This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, we focus on three picks by investment megabanker Morgan Stanley, which has announced a series of picks (and pans) in the supermarket sector: two buy recommendations for Whole Foods Market (NASDAQ:WFM) and Sprouts Farmers Market (NASDAQ:SFM), but a sell for The Fresh Market (NASDAQ:TFM).
Introducing the three "FMs"
In past columns, I've taken to calling this group of natural and organic grocery stores "the three FMs" based on the "me-too" tickering that Sprouts and Fresh Market have adopted for their stocks, in a likely attempt to ride the coattails of Whole Foods' success. However, though the tickers for their stocks differ from their rival's by just one letter, the differences in the stocks' valuations are much bigger.
Let's start with the standard-bearer for the category, and work down from there.
Whole Foods Market
With the stock priced at $39 and change today, Morgan Stanley sees Whole Foods -- the granddaddy of natural and organic groceries markets -- rising to $50 within a year, and rates the stock as overweight. If the analyst is right, this would work out to a 28% profit for investors at today's prices, as well as a nice reversal of fortunes for existing shareholders, who have seen their stock drop 25% over the past 12 months.
Problem is, Morgan Stanley is not right about Whole Foods.
Priced at 26 times earnings today, Whole Foods shares cost close to twice what you'd ordinarily pay for a company expected to grow earnings at 13.5% annually over the next five years (the consensus among analysts polled by Yahoo! Finance). Worse, Whole Foods generated only $403 million in positive free cash flow over the past year -- barely 71% of reported net income.
What this means, in an organic nutshell, is that if Whole Foods looks expensive on a P/E basis, then it's even more expensive when valued on its real cash profits. Working from S&P Capital IQ data, I calculate a price-to-free cash flow ratio of 35.6 on this stock, which is far too much to pay for 13.5% annual growth. Far from overweighting the stock, as Morgan Stanley advises, investors should probably look at today's endorsement as an opportunity to sell shares into positive sentiment.
Sprouts Farmers Market
Morgan Stanley's second organic selection of the day is Sprouts, and with its stock up 2.3% post-pick, the company is getting an even bigger boost from the overweight endorsement than Whole Foods. Trouble is, with a P/E ratio of 69, Sprouts is so obviously overpriced already that investors actually have less margin for error in buying this stock then they had with Whole Foods -- and consequently, risk even greater losses if they follow Morgan Stanley's advice.
Don't get me wrong. Of the three big organic grocery store chains, I probably like Sprouts best of all. It has the best projected growth rate, with S&P Capital IQ analysts estimating better than 25% annualized earnings growth over the next five years. And Sprouts' $95 million in trailing free cash flow exceeds reported net income by more than 40%. (Sprouts is the only organic grocery chain that can make this boast, by the way.)
Still, 69 times earnings -- or even 50 times free cash flow -- is far too much to pay for 25% growth. Morgan Stanley may think the stock is worth it. I do not.
The Fresh Market
In fact, the only Morgan Stanley rating that I do agree with today is its advice to investors to underweight (read: sell) shares of The Fresh Market.
Priced at 35 times earnings, and projected to grow at 17%, The Fresh Market looks midpriced between Whole Foods shares and those of Sprouts, and "mid-growth-ed" as well. But with only $21 million in trailing free cash flow, this company is actually the worst cash producer of the bunch. The Fresh Market earns less than $0.47 per share in real cash profit for every $1 in claimed generally accepted accounting principles net earnings.
This works out to a price-to-free cash flow ratio of more than 76 on the stock, making The Fresh Market the most expensive organic grocery chain you can buy -- and far too expensive for its 17% growth rate. Measured relative to the competition, or objectively on its own merits, The Fresh Market is clearly no buy. Morgan Stanley is right to underweight this company.
Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. Case(s) in point: The Motley Fool recommends The Fresh Market and Whole Foods Market, and owns shares of Whole Foods Market. Also, John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors.