The Organic Grocer Lovefest Has Come to an End

Between 2009 and 2013, we saw a rather evident lovefest for organic food stocks, mostly in companies like Whole Foods Market (NASDAQ: WFM  ) and Sprouts Farmers Market (NASDAQ: SFM  ) . Yet with grocery leaders Wal-Mart Stores (NYSE: WMT  ) and Kroger (NYSE: KR  ) entering the organic food game, coupled with Whole Foods' recent earnings collapse, it's now rather evident that this love affair has come to an end.

The organic backstory
In the five years prior to 2014, shares of Whole Foods soared nearly 500%; Sprouts had its IPO in 2013 but also traded considerably higher in the months following its public market debut. The excitement in these companies stemmed from their organic food focus in a supermarket setting. However, those fortunes have changed, as Whole Foods and Sprouts have both lost 30% of their value in 2014.

Whole Foods is the organic supermarket juggernaut, while Sprouts is an up-and-coming, fast-growing business. However, traditional supermarket powers have noticed the growth opportunity in organic, and as a result have entered the space. This fact was evident in Whole Foods' recent earnings report, which created mass selling pressure throughout the space.

Specifically, Whole Foods missed expectations on the top and bottom lines. Also, its comparable-store sales growth of just 4.5% was below the consensus, as was the 50-basis-point decline in gross profit. Moreover, the company lowered guidance for the third consecutive quarter, specifically noting that management was overly optimistic and underestimated the impact of new competition. As a result, shares of Whole Foods fell 19%; Sprouts fell 12% in sympathy.

Is it time to buy organic?
The big questions now surround whether Whole Foods and Sprouts have lost enough valuation to reflect their fundamental woes and if either now presents value. Setting all suspense aside, the answer is likely no.

Whole Foods and Sprouts trade at a rather lofty 26 times and 74 times earnings, respectively, and given the rate of growth for competitors, it's highly unlikely that both companies will meet double-digit growth expectations for the year.

Specifically, Kroger has added organic foods to its stores, but Wal-Mart in particular has made a real push in the industry. Wal-Mart's Wild Oats organic brand has rolled out quickly and should be in 2,000 stores by year-end, or approximately half of its U.S. locations.

Where to invest?
The problem for investors is that Wal-Mart is too big for there to be any substantial value added due to the success, or lack thereof, in organic foods alone. For example, Whole Foods is the unquestioned leader in this space, yet its total annual revenue is less than 3% of Wal-Mart's annual revenue. Hence, even if Wal-Mart is wildly successful with organics and steals substantial market share, the company should continue to grow at the rate of GDP and is fairly priced at 16 times earnings.

On the flip side, Kroger might make a good investment. Sure, Kroger is growing in the organic food market, but more important are the changes within the company's operational strategy and the room for it to grow its $98 billion in annual revenue.

Over the last couple of years, Kroger's margins have consistently risen, and its expected 8.4% increase to revenue in 2014 is twice the growth rate of GDP. At 16 times earnings, this is a company priced attractively considering its growth. And the company's decision to open larger supermarket-like stores is reminiscent of Wal-Mart's decision to adopt the "Super Wal-Mart" concept decades ago, which turned out well for it.

Final thoughts
Essentially, Kroger's move from grocery and pharmacy to gasoline, clothing, appliances, organic, etc. could spark further growth and lead to many years of above-GDP growth. Therefore, while Kroger is not a pure play on the organic market, its diversity makes it safer than the likes of Whole Foods, and its expansion program gives it similar growth.

With that said, Kroger is significantly cheaper than Whole Foods or Sprouts, and due to the increased competition, investors should worry about investing in either of the two latter companies. As competition continues to increase and more companies enter this space, Whole Foods and Sprouts will be forced to lower prices; this will cut into margins while increased competition weighs on growth. Hence, it might now be time to invest in conventional, strong-performing supermarket-like stocks, such as Kroger, and avoid the pure organic-like stocks.

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  • Report this Comment On May 14, 2014, at 10:18 AM, insight113 wrote:

    SFM has nothing but good reports, and yet the stock has gone down. It makes one wonder why? Just because Walmart is going to start offering organic products doesn't make me want to buy their stock. Walmarts produce doesn't compare to Sprouts and Sprouts has great prices. I have returned more bad produce to Walmart. As a consumer, I choose to buy Sprouts Farmers Market products and now their stock because I'm so impressed with their quality of Organic food.

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Brian Nichols

Brian Nichols is the author of "5 Simple Steps to Find the Next Top-Performing Stock: How to Identify Investments that Can Double Quickly for Personal Success (2014)" and "Taking Charge With Value Investing (McGraw-Hill, 2013)". Brian is a value investor, but emphasizes psychology in his analysis. Brian studied psychology in undergrad, and uses his experience to find illogical value in the market. Brian covers technology and consumer goods for Motley Fool. Brian also updates all of his new and current positions in his Motley Fool CAPs page. Follow Brian on Twitter and like his page on Facebook for investment conversations and recent stories.

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