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It’s Time to Invest in An Organic Grocer

organic-grocerThe organic trend is here to stay.  Buy.

Let me be clear: I think you should have one of the big organic grocers in your long-term diversified portfolio.  The reason is that “organic” is the greatest marketing scheme invented, second only to DeBeers’ campaign, “Diamonds are forever.”

“Organic” is synonymous with “healthy”, which is a code word for “doesn’t cause cancer”, which is at the root of the entire organic movement.  Yes, I said it.  The organic movement plays off people’s fears of mortality.

I have no problem with this approach at all, because it generates revenue, allows companies to charge higher prices than are reasonable, and the food generally tastes better.

This movement is not going to go away, either.  It is not engrained in our culture, and once things latch onto the culture, they tend to stick.  Therefore, I think you want an organic grocer in your portfolio.

Which one? Whole Foods Market, The Fresh Market or Sprouts?  

Whole Foods Market (NYSE:WFM) is considered the 800-pound gorilla in the sector, yet even I was surprised to discover that it only has 360 locations.  It seems like the dominant brand name in the space, so much so that it has the distinction of popular culture mocking its success, by nicknaming it “Whole Paycheck.”

That the culture does this should tell you about the business – namely, that it charges high prices for its food and if you are a shareholder, that’s a great thing.  But Whole Foods isn’t the only player.

Another is The Fresh Market (NYSE:TFM), and I was once again surprised to find that this company was founded  in 1982, even though I only heard of it a few years ago.  Finally, we have the aptly named Sprouts (NYSE:SFM), a 12-year-old chain that has some catching up to do.

First, on a footprint basis, we have the aforementioned Whole Foods leading the way with 360 stores.

Sprouts has gone for the regional markets, with just over 160 locations in eight states. The Fresh Market has 156 stores.  Despite being an upstart, Sprouts is right alongside with 170 stores.

You would expect that Fresh Market and Sprouts, being half the size of Whole Foods, would have comps that are 50% of the gorilla’s.  Not so.  Sprouts only generates about 19% of the revenue of Whole Foods and about 12% of the net income, although those numbers have bumped up by 300bps and 500bps recently. The Fresh Market has 11% of Whole Foods’ revenue, with 8% of the net income, and those numbers have declined recently.

That tells me that Whole Foods is operating with vastly more efficiency than its competitors.  This is also apparent in the profit arena.  Whole Foods TTM net margins are 4.14%.  The Fresh Market sits at 2.87%.  Sprouts is at 2.59%.

Much has been made of Whole Foods getting hammered by competition, not only from these two companies, but because Wal-Mart (WMT) and other stores are offering organic food.  That’s nonsense.  Whole Foods serves an upscale demographic who can afford its prices.  Nobody is going to leave a 100% organic grocer to slum it at Wal-Mart for however few organic products it carries.

Still, Whole Foods has struggled a bit recently, and that’s taken the stock down.  Long term annualized EPS is pegged at 13.5%.  However, Whole Foods generates $800 million in FCF each year.  It has almost $1.5 billion in cash and only $60 million in debt, which is about $4 per share in cash.

Those kind of numbers, plus EPS estimates that I think are too low, are enough for me to give it a 20x valuation, or $34 per share of FY15 earnings.  The stock is at $36.85. It’s well off its old highs.  I would buy some here and look to add on dips.  The cash flow practically makes it a defensive stock.

Sprouts has 25% annualized growth, but it has $150 million in cash and $423 million in debt. A 25x estimate on FY15 earnings of $0.85 give me a fair value of around $21.50.  The stock is at $31.50, so I’ll pass.

Fresh Market is looking at 17% annualized growth, $19 million in cash and $34 million in debt.  FY15 earnings of $1.82 give it fair value of around $32, so there may be some value here.  If you like the idea that an upstart is growing quickly and may experience the high-growth valuation the market sometimes rewards small-caps with, consider Sprouts.

Lawrence Meyers owns shares of WFM.

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