The Tale of Two Organic Markets
Since reporting their respective 1Q16 results in early May, the stocks of Whole Foods (WFM: $34) and Sprouts Farmers Market (SFM: $25) have gone in opposite directions. Whole Foods has been the clear winner, adding 20% to stockholder value. This is after the company reported results that featured flat sales, a 3% drop in comp store sales, and a 10% drop in net income.
On the other hand, Sprouts is virtually unchanged since the May 5th quarterly release. The company produced a 16% sales increase, 5% comp store sales increase and net income up 20%.
So what gives here? Figuring out the motives of investor s is a lost cause but one thing is very clear, Wall Street is suddenly very enamored with the prospects for Whole Foods new “365” stores. This is a concept that bears interesting similarity to the Sprouts’ format in terms of a footprint of 30,000 square feet and a more limited selection than the full-sized Whole Foods Stores. It also features lower prices.
The first 365 store located in a trendy neighborhood of LA just opened in recent days sparking enormous local news coverage, which coincidentally was followed by a big CNBC on-air boost from Jim Cramer and by an upgrade by Credit Suisse. The way the stocks are acting you have to ask, does the 365 concept threaten the future existence of Sprouts?
The answer is no. We like both stocks for three basic reasons. First, the Organic grocery trend is real and more and more intelligent people are adding to the huge number that already only buy organic. Second, the market is segmenting based on price. Not everybody can afford Whole Foods’ prices, but they still seek a healthy diet. Third, there are many parts of the US where neither company has locations. So there is room for both.
The notion that Whole Foods 365 Stores are a threat to Sprouts doesn’t stand the test of reason. At the moment, there is only one 365 Store. The format is new and will require fine-tuning. We might see 6-10 new 365 stores in the next year at most. Whole Foods has about 450 total stores. We challenge neither the wisdom nor the likely success of the 365 concept. In fact we are big fans of this move. It addresses the increasing market segmentation taking place in organic food products but there will be some time before 365 will have a transformative impact on the company as a whole. We are happy to see Wall Street’s renewed enthusiasm and support it fully.
Sprouts does not need to be put into some sort of endangered species program. With 230 stores in 13 states, Sprouts is most heavily concentrated in California, Texas, Colorado and other southern states. The most conspicuous gap is in the northeast and southeast where there are only 17 stores, none of which are in the Carolinas or Florida. This is fertile territory and where Sprouts plans a major store expansion. Ultimately, a move into metro New York is inevitable.
We think both stocks will produce major gains in the years ahead. They are both going to be growing their business for a long time before it becomes a competitive head-to-head type of Kmart versus Sears situation. Which is cheaper in the short term? Here is a guide. Sprouts is priced at 26 times consensus 2016 earnings of $0.97 per share, while Whole Foods is only 22 times the $1.59 estimate for this year. However, since Sprouts is growing more rapidly, it is priced at only 1.6 times its growth rate (the so called PEG ratio) compared with Whole Foods at 3.7 times.
From our point of view, in three years today’s valuation will be long forgotten. Let’s call it a draw; you should own them both.