Rapidly growing grocer Sprouts Farmers Market (NASDAQ:SFM) reported robust second quarter numbers at the beginning of August that included a lift to the full-year earnings guide. SFM stock popped more than 10% the day of the report, and hasn’t looked back since. Today, it trades at $27.50, up 30% since early August.
To put that run in comparison, the S&P 500 is up less than 4% during that stretch.
Unfortunately, this rally won’t last forever. SFM stock is no stranger to big rallies like the one it’s had since August. But, historically speaking, such big rallies have always been followed by equally big drops. Granted, history is no perfect guide for the future. But, the fundamentals at this point in time support a valuation reset and some weakness in SFM.
All in all, I think the SFM rally is over. This stock needs to cool off, both from a fundamental and technical perspective. Once that cooling off is done, depending on where the stock is, there could be a buying opportunity.
Until then, SFM stock is best avoided.
Technicals Are Overstretched
Ever since Sprouts reported better-than-expected second quarter numbers and delivered an above-consensus guide in early August, it has been red hot. Not only has it rallied by 30%, but it did so quickly. The result is that SFM stock currently trades more than 10% above its 200-day moving average.
This is not unfamiliar territory for SFM. The stock has traded 10% or more above its 200-day moving average four times before over the past five years.
Each time, the rally was faded before it went much further, and SFM dropped in a big way over the subsequent several weeks to months. The most recent examples of such peaks were in August 2017 and January 2018.
In other words, history says that SFM stock starts to get maxed when it trades 10% above in 200-day moving average after a strong rally. That is exactly where we sit today. The stock has already pulled back some, so it looks like history is going to repeat itself. If so, we could be due for a correction of 10% or more.
Fundamentals Point to a Downside
Of course, history is no perfect indicator of the future. But, go-forward fundamentals support that history will repeat itself this time around.
During this rally, the valuation on SFM stock has run up to historically unsustainable levels. The stock current trades at 22X forward earnings. SFM stock has traded at a similar multiple three times since the start of 2017. Not once did the stock hold that valuation, nor did the valuation ever get above 25X. Thus, 22X seems to be a near-term top in terms of valuation for SFM.
Moreover, there are competitive concerns lingering on the horizon. Although Sprouts and other grocers have seemingly survived the first Amazon (NASDAQ:AMZN) grocery onslaught with the Whole Foods acquisition, Amazon refuses to go away quietly.
The company is now expanding its AmazonGo concept from a handful of stores to several thousand locations over the next several years. While those stores are more of a threat to urban convenience stores than grocers, the long-term implications of Amazon operating cashier-less stores en masse are negative for Sprouts.
As such, the Amazon threat cannot discounted in a long-term window, nor should it be.
From a pure fundamental standpoint, I think SFM stock is worth around $25 today. This is a grocery store with a unique value prop of selling health-oriented foods at discounted prices and in a family market setting.
That value prop is strong and enduring, and should continue to drive slightly positive comparable sales growth into perpetuity, barring Amazon encroachment.
Slightly positive comparable sales growth plus unit expansion (Sprouts operates just 300 stores versus roughly 500 for closely related peers Whole Foods and Trader Joe’s) and margin stabilization should drive earnings per share to $2.25 in five years.
An industry average 15X multiple on that implies four-year forward price target of ~$34. Discounted back by 10% per year, that equates to a year-end price target of ~$25.
Bottom Line on SFM Stock
The rally in SFM stock has come and gone. Now, the stock needs to cool off. Any dips towards $25 should be viewed as buying opportunities, but prices above $25 seem fundamentally and technically overstretched.
As of this writing, Luke Lango was long AMZN.