Apollo Hits A Home Run With Sprouts IPO

By Investopedia | August 06, 2013 AAA

Alternative asset manager Apollo Global Management (NYSE:APO) took Phoenix-based Sprouts Farmers Markets (Nasdaq:SFM) public July 31. Its first day return on its $18 IPO price was an amazing 123%. Apollo made out like bandits. How can you benefit? I'll look at the possible scenarios.

Scenario # 1
It's possible that the lead underwriters--Goldman Sachs (NYSE:GS), Credit Suisse (NYSE:CS) and Bank of America (NYSE:BAC) dramatically underestimated investor interest in the organic grocery store chain. Based on an IPO price of $18, Sprouts' enterprise value was $3.2 billion. After the first day of trading it jumped to $6.3 billion by the close or 43 times adjusted EBITDA. That's almost three times Whole Foods' (Nasdaq:WFM) EBITDA. I suppose they could have gone with a higher initial range than $14-$16, but hindsight is 20/20.

Is there enough growth to justify the pricey valuation?

Well, let's look at the valuation from both its IPO price of $18 and its August 1 closing price of $40.11. In its second quarter ended June 30 it expects to grow revenues by 30% to $622 million. Its pro forma 2012 revenue was $1.99 billion. Let's assume it does $3 billion in 2013 and $4.5 billion in 2014. Let's also assume that its net margin of 1.5% generates $67.5 million in net income in 2014 or $0.46 per share. That's a 2014 forward P/E of 39 based on $18 per share and 87 based on $40.11 per share. If it's able to grow earnings per share by 25% annually over the next five years, its PEG ratio at $18 was 1.56, which is very reasonable. At $40, it jumps to 3.48, almost double Whole Foods.

SEE: How An IPO Is Valued

This tells me the underwriters did a good job valuing Sprouts' business. Investors simply decided it was worth more. If you don't feel that way, I suppose you could always short its stock. However, it seems to me like momentum is going to carry this stock higher over the next week or so. I'd say a better solution would be to wait until the excitement wears off and its stock drops down to around $26. It's not $18 but it's better than $40.

Scenario # 2
It's my hypothesis that Sprouts merge with The Fresh Market (Nasdaq:TFM) to create the nation's second national health food chain. Both companies have similar-sized stores (between 20,000 and 28,000 square feet) selling higher-margin, quality products. Together they would have 279 locations in 34 states with annual revenues of $3.3 billion.

Of the two businesses, The Fresh Market has higher margins. With Sprouts 123% jump in price its enterprise value is more than double The Fresh Market. Granted, Sprouts' Q2 comparable store sales growth is expected to be 10.8%, 780 basis points higher than The Fresh Market. However, at the end of the day, The Fresh Market delivers better earnings.

Whether or not a deal is possible, The Fresh Market is a smarter way to play the healthy food industry, especially after Sprouts' big opening day. Don't be a patsy for Apollo - take your money elsewhere.

Scenario # 3
If you can't beat 'em, join 'em. Apollo acquired Los Angeles-based Smart & Final in February 2007 for $813 million including the assumption of debt. In October of that year Smart & Final acquired Henry's for $166 million. In April 2011, Apollo acquired 58.5% of Sprouts for an equity contribution of $214 million. At the same time, Sprouts acquired Henry's from Smart & Final for $275 million.

Lastly, Apollo sold Smart & Final in October 2012 to Ares Management for $975 million. Add in Apollo's $147 million cut of a dividend paid by Sprouts in 2013 and you'll find that Apollo owns 65.2 million shares of Sprouts while putting $96 million in cash in its pockets since 2007. Those 65.2 million shares are now worth $2.6 billion.

It's not very often that you can walk away from six years of work with $2.6 billion and your time being the only cost of that work. This has to go down as one of Apollo's most successful deals in its history. Why not buy its stock and participate in its future success.

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