Who’s The Next Whole Foods Market, Inc. (WFM)?

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Unless you live in the Southwest United States, you have probably never been to a Sprouts Farmers Market Inc (NASDAQ:SFM). However, if the company’s ambitions are fulfilled, the company will soon be as recognizable as grocery giants Whole Foods Market, Inc. (NASDAQ:WFM) and The Kroger Co. (NYSE:KR).

Sprouts Farmers Market Inc (NASDAQ:SFM) targets health-conscious shoppers on a budget — sort of a lower-priced Whole Foods Market, Inc. (NASDAQ:WFM). The company’s origins date back to 1969 when Stan Boney opened Boney’s Marketplace in California. Boney’s, later renamed Henry’s Farmers Market, focused on selling natural food at affordable prices. After selling the company in 1999, the Boneys opened Sprouts in 2002 as an affordable provider of natural foods, vitamins, and other products.

Sprouts Farmers Market Inc

In 2010, the company had 54 stores and $517 million in sales. Riding the wave of enthusiasm for organic food, the company has since tripled its size — expanding to 163 stores in eight states with $1.7 billion in sales.

A different model

Like many other grocers, Sprouts Farmers Market Inc (NASDAQ:SFM) offers a wide variety of fresh and natural foods. Unlike most grocers, Sprouts accepts razor-thin margins on its fresh produce. The stores’ inexpensive — yet high-quality — produce draws customers in, and the stores make money on the high-margin products that surround the produce on the store floor: vitamins, meat, bulk foods, beer and wine, baked goods, seafood, and similar items. In addition, about one-quarter of Sprouts’ items are on sale on any given day.  Sprouts is sort of like Whole Foods Market, Inc. (NASDAQ:WFM) with Wal-Mart prices (or, as close to Wal-Mart prices as a natural grocer can get).

The model has worked extremely well for Sprouts Farmers Market Inc (NASDAQ:SFM); it earns a 30% gross margin, compared to 35% for Whole Foods Market, Inc. (NASDAQ:WFM) and 22% for The Kroger Co. (NYSE:KR). Meanwhile, Sprouts’ operating margin is similar to that of Whole Foods Market, Inc. (NASDAQ:WFM), while both stores’ margins are much higher than Kroger’s. This is impressive because Sprouts has a smaller store base than its upscale rival: Sprouts has 163 stores, compared to Whole Foods’ 355.

Whole Foods has tremendous brand recognition for a company that may still triple in size before it is done growing in the United States. The company’s stature as the largest business in the organic food market affords it significant bargaining power over suppliers, particularly organic farmers.

Moreover, its stores are about 40,000 square feet — double that of smaller rivals like Sprouts Farmers Market Inc (NASDAQ:SFM). This allows Whole Foods to take advantage of its high store traffic and burn through its inventory faster than traditional grocers; Whole Foods turns its inventory over about eighteen times per year, whereas The Kroger Co. (NYSE:KR)’s inventory turnover is about twelve times per year. As a result of earning higher margins and a higher inventory turnover, Whole Foods earns much higher returns on capital than almost any other grocer.

Sprouts is not nearly as profitable as Whole Foods, however. Its items sell for less, which means slightly lower margins. But its inventory turnover is much lower — about equal to that of traditional grocer Kroger. This is due to the company’s relatively low profile, which makes it difficult to generate substantial store traffic.

But there is an important distinction between The Kroger Co. (NYSE:KR) and Sprouts: whereas Kroger’s inventory turnover has improved as its gross margin has declined, Sprouts continues to earn a higher margin than Kroger despite turning its inventory over at an equal rate. In other words, Sprouts is able to earn a higher profit on each round of inventory than Kroger can.

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