Can Sprouts Serve a Cup of 'Joe'?

Amid deep investor skepticism and an industry shaken by back-to-back collapses of its small-box natural food peers, Sprouts Farmers Market delivered a financial wallop from the ropes—a signal that new CEO Jack Sinclair’s early moves to reposition the chain packed some power.

As previously reported, Sprouts’ fourth-quarter results exceeded both consensus expectations and the company’s own guidance, driving eye-opening sales, earnings and profit growth for the period. Speaking to analysts in a conference call following the Feb. 20 announcement, Sinclair said the beat gave evidence that his strategy to revamp the chain’s approach—specifically switching its promotional focus from hot commodities to unique items, a strategy one analyst compared to a Trader Joe’s-like approach—held new promise.

“To be clear, we’re still promoting and providing value to our customers. But we’re doing so differently,” said Sinclair, the veteran Walmart and 99 Cents Only executive who joined Sprouts over the summer. “We focused our promotional activity by responding to opportunities in the marketplace rather than reacting to promotional pricing elsewhere, resulting in improved cost of merchandise. We focused our display and presentation in-store on items that differentiate us in the marketplace and provide uniqueness to the customer. If the competition zigged, we zagged.”

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This approach, he said, “turned off promiscuous shoppers,” who tended to shop Sprouts for its bargains only, and traffic subsequently was down despite a 1.5% comp figure. Those same shoppers tended to be an enemy to profitability, however, and a focus on unique and specialty items, such as vegan holiday meals and sides; new brands such as Van Leeuwen’s oatmeal vegan ice cream and Pipcorn snacks; and specialty fruit varieties such as Lucy Glo apples drove a 120-basis-point increase in gross margin percentage, Sinclair noted.

Until recently, Sprouts thrived behind taking sales not from other specialty providers but from conventional competitors. But with the conventional channel now onto Sprouts' best tricks—particularly its emphasis on pricing in produce and many with meal-prep and delivery options arguably ahead of Sprouts’ more recent moves in that direction—Sinclair’s emerging game plan would indicate a new attempt to differentiate, seemingly channeling a health-focused version of Trader Joe’s, the wildly successful and nearly impenetrable wonder that thrives even as small-box peers encounter trouble.

“Our brand can and will be known as a treasure hunt for healthy eating across this country,” Sinclair said.

He was careful not to declare victory yet. He warned analysts not to expect a 34.4% margin rate every quarter, and said traffic was likely to be constrained in the months ahead as Sprouts eases on commodity promotions and printed sales flyers. Guidance for comps in the quarter and the fiscal year ahead are in the flat to 1% range.

“We’re keenly aware that our traffic remains negative,” he said. “We’re taking a long-term view and know as we move towards a new marketing strategy, a stronger everyday price position and pulling back on unprofitable promotions may result in continued traffic headwinds. We expect an adjustment period and then profitable customers will respond.”

Though Sprouts is reeling in near-term new store growth—it expects to open 20 new units this year vs. its typical 30-per-year pace—Sinclair declared intentions to accelerate in years ahead, though by building smaller units that he said would more closely resemble the chain’s early units in Southern California than the larger, more elaborate and more expensive newer stores Sprouts has built as it expands to places like Philadelphia. They are also likely to be more concentrated geographically as the chain works toward a more efficient supply chain capable of delivering fresher items faster.

The earnings beat came amid low expectations for specialty small-box operators following the bankruptcies of Earth Fare and Lucky’s Market, and shortly after the anniversary of the departure of former Sprouts CEO Amin Maredia, triggering a lengthy period of uncertainty for the chain’s direction that turned even more negative amid an epidemic of Chapter 11 bankruptcies among peers. Sprouts stock, trading at all-time lows, jumped by 9% after market.

Analysts such as Karen Short of Barclays sounded an encouraging but cautious message.

“Notably, while [Sprouts'] strategic changes remain early stage, [it] appears to be pivoting toward Trader Joe’s-type differentiation with respect to specialty/treasure hunt assortments and remains confident that it can reaccelerate unit growth after this year,” Short said in a note to clients. “Conceptually, attempting to be more like a top-tier operator like Trader Joe’s (when they already exist) appears risky—as does accelerating store growth when traffic remains negative, competition is aggressive and many of the new strategies are unproven.”

Evidence of a more Trader Joe’s-like approach could be seen more directly in the appointment of former Trader Joe’s President Doug Rauch to Sprouts' board of directors, which was also announced Feb. 20.