Sprouts Farmers Market, Inc.: Form 10-Q for the period ended Oct 2, 2022

You should read the following discussion of our financial condition and results of operations together with the consolidated financial statements and related notes that are included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Annual Report on Form 10-K for the 2021 fiscal year, filed on February 24, 2022 (“Form 10-K”) with the Securities and Exchange Commission. All dollar amounts included below are in thousands, unless otherwise noted.

Business Overview

Sprouts Farmers Market offers a unique grocery experience featuring an open layout with fresh produce at the heart of the store. Sprouts inspires wellness naturally with a carefully curated assortment of better-for-you products paired with purpose-driven people. We continue to bring the latest in wholesome, innovative products made with lifestyle-friendly ingredients such as organic, plant-based and gluten-free. Headquartered in Phoenix with 379 stores in 23 states as of October 2, 2022, we are one of the largest and fastest growing specialty retailers of fresh, natural and organic food in the United States.

Our Heritage

In 2002, we opened the first Sprouts Farmers Market store in Chandler, Arizona. From our founding in 2002, we have grown rapidly, significantly increasing our sales, store count and profitability, including successfully rebranding 43 Henry’s Farmers Market and 39 Sunflower Farmers Market stores added in 2011 and 2012, respectively, through acquisitions to the Sprouts banner. These three businesses all trace their lineage back to Henry’s Farmers Market and were built with similar store formats and operations including a strong emphasis on value, produce and service in smaller, convenient locations.

Outlook

In 2020, we announced our new long-term growth strategy that we believe will transform our company and drive profitable growth. We are executing on this strategy, focusing on the following areas:

• Win with Target Customers. We are focusing attention on our target customers, identified through research as 'health enthusiasts' and 'experience seekers', where there is ample opportunity to gain share within these customer segments. We believe our business can continue to grow by leveraging existing strengths in a unique assortment of better-for-you, quality products and by providing a full omnichannel offering through delivery or pickup via our website or the Sprouts app.
• Update Format and Expand in Select Markets. We are beginning to deliver unique smaller stores with expectations of stronger returns, while maintaining the approachable, fresh-focused farmer’s market heritage Sprouts is known for. In 2021, we opened three stores and remodeled one store featuring our new format, and in the thirty-nine weeks ended October 2, 2022, we opened two new format stores. Our geographic store expansion and new store placement will intersect where our target customers live, in markets with growth potential and supply chain support, which we believe will provide a long runway of approximately 10% annual unit growth beginning in 2024.
• Create an Advantaged Fresh Supply Chain. We believe our network of fresh distribution centers can drive efficiencies across the chain and support growth plans. To further deliver on our fresh commitment and reputation, as well as to improve financial results, we aspire to ultimately position fresh distribution centers within a 250-mile radius of stores. With the opening of two fresh distribution centers in 2021, we now have more than 85% of our stores within 250 miles of a distribution center.
• Refine Brand and Marketing Approach. We believe we are elevating our national brand recognition and positioning by telling our unique brand story rooted in product innovation and differentiation. We are investing savings from removing our print ad into increasing customer engagement through digital and social connections, driving additional sales growth and loyalty.
• Deliver on Financial Targets and Box Economics. We are measuring and reporting on the success of this strategy against a number of long-term financial and operational targets. With the implementation of our strategy, we have significantly improved our margin structure above our 2019 baseline.

Recent Developments

Our operations have generally stabilized since the onset of the COVID-19 pandemic. However, we continue to experience varying levels of inflation through increased product costs which we continue to pass through to retail pricing. In addition, due to continued difficulties in obtaining necessary equipment from third parties and inflationary pressures due to supply chain delays complicated by the COVID-19 pandemic, we have experienced and may continue to experience increased costs and delays in our planned new store openings. See “Risk Factors—The coronavirus (COVID-19) pandemic has disrupted our business and could negatively impact our financial condition.” in our Form 10-K for additional information.

Results of Operations for Thirteen Weeks Ended October 2, 2022 and October 3, 2021

The following tables set forth our unaudited results of operations and other operating data for the periods presented. The period-to-period comparison of financial results is not necessarily indicative of financial results to be achieved in future periods. All dollar amounts are in thousands, unless otherwise noted.

Unaudited Quarterly Consolidated Statement of Income Data:

Comparison of Thirteen Weeks Ended October 2, 2022 to Thirteen Weeks Ended

October 3, 2021

Net sales

Net sales during the thirteen weeks ended October 2, 2022 totaled $1.6 billion, an increase of $81.4 million, or 5%, compared to the thirteen weeks ended October 3, 2021. The sales increase was driven by sales from new stores opened in the last twelve months and a 2.4% increase in comparable store sales. The increase in comparable store sales was due in part to an increase in basket value due to retail price inflation, partially offset by a slight reduction in the number of items per basket. Comparable stores contributed approximately 97% of total sales for each of the thirteen weeks ended October 2, 2022 and October 3, 2021.

