Sprouts Farmers Market, Inc. — Q2 2019 Form 10-Q
Business context and reporting period. Sprouts operates healthy grocery stores focused on fresh, natural and organic products. The quarter ended June 30, 2019 (13 weeks); year-to-date figures cover the 26 weeks ended June 30, 2019. Comparatives are the corresponding periods ended July 1, 2018. Sprouts had 326 stores in 21 states at quarter-end and 331 stores as of July 29, 2019.
Financial performance
| Metric | Q2 2019 | Q2 2018 | 26 weeks 2019 | 26 weeks 2018 |
|---|---|---|---|---|
| Net sales | $1,415.7 million | $1,321.7 million | $2,829.6 million | $2,608.9 million |
| Comparable-store sales growth | 0.1% | 2.0% | 0.8% | 2.3% |
| Gross margin | 32.8% | 33.2% | 33.5% | 33.9% |
| Operating income | $51.3 million | $61.7 million | $130.9 million | $141.4 million |
| Net income | $35.3 million | $41.7 million | $91.7 million | $108.3 million |
| Diluted EPS | $0.30 | $0.32 | $0.76 | $0.82 |
- Q2 sales rose 7%, primarily from stores opened in the prior 12 months; comparable-store growth was only 0.1%. Year-to-date sales rose 8%, also led by new stores.
- Q2 gross profit increased 6%, slower than sales growth, as gross margin contracted 0.4 percentage points. Management cited product-cost inflation not fully passed through in pricing and higher distribution and transportation costs. Year-to-date margin was also down 0.4 points, with promotional activity an additional factor.
- Q2 SG&A rose 9% and was 27.1% of sales, up 0.6 points. Year-to-date SG&A rose 10% and was 26.8% of sales, up 0.4 points. Drivers included new stores, lease-related occupancy costs, credit-card interchange, home delivery expansion, and—year to date—wage, benefit and training investments.
- Q2 net income fell 15%; year-to-date net income fell 15%. Lower operating income weighed on results; year-to-date results also reflected a higher effective tax rate (23.8% versus 16.1%), as the prior-year period benefited from tax benefits on exercises of expiring pre-IPO options. Q2 effective tax rate was 23.0%, versus 24.5%.
- Q2 diluted EPS declined 6%, less than the net-income decline, partly because repurchases reduced diluted weighted-average shares. Year-to-date diluted EPS declined 7%.
Cash flow, liquidity and debt
- For the first 26 weeks, operating cash flow was $249.2 million, versus $171.1 million; management attributed the increase primarily to working capital, including elevated accounts payable and accrual balances. Capital expenditures were $93.4 million, versus $103.9 million. Operating cash flow less capital expenditures, calculated from reported figures, was $155.8 million, versus $67.2 million.
- Cash, cash equivalents and restricted cash totaled $60.2 million at June 30, 2019; balance-sheet cash and cash equivalents were $58.6 million. The company stated existing cash and expected operating cash generation should cover anticipated needs for at least 12 months.
- Revolver borrowings were $515.0 million, up $62.0 million from December 30, 2018, primarily to fund repurchases. The $700 million facility matures March 27, 2023; $26.9 million of letters of credit reduce available capacity. The company reported compliance with its financial covenants at quarter-end.
- Operating and finance lease liabilities totaled $1,166.7 million. Adoption of ASC 842 brought substantial lease assets and liabilities onto the balance sheet; management said adoption did not affect liquidity or cash flows. Lease-related occupancy costs contributed to higher SG&A.
- Financing cash use was $97.8 million, including $163.3 million of stock repurchases, partly offset by $62.0 million of net credit-facility borrowings. The board authorization had $55.0 million remaining at quarter-end.
Outlook, commentary and risks
- Management expects approximately 30 new stores annually in the near term; 18 had opened through July 29, 2019. Fiscal 2019 capital expenditures were expected to be $170–$175 million, net of estimated landlord tenant-improvement allowances. Management aims to continue positive comparable-store growth but did not provide a specific numerical full-year sales or earnings forecast in the filing text.
- Management identified food-cost inflation or deflation, competitive pricing and promotions, distribution and transportation costs, and consumer spending as factors that can pressure sales and margins. It also cited higher costs associated with expanding home delivery.
- Interest-rate exposure: each 100-basis-point change in LIBOR was estimated to change annual interest expense by $5.2 million before swaps and $2.7 million after swaps, based on quarter-end debt. Swaps covered $250 million of debt notional.
- A securities class action settlement was court-approved and dismissed; D&O insurance funded it, with no material financial-statement impact. Phishing-related class litigation and individual arbitrations remained unresolved, and potential liability could not be reasonably estimated. A Proposition 65 coffee-labeling case remained contingent on court rulings; the company recorded no loss contingency and could not estimate a potential loss.
- A planned store closure and relocation generated $1.3 million of costs year to date. Subsequent to quarter-end, the President and COO agreed to transition to Senior Advisor through March 31, 2020; the company expected about $2.0 million of compensation expense in Q3 2019.
- The company completed implementation of a new ERP system on April 29, 2019 and incorporated related processes and controls. Management concluded disclosure controls were effective as of June 30, 2019. No material changes to the previously disclosed risk factors were reported.
Most important facts for investors to verify
- Whether weak comparable-store growth (0.1% in Q2) and gross-margin pressure persist, and whether pricing can keep pace with product-cost inflation.
- How lease-accounting occupancy expense and delivery, labor and interchange costs affect operating margins and cash generation.
- Whether continued buybacks—partly funded by borrowing—are sustainable alongside planned store investment; monitor debt, covenant headroom and interest-rate exposure.
- Execution of the roughly 30-store annual expansion plan and the $170–$175 million fiscal 2019 capital-expenditure outlook.
- Developments in the unresolved phishing and Proposition 65 cases, including any change to the company’s inability to estimate potential exposure.