I have no inside info and I am not making an investment recommendation. But Sprouts Farmers Market will not be an independent company a year from today. The dynamics of the retail food business are changing. Right now Sprouts is caught in the middle and that is not an ideal place. The solution: sell out or suffer.

Full Disclosure

I am a big fan of Sprouts: written about them several times, believe they compare favorable to Whole Foods on several metrics and even shop there regularly.

The reason for this was simply that Sprouts stores offered essentially the same organic foods as Whole Foods but at a smaller markup without sacrificing profits.

Admittedly, going into Whole Foods is a mind altering experience with vastly more products to choose from and a super slick store presentation. But those prices at Whole Foods are ridiculous.

Previously we presented a financial table that showed the gross profit margins at Whole Foods were 34% versus 29% at Sprouts and 21% at Kroger. Bear in mind that all three concerns offer a full range of organic products. The conclusion at the time seemed obvious, prices at Whole Foods somehow, someway had to come down.

Enter Amazon The Disrupter

The August acquisition by Amazon of Whole Foods is history. What followed the closing of the deal was Amazon’s action to begin lowering prices at Whole Foods.
The headlines of this move served as a warning shot over the bow of Sprouts and many other food retailers.

Not only was Whole Foods becoming more aggressive on price, but with the unpredictable likes of Jeff Bezos running the ship, a new level of uncertainty came into play. Would robots be taking over and speeding the checkout process, would drones be delivering customer orders? Does Jeff have another card up his sleeve to surprise the food-retailing world?

Since Amazon made their buy out offer in mid June, Whole Foods shareholders have enjoyed their payday watching the stock gain over 27% in about 60 days. Sprout shareholders have not fared as well with the stock selling just below its mid June price level.

Eat Or Be Eaten

Does Sprouts become an acquisition target now that Whole Foods is gone or is its survival threatened by the new Amazon presence and pricing strategy?

In the initial days following the Amazon deal, investors bit up the price of Sprouts by 20%, fueling hope a suitor would emerge. And why not, Sprouts is fundamentally sound having recently beat Wall Street earnings estimates of their second quarter.

However with Wall Street traders having short-term perspective and no deal for Sprouts, the stock price has fallen rather quickly.

What Does Sprouts Offer?

As one top analyst stated it, “Sprouts is the only likely takeout candidate left among grocers.” True, but there is more to Sprouts. The stock could hardly be considered overvalued selling at about 22 times earnings. That is just an average valuation in today’s market. However Sprouts is growing far faster than the 2% of the economy.

Currently there are only 216 stores in 15 states. This is small change compared to Whole Foods or Kroger. The brand is well respected for quality, price and convenience. There is no reason that another 200-400 stores could be added and still not saturate the market.

Secondly, Sprouts enjoys the industries second best gross profit margins at just about 29% and above average operating margin of about 7%.

Reversal Of Fortunes

Now with Whole Foods under control of Amazon, Sprouts has taken on the same role with regard to price levels as Whole Foods has previously. What we mean is someone including Kroger or others could buy Sprouts lower prices to more effectively compete. For example, Sprouts is almost twice as profitable as Kroger. This alone offers lots of flexibility on pricing.

Amazon is the technology leader in the food shopping using, fast electronic checkout, home delivery via trucks and maybe even drones some day. This gives them a chip to play in the market share game.

However, there is nothing proprietary here that cannot be replicated by Sprouts or others. Virtually anything from Amazon could be a game changer but it is not going to be a knock out move. The world usually doesn’t work that way so keep an eye on Sprouts.