Sprouts Farmers Market, Inc. — Q3 2017 Form 10-Q
Business and period. Sprouts operates healthy grocery stores. This unaudited report covers the 13 and 39 weeks ended October 1, 2017; comparisons are with the periods ended October 2, 2016. The company had 282 stores in 15 states at quarter-end and 285 as of November 1, 2017.
Financial performance
| Metric | 13 weeks ended Oct. 1, 2017 | Change vs. prior year | 39 weeks ended Oct. 1, 2017 | Change vs. prior year |
|---|---|---|---|---|
| Net sales | $1,206.1 million | +16% | $3,520.7 million | +15% |
| Comparable-store sales growth | 4.6% | 1.3% prior year | 2.4% | 3.4% prior year |
| Gross margin | 28.7% | 28.1% prior year | 29.1% | 29.5% prior year |
| Operating income | $53.0 million | $41.4 million prior year | $189.0 million | $182.7 million prior year |
| Net income | $31.5 million | +32% | $118.7 million | +11% |
| Diluted EPS | $0.23 | $0.16 prior year | $0.86 | $0.71 prior year |
| Net margin | 2.6% | 2.3% prior year | 3.4% | 3.5% prior year |
Drivers and costs. Quarterly gross margin improved, which management attributed mainly to cycling the prior-year promotional environment and leverage from comparable sales. Year-to-date gross margin declined amid competition, particularly in the first half, and higher occupancy costs. Year-to-date direct store expenses rose 16%, faster than sales, reflecting payroll and benefit costs and fixed-cost deleverage. Interest expense rose 41% year to date, mainly due to higher borrowings used to support repurchases. The year-to-date effective tax rate fell to 31.7% from 37.7%, primarily reflecting tax benefits from equity awards; these benefits contributed to reported earnings.
Cash, liquidity, debt, and capital allocation
- Cash was $18.9 million at October 1, 2017, versus $12.5 million at January 1, 2017. Current assets were $289.9 million and current liabilities $290.2 million.
- For the 39 weeks, operating cash flow was $259.0 million, investing cash outflow $158.4 million, and financing cash outflow $94.1 million. Property and equipment purchases were $158.5 million.
- Long-term debt was $349.0 million, up from $255.0 million at January 1, 2017, under a $450 million variable-rate revolving credit facility maturing in April 2020. Letters of credit totaled $24.8 million. The company reported covenant compliance; the facility requires maximum total net leverage of 3.00x and minimum interest coverage of 1.75x.
- Capital and financing lease obligations were $142.2 million; operating lease payments totaled $1.590 billion, undiscounted, across future periods. These commitments are significant relative to reported debt.
- The company repurchased 9.14 million shares for $192.0 million year to date, using credit-facility borrowings in part. $138.0 million remained under the February 2017 authorization at quarter-end. Repurchases reduced weighted-average shares and supported EPS growth.
Outlook, risks, and unusual items
- Management planned 32 store openings in 2017; all 32 had opened by November 1. It expected approximately 30 openings annually in the near term and cited store expansion, positive comparable sales, and brand development as growth strategies. No specific earnings or comparable-sales guidance was provided.
- Fiscal 2017 capital expenditures were expected to be approximately $170 million, net of estimated landlord allowances. Management said cash, operating cash generation, and, if needed, facility borrowings should cover anticipated needs for at least 12 months.
- Fourteen stores in Texas, Florida, and Georgia were affected by Hurricanes Harvey and Irma. Physical damage was minimal; estimated costs were $1.0 million before an estimated $0.3 million insurance recovery. Management reported about $0.7 million of net costs in the quarter and did not expect further insurance recoveries to be material.
- Risks include competition and food-price inflation or deflation, which may affect sales and margins; self-insurance estimates and ordinary-course claims; and variable-rate debt exposure. A 100-basis-point LIBOR change would affect annual interest expense by about $3.5 million, based on the period-end balance.
- A securities class action concerning alleged disclosure of produce-price deflation in the 2015 secondary offering remained pending; the company said outcome and potential liability could not be reasonably estimated. Separate phishing-related privacy actions were stayed pending a U.S. Supreme Court decision on arbitration enforceability; outcome and potential liability were also not estimable.
- The company expected lease-accounting adoption in fiscal 2019 to materially increase reported assets and liabilities. Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether the stronger Q3 comparable sales and gross margin can persist, given year-to-date comparable-sales deceleration and competitive pressure on margins.
- How much earnings growth depends on equity-award tax benefits and share-count reduction from debt-supported buybacks.
- Debt capacity, interest-rate sensitivity, covenant headroom, and the cash demands of substantial lease commitments and planned store investment.
- Actual 2017 capital spending and store-opening performance versus management’s stated plans.
- Developments in the securities and phishing-related litigation, including any change in potential exposure or insurance recovery.