Sprouts Farmers Market, Inc. — Q3 2015 Form 10-Q
Business context and period: The filing covers the 13 weeks ended September 27, 2015, and year-to-date results for the 39 weeks then ended; comparisons are with the corresponding 2014 periods. Sprouts operates specialty grocery stores focused on fresh, natural and organic products. It had 216 stores in 13 states at quarter-end. Fiscal 2015 is a 53-week year, with a 14-week fourth quarter.
Financial performance
| Metric | Q3 2015 | Q3 2014 | 39 weeks 2015 | 39 weeks 2014 |
|---|---|---|---|---|
| Net sales | $903.1 million | $766.4 million | $2,662.7 million | $2,232.8 million |
| Gross profit / margin | $261.5 million / 29.0% | $226.0 million / 29.5% | $782.9 million / 29.4% | $674.0 million / 30.2% |
| Operating income | $54.4 million | $49.7 million | $181.0 million | $166.9 million |
| Net income | $32.0 million | $26.1 million | $100.8 million | $89.9 million |
| Diluted EPS | $0.21 | $0.17 | $0.65 | $0.58 |
| Comparable-store sales growth | 5.8% | 9.0% | 5.2% | 10.4% |
Cash flow and liquidity: For the 39 weeks, operating cash flow was $179.1 million, investing cash outflow was $97.3 million, and financing cash outflow was $80.3 million. Cash ended at $132.0 million, versus $118.4 million a year earlier. Management said cash on hand and expected operating cash generation should cover anticipated needs for at least 12 months. Fiscal 2015 capital expenditures were expected to be approximately $105 million, net of estimated landlord allowances.
Debt and balance sheet: Long-term debt was $160.0 million at September 27, 2015, down from $256.4 million at December 28, 2014; cash exceeded reported debt by $28.0 million. The April 2015 refinancing established a $450 million revolving credit facility maturing in April 2020. The company had drawn $160 million and issued $2.5 million in letters of credit. It reported compliance with the facility’s financial covenants. Capital and financing lease obligations were $131.3 million on the balance sheet; disclosed future operating lease payments totaled $1,274.7 million.
Material changes and management commentary
- Q3 sales rose 18%; 57% of the increase came from stores opened after the prior-year quarter, with the balance attributed to comparable-store growth and fiscal 2014 openings not yet included in comps. Year-to-date sales rose 19%, with 39% of the increase from newer stores. Comparable-store growth slowed materially versus 2014.
- Gross margin declined 0.5 percentage point in Q3 and 0.8 point year to date. Management attributed the decline primarily to continued price investments in certain categories. Store expenses rose as a share of sales, reflecting higher depreciation, training and labor costs at new stores.
- Net income increased 23% in Q3 and 12% year to date. Lower interest expense supported earnings; year-to-date results also included a $5.5 million debt-extinguishment loss from the refinancing.
- Sprouts planned 27 store openings in fiscal 2015, of which 26 had opened as of the filing date, and stated an aim to achieve 14% annual new-store growth for at least five years. It also cited comparable-store growth, product offerings, targeted marketing and brand development as growth priorities. No specific earnings or comparable-sales forecast was provided.
Risks, contingencies and unusual items
- The company changed store inventory counts to a rotational basis and recorded a $3.8 million estimated shrink reserve at quarter-end. Inventory shrink estimation is a key judgment area.
- Variable-rate debt exposes the company to interest-rate risk: management estimated that a 100-basis-point LIBOR change would affect annual interest expense by $1.6 million, based on quarter-end debt outstanding.
- Self-insurance claims are the company’s primary contingencies and depend on estimates; ordinary-course litigation was also disclosed. Management did not expect current proceedings to materially affect results, while noting litigation is unpredictable. The filing reported no material changes to previously disclosed risk factors.
- Related-party matters include purchases from suppliers connected to directors. After quarter-end, the company agreed to buy an airplane from an entity controlled by a director for $7.5 million, subject to inspection; the filing said the price was below a third-party appraisal’s estimated market value.
- After quarter-end, the board adopted an executive severance and change-in-control plan. The company also recognized $0.8 million of gift-card breakage year to date after determining it could estimate redemption patterns.
Important facts for investors to verify
- Whether comparable-store sales and gross-margin trends stabilize, and how price investments affect profitability.
- Store-opening execution, returns on new stores, and progress toward the stated expansion pace and capital-spending plan.
- Debt repayment, variable-rate exposure, covenant headroom, and the cash demands of substantial lease commitments.
- The assumptions behind inventory shrink, self-insurance reserves and gift-card breakage recognition.
- Terms, approval and completion of the $7.5 million related-party airplane purchase, along with ongoing director-linked supplier relationships.