Cost of sales and gross profit

Gross profit totaled $583.7 million during the thirteen weeks ended October 2, 2022, an increase of $43.9 million, or 8%, compared to the thirteen weeks ended October 3, 2021, driven by increased sales volume. Gross margin increased by 0.9% to 36.7% for the thirteen weeks ended October 2, 2022, compared to 35.8% for the thirteen weeks ended October 3, 2021, primarily as a result of offering fewer promotions in the current year.

Selling, general and administrative expenses

Selling, general and administrative expenses increased $37.4 million, or 9%, compared to the thirteen weeks ended October 3, 2021.The increase is primarily due to new stores opened since the comparable period in the prior year, higher wages and higher marketing spend in the current year, as well as higher credit card and ecommerce fees.

Depreciation and amortization

Depreciation and amortization expense (exclusive of depreciation included in cost of sales) was $30.3 million for the thirteen weeks ended October 2, 2022, compared to $30.4 million for the thirteen weeks ended October 3, 2021. Depreciation and amortization primarily consists of depreciation and amortization for buildings, store leasehold improvements, and equipment.

Store closure and other costs, net

Store closure and other costs, net increased $2.0 million to $2.2 million for the thirteen weeks ended October 2, 2022 compared to $0.1 million for the thirteen weeks ended October 3, 2021. The increase in store closure and other costs, net was driven by inventory loss and other expenses incurred by several of our stores impacted by Hurricane Ian in the current quarter.

Interest expense, net

Interest expense, net decreased to $2.0 million for the thirteen weeks ended October 2, 2022, compared to $2.9 million for the thirteen weeks ended October 3, 2021 primarily due to higher interest income and lower credit facility fees. See Note 4, “Long-Term Debt and Finance Lease Liabilities” of our unaudited consolidated financial statements.

Income tax provision

Income tax provision differed from the amounts computed by applying the U.S. federal income tax rate to pretax income as a result of the following:

The effective tax rate increased to 25.6% for the thirteen weeks ended October 2, 2022 from 23.0% for the thirteen weeks ended October 3, 2021. The increase in the effective tax rate was primarily due to an increase of non-deductible executive compensation as well as a decrease in enhanced charitable contributions due to the expiration of CARES Act benefits.

Net income

Net income increased $1.9 million primarily due to increased sales and gross profit, partially offset by higher selling, general and administrative expenses and a higher effective tax rate for the reasons discussed above.

Diluted earnings per share

The increase in diluted earnings per share of $0.05 was driven by higher net income in addition to fewer diluted shares outstanding compared to the prior year, due primarily to the share repurchase program.

Results of Operations for Thirty-nine Weeks Ended October 2, 2022 and October 3, 2021

The following tables set forth our unaudited results of operations and other operating data for the periods presented. The period-to-period comparison of financial results is not necessarily indicative of financial results to be achieved in future periods. All dollar amounts are in thousands, unless otherwise noted.

Comparison of Thirty-nine Weeks Ended October 2, 2022 to Thirty-nine Weeks Ended

October 3, 2021

Unaudited Quarterly Consolidated Statement of Income Data:

29

Net Sales

Net sales during the thirty-nine weeks ended October 2, 2022 totaled $4.8 billion, an increase of $220.6 million, or 5%, over the same period of the prior fiscal year. The sales increase was primarily due to a 2.0% increase in comparable store sales, driven primarily by an increase in basket due to retail inflation partially offset by a slight reduction of items in the basket, as well as sales from new stores opened in the last twelve months. Comparable stores contributed approximately 97% of total sales for the thirty-nine weeks ended October 2, 2022 and approximately 96% for the thirty-nine weeks ended October 3, 2021.

Cost of sales and gross profit

Gross profit totaled $1.8 billion during the thirty-nine weeks ended October 2, 2022, an increase of $99.8 million, or 6%, compared to the thirty-nine weeks ended October 3, 2021 driven by increased sales volume. Gross margin increased to 36.8% for the thirty-nine weeks ended October 2, 2022, compared to 36.4% for the thirty-nine weeks ended October 3, 2021, due to improved shrink and offering fewer promotions in the current year.

