What's Best of Breed in the Organic Aisle?

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Once the domain of hippies and yuppies, organic food have gone mainstream. As part of the overall theme in healthy living, organic grocery sales have grown 15% in the past year creating a remarkable opportunity for investors. 

But what's the best way to play this trend? A few years ago Whole Foods Market (NASDAQ: WFM) was the only public pure-play on organic supermarkets. But recently there's been a rash of IPOs including Natural Grocer by Vitamin Cottage (NYSE: NGVC)The Fresh Market (NASDAQ: TFM), and Fairway Group Holdings (NASDAQ: FWM). Just like inspecting fruit and veggies in the store, this abundance of selection requires a little extra homework in order to find the top name in the space. 

So let's knock on those watermelons and squeeze some avocados. It's time to find the freshest stock in the organic aisle. 

Fairway Group Holdings

Fairway Group Holdings is the most recent addition to the organic space with the company going public last April. The popular New York retailer boasts the highest sales per square foot in the grocery space. Since being purchased by Sterling Investment Partners in 2007, a private equity group, the company has opened eight new locations with plans to open 300 stores in the northeast. 

But there are a lot of problems with the Fairway story. First, the balance sheet is stretched. Sterling has saddled the company with $332 million in debt reducing the company's financial flexibility  Second, the company's operations aren't profitable. Fairway Group hasn't turned a profit in three years. Third, expansion is already cannibalizing sales with comparable store sales declining in recent quarters. 

This is a highly speculative play and it's not clear if the company can grow from a beloved neighborhood store into a national chain. Outside of New York, I'm not sure how many people have even heard of the company. 

Natural Grocers by Vitamin Cottage

Natural Grocers is a regional chain selling organic products and dietary supplements. The company has 66 locations in 13 states with room to grow that total to 1,100 stores. 

Let me be frank. Natural Grocers' operating results are spectacular. Last year the company grew revenues 27% with same store sales increasing 11.3%. Analysts project the company to post 25% EPS next year. 

My only problem with Natural Grocer: valuation. The stock trades at nearly 50 times next year's earnings giving the stock an alarming 1.80 PEG ratio. That doesn't leave much room for multiple expansion and any hiccup could send the stock into free fall. 

The Fresh Market

Fresh Market is another great regional to national growth story with 130 stores throughout the Southeast, Midwest, and Mid-Atlantic. Management thinks there's room to triple its store count to 500 locations. 

At first glance, Fresh Market looks like the cheapest name in the space. The stock trades at only 25 times forward earnings and sports a 1.2 PEG ratio. Case closed! The Fresh Market is clearly best of breed. 

But the company has had problems recently. Fresh Market has missed estimates in its last two quarters and several executives have left the company to pursue other opportunities  This calls into question whether the company has the managerial talent needed to execute its growth plan. In addition, the company lowered in 2013 EPS guidance to $1.55. Significantly lower than the $1.69 the street had been looking for. 

Given these problems, the discount may be deserved. 

Whole Foods Market

Which brings us back to ol' Whole Foods. The company has a clean balance sheet with only $24 million in long-term debt while generating ample cash flow from operations to fund expansion. Whole Foods has roughly 350 locations with room to open 1,000 stores in the United States in addition to international possibilities. Given the company's strong national brand, it shouldn't have any problems becoming established in new markets. Plus the company's size gives Whole Foods the best margins in the industry. 

No doubt, based on the fundamentals Whole Foods is top name in the space. 

Investors may quibble on Whole Foods' valuation. At 25 times forward earnings, the stock sports a premium 1.3 PEG ratio. But when picking stocks, it's always desirable to pay up for best of breed. It's the peace of mind. 

It's hard to believe that a grocery store could book investors more than 30 times their initial investment, but that's just what Whole Foods has done for those who saw the organic trend coming some 20 years ago. However, it may not be too late to participate in the long-term growth of this organic foods powerhouse. The Motley Fool's premium report on the company walks through the must-know items for every Whole Foods investor, including the main opportunities and threats facing the company. So make sure to claim your copy today by clicking here.

Robert Baillieul has no position in any stocks mentioned. The Motley Fool recommends The Fresh Market and Whole Foods Market. The Motley Fool owns shares of Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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