | First half 2012 pro forma |
|---|---|---|---|---|---|---|
| Net sales | $622.4m | $430.1m | $508.5m | $1,196.1m | $805.8m | $1,002.0m |
| Comparable-store sales growth | 10.8% | — | 10.2% | 9.4% | — | 10.1% |
| Gross profit / margin | $187.0m / 30.1% | $130.7m / 30.4% | $152.7m / 30.0% | $360.9m / 30.2% | $247.5m / 30.7% | $305.2m / 30.5% |
| Income from operations | $40.1m | $17.7m | $24.0m | $80.1m | $41.9m | $55.9m |
| Net income | $12.5m | $5.3m | $7.2m | $30.6m | $14.9m | $19.5m |
| Diluted earnings per share | $0.10 | $0.05 | — | $0.24 | $0.13 | — |
- Against reported prior-year results, Q2 sales rose 45% and first-half sales rose 48%; against pro forma comparisons, growth was 22% and 19%, respectively. Store additions and comparable-store growth contributed to the increase.
- Gross margin declined 30 basis points year over year in Q2 and 50 basis points in the first half on a reported basis. Management cited commodity inflation in produce and meat and temporary markdowns associated with aligning acquired-store merchandise; lower buying and occupancy costs partly offset the pressure.
- Q2 net income included an $8.2m loss on extinguishment of debt from the April refinancing. Interest expense was $11.4m for Q2 and $21.6m for the first half, up from $8.4m and $15.5m, respectively, in the reported prior-year periods.
Cash flow, balance sheet and debt
- For the first half, operating cash flow was $101.0m, versus $62.1m a year earlier. Investing activities used $51.5m, including $51.7m of property and equipment purchases; financing activities used $51.0m. Cash ended the period at $65.6m, compared with $67.2m at fiscal 2012 year-end.
- At June 30, total assets were $1.144bn, total liabilities $1.015bn and stockholders’ equity $128.4m. Current assets were $202.4m and current liabilities $162.6m.
- Debt at June 30 was $683.4m net of discount, including $680.6m long-term debt and $2.7m current debt; the new term loan had $700m original principal. The company also had $115.5m of long-term capital and financing lease obligations. Its $60m revolving facility had no borrowings; $8m of letters of credit left $52m available. The company reported compliance with applicable credit covenants.
- The April refinancing funded repayment of the former term loan and subordinated notes, a $282.0m distribution to equity holders, $13.9m in payments to vested option holders, and transaction costs. The distribution and option payments totaled $295.9m in first-half cash-flow reporting.
- After quarter-end, the August 2013 IPO raised $344.7m net for the company. Sprouts used $340m to repay term debt; the repayment triggered a further $9m debt-extinguishment loss to be recognized in the subsequent quarter. The filing estimated that the repayment and a 50-basis-point interest-margin reduction would lower annual cash interest by about $17.1m, from approximately $31.5m to $14.4m, using June 30 debt and rate assumptions.
Outlook, commentary and risks
- Management planned 19 store openings in fiscal 2013 and approximately 20 in 2014. It expected fiscal 2013 capital expenditures of $70m–$75m, net of estimated landlord allowances, and said cash, operating cash generation and IPO proceeds were expected to meet anticipated needs for at least 12 months.
- Management’s stated priorities included store expansion, comparable-store sales, margin improvement and brand growth. It expected scale, systems and cost discipline to support margins, while warning that public-company compliance costs and growth-related expenses would rise.
- Material control issue: management concluded disclosure controls were not effective at June 30 because a material weakness in inventory costing remained. The weakness involved controls over applying an appropriate GAAP method for non-perishable inventory; management said remediation was underway but could not estimate its duration.
- Key exposures include intense grocery competition; produce availability, commodity inflation and food-safety risks; concentration of stores and produce sourcing in California and other western states; and reliance on Nature’s Best for approximately 23% of purchases in the first half. The company also cited self-insurance estimation risk, changing regulation and consumer preferences, and reliance on third-party distribution and service providers.
- Debt is floating-rate: at the June 30 principal balance, a 100-basis-point rate increase above the loan’s LIBOR floor would change annual interest expense by about $7m; the filing estimated approximately $3.6m sensitivity after the subsequent $340m repayment. Lease commitments are substantial: the contractual-obligations table reported $696.3m of operating lease payments and $132.7m of capital and financing lease obligations. Ordinary-course legal matters were disclosed; management did not expect them to have a material adverse effect, while noting litigation is unpredictable.
Important facts for investors to verify
- Assess comparable-store growth and margins using the Sunflower pro forma comparison as well as reported results, and confirm the definitions and store eligibility underlying the company’s comparable-sales measure.
- Confirm the effect of the IPO debt repayment on debt balances, interest expense, the subsequent-quarter $9m extinguishment charge and covenant capacity.
- Monitor remediation of the inventory-costing material weakness and any resulting financial-statement adjustments or control disclosures.
- Track store-opening execution, capital spending, cash generation and the ability of new stores to achieve mature-store sales and profitability.
- Evaluate exposure to floating rates, lease commitments, produce and supplier concentration, and the timing and adequacy of self-insurance and other contingencies.