Selling, general and administrative expenses

Selling, general and administrative expenses increased $83.4 million, or 6%, compared to the thirty-nine weeks ended October 3, 2021.The increase was primarily driven by the net increase in new stores opened since the prior year period as well as inflationary conditions driving increases in costs including wages, utilities and supplies. In addition, we have seen higher credit card fees as more consumers shift to credit compared to the prior year and ecommerce costs resulting from an increase in ecommerce sales compared to the prior year.

Depreciation and amortization

Depreciation and amortization expense (exclusive of depreciation included in cost of sales) was $93.4 million for the thirty-nine weeks ended October 2, 2022, compared to $92.0 million for the thirty-nine weeks ended October 3, 2021.Depreciation and amortization expenses (exclusive of depreciation included in cost of sales) primarily consists of depreciation and amortization for buildings, store leasehold improvements, and equipment.

Store closure and other costs, net

Store closure and other costs, net increased $1.3 million to $3.0 million, compared to $1.8 million for the thirty-nine weeks ended October 3, 2021. Store closure and other costs, net during the thirty-nine weeks ended October 2, 2022 primarily related to inventory loss and expenses incurred by several of our stores impacted by Hurricane Ian in addition to costs associated with the closing of four stores year-to-date. Store closure and other costs, net during the thirty-nine weeks ended October 3, 2021 was driven by inventory loss and additional expenses, net of insurance recovery, related to the impact of winter storms at several of our stores and a fire at one of our stores during the thirty-nine weeks ended October 3, 2021.

Interest expense, net

Interest expense, net decreased to $7.6 million for the thirty-nine weeks ended October 2, 2022, compared to $8.8 million for the thirty-nine weeks ended October 3, 2021 primarily due to higher interest income and lower credit facility fees. See Note 4, “Long-Term Debt and Finance Lease Liabilities” of our unaudited consolidated financial statements.

Income tax provision

Income tax provision differed from the amounts computed by applying the U.S. federal income tax rate to pretax income as a result of the following:

The effective tax rate increased to 25.2% for the thirty-nine weeks ended October 2, 2022 from 24.1% in the same period last year. The increase in the effective tax rate is primarily due to an increase of non-deductible executive compensation as well as a decrease in enhanced charitable contributions due to the expiration of CARES Act benefits, partially offset by an increase in benefit from share-based payment awards in the current year.

Net income

Net income increased $8.1 million primarily due to increased sales and gross profit, partially offset by higher selling, general and administrative expenses and a higher effective tax rate for the reasons discussed above.

Diluted earnings per share

The increase in diluted earnings per share of $0.20 was driven by higher net income in addition to fewer diluted shares outstanding compared to the prior year, due primarily to the share repurchase program.

Return on Invested Capital

In addition to reporting financial results in accordance with generally accepted accounting principles, or GAAP, we provide information regarding Return on Invested Capital (referred to as “ROIC”) as additional information about our operating results. ROIC is a non-GAAP financial measure and should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. ROIC is an important measure used by management to evaluate our investment returns on capital and provides a meaningful measure of the effectiveness of our capital allocation over time.

We define ROIC as net operating profit after tax (referred to as “NOPAT”), including the effect of capitalized operating leases, divided by average invested capital. Operating lease interest represents the add-back to operating income driven by the hypothetical interest expense we would incur if the property under our operating leases were owned or accounted for as a finance lease (capital lease prior to adoption of ASC 842). The assumed ownership and associated interest expense are calculated using the discount rate for each lease as recorded as a component of rent expense within selling, general and administrative expenses. Invested capital reflects a trailing twelve-month average.

As numerous methods exist for calculating ROIC, our method may differ from methods used by other companies to calculate their ROIC. It is important to understand the methods and the differences in those methods used by other companies to calculate their ROIC before comparing our ROIC to that of other companies.

Our calculation of ROIC for the fiscal periods indicated was as follows:

(dollars in thousands)

33

(1) Fiscal 2020 included 53 weeks.

(2) Net income amounts represent total net income for the past four trailing quarters.

(3) Special items include professional fees related to strategic initiatives.

(4) Net of tax amounts are calculated using the normalized effective tax rate for the periods presented.

(5) 2022 and 2021 estimated interest on operating leases is calculated by multiplying operating leases by the 6.7% and 7.2% discount rate, respectively, for each lease recorded as rent expense within direct store expense.

(6) Average operating leases represents the average net present value of outstanding lease obligations over the past four trailing quarters.

