Sprouts Farmers Market, Inc. — Q2 2014 Form 10-Q
Business context and reporting period. The filing covers the 13 weeks ended June 29, 2014, and compares results with the 13 weeks ended June 30, 2013; year-to-date figures cover 26 weeks. Financial statements are unaudited. Sprouts operated 177 stores in 10 states at quarter-end, selling fresh, natural and organic groceries.
Key financial results
| Metric | Q2 2014 | Q2 2013 | 26 weeks 2014 | 26 weeks 2013 |
|---|---|---|---|---|
| Net sales | $743.8m | $622.4m | $1,466.4m | $1,196.1m |
| Comparable-store sales growth | 9.5% | 10.8% | 11.1% | 9.4% |
| Gross profit / margin | $224.0m / 30.1% | $187.0m / 30.1% | $447.9m / 30.5% | $360.9m / 30.2% |
| Operating income | $55.6m | $40.1m | $117.2m | $80.1m |
| Net income | $30.2m | $12.5m | $63.9m | $30.6m |
| Diluted EPS | $0.20 | $0.10 | $0.42 | $0.24 |
Margins and operating drivers. Q2 net margin was 4.1%, versus 2.0% a year earlier; year-to-date it was 4.4%, versus 2.6%. Q2 sales rose 20%, with about half of the increase from stores opened after June 30, 2013 and half from comparable-store growth and prior-year openings not yet in the comp base. Year-to-date sales rose 23%; 60% of the increase came from comparable-store growth and prior-year openings not yet in the comp base, and 40% from newer stores. Q2 gross margin was unchanged: occupancy, utilities and buying-cost leverage offset lower merchandise margins from promotions and higher inflation in some categories. Year-to-date gross margin improved 30 basis points, mainly from occupancy and utilities leverage. Direct-store expenses fell as a share of sales year over year in both periods.
Cash flow and liquidity. For the 26 weeks, operating cash flow was $137.9m, investing cash outflow was $57.7m, and financing cash inflow was $26.4m; cash increased $106.6m to $184.3m. Comparative 2013 amounts were $96.5m, $51.5m outflow and $46.6m outflow, respectively. At June 29, current assets were $340.8m and current liabilities $226.9m. The company said cash on hand and expected operating cash generation should cover anticipated needs for at least 12 months.
Debt and obligations. Term-loan debt was reported at $308.3m net of original issue discount, including $5.8m current; gross principal was $314.8m. The $60m revolving facility had no borrowings, $7.4m of letters of credit and $52.6m available. The company was in compliance with applicable covenants. Capital and financing lease obligations totaled $124.2m on the balance sheet; disclosed future capital, financing and operating lease payments totaled $1,159.9m, including $998.5m of operating leases, before subtenant receipts. Term-loan interest is variable; management estimated a 100-basis-point LIBOR increase above the 1% floor would raise annual interest expense by $3.1m.
Material changes, outlook and risks
- Q2 net income increased 142%; lower interest expense and the absence of the prior-year $8.2m debt-extinguishment loss contributed alongside sales growth and operating leverage. Interest expense fell to $6.5m from $11.4m. For the first half, interest expense fell to $13.0m from $21.6m.
- Management planned 24 store openings for fiscal 2014; 15 had opened as of the report date. It stated an intention to achieve 14% annual new-store growth for at least five years. Expected fiscal 2014 capital expenditures were $110m–$120m, net of estimated landlord allowances. Management expected an additional $50m term-loan principal payment in the quarter ending September 28, 2014.
- Management cited store expansion, comparable-store growth, margin enhancement, cost discipline and brand development as growth priorities. Sales are seasonally stronger in the first half; produce represented 26% of first-half sales. Food-price inflation or deflation, competition, customer trends and execution of new-store expansion may affect results.
- Control weakness: Management concluded disclosure controls were not effective at June 29, 2014 because of a material weakness in costing non-perishable inventory. The company was implementing and testing an automated per-unit costing system to replace statistical sampling.
- Self-insurance claims involve estimation uncertainty; ordinary-course litigation is described as inherently unpredictable, though management did not expect current proceedings to materially affect results. A $4.8m liability-insurance collateral deposit was made after quarter-end.
- Q2 store-closure and exit costs included a $0.2m net credit, primarily from a former-warehouse liability write-off, partly offset by ongoing closure costs. The company also recorded a $0.9m write-off of prepaid software-system costs in Q2 SG&A. No company shares were sold in the April 2014 secondary offering; it generated no proceeds for Sprouts.
Most important facts for investors to verify
- Whether the inventory-costing system remediates the disclosed material weakness, and whether management later reports effective controls.
- Comparable-store sales trends, gross-margin drivers and the extent to which growth and operating leverage persist as store expansion continues.
- Execution of the 2014 store-opening and capital-expenditure plans, and the planned $50m term-loan payment.
- Variable-rate debt exposure, lease commitments and the availability of the revolving facility after letters of credit and other requirements.
- Potential changes in self-insurance reserves, litigation exposure and sublease assumptions for closed properties.