Which organic grocery store belongs in your portfolio?

The organic food movement is perhaps the most brilliant example of marketing ever created, second only to the phrase, “Diamonds are forever.” There’s plenty of reason to like organic food. In general, fresh organics taste better, at least to my palette. In other cases, studies have shown there really isn’t much difference.

organic-grocery-stocks

That hasn’t stopped people from falling over themselves to get at those organics, though. Now there are three public companies taking advantage of the shift to organic foods. Which is best – and does it make a good investment?

Whole Foods Market (NYSE: WFM) is the biggest brand name. Through a combination of organic growth and acquisitions, like buying niche brand names such as Mrs. Gooch’s, Whole Foods has captured the attention of anyone who claims to be serious about organic shopping.

Today, WFM has 400 stores and management thinks there’s room for 2,000. 2014 proved to be challenging for Whole Foods as other grocers, like those I’m going to mention as well as traditional grocers and Wal-Mart (NYSE:WMT), have entered the field. In truth, I think the slowdown in sales was more a result of the economy and direct competition than regular grocers.

The thing about Whole Foods is that it appeals to an upscale demographic that doesn’t mind paying outlandish amounts for organics. If you shop at Ralph’s, you may upsell yourself to Whole Foods, but not the other way around. Same thing with Wal-Mart.

Whole Foods has $970 million in cash and only $60 million in debt. It routinely generates $700-$800 million of free cash flow annually. It trades at 28x FY15 estimates, so it feels a bit pricey when long-term earnings growth projections are at 12%. Nevertheless, it has traded at much higher P/E ratios before.

The Fresh Market (NYSE: TFM) opened in 1982 and focuses more on regional markets, with just over 160 locations in eight states. Since then, the company has expanded into 27 states.

It has $20 million in cash and $30 million in debt, and generates only $20 million of free cash flow every year. The Fresh Market has 40% of Whole Foods’ store base, 12% of its revenue, and only 8% of its net income. Its margins are the same, but that’s small consolation.

I don’t see how I can suggest buying TFM when it trades at 25x FY15 estimates on long-term earnings growth expectations of 17%. It may be less overpriced then WFM, but it is not in nearly as solid a position.

That leaves Sprouts Farmer’s Market (NYSE: SFM). Again, it can’t compete with WFM on various metrics. With 182 stores, or about 45% the footprint of Whole Foods, it only generates about 20% the revenue (although that’s improved from 16% in 2012) and about 17% of the net income (which is much improved from 7% in 2012). Margins have also substantially improved over the past two years.

So has free cash flow, which grew from $25 million in FY11 to $38 million in FY12, to $73 million in FY13, and $55 million year to date. If last year is any indication, FY14 free cash flow should come in around $67 million. It has $118 million in cash and $374 million in debt.

Valuation has also gotten much more reasonable, down from 100x earnings in 2012 to “only” 45x FY14 earnings, and 35x FY15 earnings. Earnings are expected to rise 43% in FY14 and 28% in FY15, which matches long-term projections.

It seems like Sprouts is improving on its execution, and isn’t wildly overvalued. I think if you want a growth stock that carries some risk on valuation and competition, you go with Sprouts. Otherwise, you go with Whole Foods and the huge brand name, footprint, and financial advantage it has.

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Published by Wyatt Investment Research at