Liquidity and Capital Resources

The following table sets forth the major sources and uses of cash for each of the periods set forth below, as well as our cash, cash equivalents and restricted cash at the end of each period (in thousands):

We have generally financed our operations principally through cash generated from operations and borrowings under our credit facilities. Our primary uses of cash are for purchases of inventory, operating expenses, capital expenditures primarily for opening new stores, remodels and maintenance, repurchases of our common stock and debt service. Our principal contractual obligations and commitments consist of obligations under our Credit Agreement, interest on our Credit Agreement, operating and finance leases, purchase commitments and self-insurance liabilities. Our operating and finance leases for the rental of land, buildings, and for rental of facilities and equipment expire or become subject to renewal clauses at various dates through 2045. We believe that our existing cash, cash equivalents and restricted cash, and cash anticipated to be generated from operations will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors, including new store openings, remodel and maintenance capital expenditures at existing stores, store initiatives and other corporate capital expenditures and activities. Our cash, cash equivalents and restricted cash position benefits from the fact that we generally collect cash from sales to customers the same day or, in the case of credit or debit card transactions, within days from the related sale.

Operating Activities

Cash flows from operating activities increased $10.1 million to $306.8 million for the thirty-nine weeks ended October 2, 2022 compared to $296.7 million for the thirty-nine weeks ended October 3, 2021. The increase in cash flows from operating activities was primarily a result of cash generated from higher net income and changes in working capital.

Cash flows used in operating activities from changes in working capital were $6.9 million in the thirty-nine weeks ended October 2, 2022 compared to $9.9 million in the thirty-nine weeks ended October 3, 2021. The decrease was primarily driven by the higher payout of COVID related incentive compensation amounts earned in 2020 and paid in 2021, partially offset by higher inventories impacted by inflationary cost increases on our purchases in the current year.

Investing Activities

Cash flows used in investing activities consist primarily of capital expenditures in new stores, including leasehold improvements and store equipment, capital expenditures to maintain the appearance of our stores, sales enhancing initiatives and other corporate investments. Cash flows used in investing activities were $80.7 million and $70.0 million, for the thirty-nine weeks ended October 2, 2022 and October 3, 2021, respectively.

We expect capital expenditures to be in the range of $120 - $135 million in 2022, including expenditures incurred to date, net of estimated landlord tenant improvement allowances, primarily to fund investments in new stores, remodels, maintenance capital expenditures and corporate capital expenditures. We expect to fund our capital expenditures with cash on hand and cash generated from operating activities.

Financing Activities

Cash flows used in financing activities were $155.0 million for the thirty-nine weeks ended October 2, 2022 compared to $136.1 million for the thirty-nine weeks ended October 3, 2021. During the thirty-nine weeks ended October 2, 2022, cash flows used in financing activities primarily consisted of $155.1 million for stock repurchases and $3.4 million in debt issuance costs in connection with our Credit Agreement, partially offset by $4.1 million in proceeds from the exercise of stock options.

During the thirty-nine weeks ended October 3, 2021, cash flows used in financing activities primarily consisted of $137.5 million for stock repurchases.

Long-Term Debt and Credit Facilities

Long-term debt outstanding was $250.0 million as of October 2, 2022 and January 2, 2022.

See Note 4, “Long-Term Debt and Finance Lease Liabilities” of our unaudited consolidated financial statements for a description of our new Credit Agreement and our Former Credit Facility (each as defined therein).

Share Repurchase Program

Our board of directors from time to time authorizes share repurchase programs for our common stock. The following table outlines the share repurchase programs authorized by our board, and the related repurchase activity and available authorization as of October 2, 2022.

The shares under our current repurchase program may be purchased on a discretionary basis from time to time through the applicable expiration date, subject to general business and market conditions and other investment opportunities, through open market purchases, privately negotiated transactions, or other means, including through Rule 10b5-1 trading plans. Our board’s authorization of the share repurchase program does not obligate our Company to acquire any particular amount of common stock, and the repurchase program may be commenced, suspended, or discontinued at any time.

Share repurchase activity under our repurchase program for the periods indicated was as follows (total cost in thousands):

Shares purchased under our repurchase programs were subsequently retired and the excess of the repurchase price over par value was charged to retained earnings.

Subsequent to October 2, 2022 and through November 4, 2022, we repurchased an additional 0.6 million shares of common stock for $17.8 million.

Contractual Obligations

Our principal contractual obligations and commitments arising in the normal course of business consist of obligations under our Credit Agreement, interest on our Credit Agreement, operating and finance leases, purchase commitments and self-insurance liabilities. Except as otherwise disclosed in Note 4, “Long-Term Debt and Finance Lease Liabilities” of our unaudited consolidated financial statements, there have been no material changes outside the normal course of business as of October 2, 2022 in our contractual obligations and commitments from those reported in our Annual Report on Form 10-K for the fiscal year ended January 2, 2022.

The future amount and timing of interest payments are expected to vary with the outstanding amounts and then prevailing contractual interest rates, net of interest rate swaps. Interest payments through the March 25, 2027 maturity date of our Credit Agreement based on the outstanding amounts as of October 2, 2022 and interest rates in effect at the time of this filing, are estimated to be approximately $52.7 million, with $12.5 million payable within 12 months.

Impact of Inflation and Deflation

Inflation and deflation in the prices of food and other products we sell may periodically affect our sales, gross profit and gross margin. Food inflation, when combined with reduced consumer spending, could also reduce sales, gross profit margins and comparable store sales. Inflationary pressures on compensation, utilities, commodities, equipment and supplies may also impact our profitability. Food deflation across multiple categories, particularly in produce, could reduce sales growth and earnings if our competitors react by lowering their retail pricing and expanding their promotional activities, which can lead to retail deflation higher than cost deflation that could reduce our sales, gross profit margins and comparable store sales. The short-term impact of inflation and deflation is largely dependent on whether or not the effects are passed through to our customers, which is subject to competitive market conditions.

Food inflation and deflation is affected by a variety of factors and our determination of whether to pass on the effects of inflation or deflation to our customers is made in conjunction with our overall pricing and marketing strategies, as well as our competitors’ responses. Although we may experience periodic effects on sales, gross profit, gross margins and cash flows as a result of changing prices, including pressures we are currently experiencing due to product cost inflation which we are largely passing along to retail pricing, we do not expect the effect of inflation or deflation to have a material impact on our ability to execute our long-term business strategy.

Critical Accounting Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales and expenses, cash flow and related disclosure of contingent assets and liabilities. Our critical accounting estimates include inventories, lease assumptions, self-insurance reserves, goodwill and intangible assets, impairment of long-lived assets, and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

There have been no substantial changes to these estimates, or the policies related to them during the thirteen and thirty-nine weeks ended October 2, 2022. For a full discussion of these estimates and policies, see “Critical Accounting Estimates” in Item 7 of our Annual Report on Form 10-K for the fiscal year ended January 2, 2022.

Recently Issued Accounting Pronouncements

See Note 2, “Summary of Significant Accounting Policies” to our accompanying unaudited consolidated financial statements contained in this Quarterly Report on Form 10-Q.

As described in Note 4, “Long-Term Debt and Finance Lease Liabilities” to our unaudited consolidated financial statements located elsewhere in this Quarterly Report on Form 10-Q, our Credit Agreement bears interest at a rate based in part on SOFR. Accordingly, we could be exposed to fluctuations in interest rates. Based solely on the $250.0 million principal outstanding under our Credit Agreement as of October 2, 2022, each hundred basis point change in SOFR would result in a change in interest expense by $2.5 million annually. We entered into an interest rate swap agreement in December 2017 to manage our cash flow associated with variable interest rates. The notional dollar amount of the one outstanding swap at October 2, 2022 and January 2, 2022 was $250.0 million under which we pay a fixed rate and received a variable rate of interest (cash flow swap). Taking into account the interest rate swap, based on the $250.0 million principal outstanding under our Credit Agreement as of October 2, 2022, each hundred basis point change in SOFR would result in no change in interest expense annually.

This sensitivity analysis assumes our mix of financial instruments and all other variables will remain constant in future periods. These assumptions are made in order to facilitate the analysis and are not necessarily indicative of our future intentions.

We do not enter into derivative financial instruments for trading purposes (see Note 10, “Derivative Financial Instruments” of our unaudited consolidated financial statements).

Evaluation of Disclosure Controls and Procedures

We maintain a system of disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) designed to ensure that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and is accumulated and communicated to our management, including our Chief Executive Officer (our principal executive officer) and Chief Financial Officer (our principal financial officer), as appropriate, to allow timely decisions regarding required disclosure.

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures under the Exchange Act as of October 2, 2022, the end of the period covered by this Quarterly Report on Form 10-Q. Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting

During the quarterly period ended October 2, 2022, there were no changes in our internal controls over financial reporting that materially affected, or were reasonably likely to materially affect, our internal control over financial reporting.

Certain factors may have a material adverse effect on our business, financial condition and results of operations. You should carefully consider the risks and uncertainties referenced below, together with all of the other information in this Quarterly Report on Form 10-Q, including our consolidated financial statements and related notes. Any of those risks could materially and adversely affect our business, operating results, financial condition, or prospects and cause the value of our common stock to decline, which could cause you to lose all or part of your investment.

There have been no material changes to the Risk Factors described under “Part I – Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended January 2, 2022.