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David Versus Goliath in the Natural Grocery Aisle

Mark Yagalla
October 28, 2013

The trend for American consumers and their families is to live healthier lives and eat better. More families than ever before are concerned about what they put on the dinner plate and are choosing natural and organic foods. Even though these products cost more, the thinking is that the long-term health benefits outweigh the costs.

For an investor to play the space, the only option used to be the market leader Whole Foods Market (NASDAQ: WFM). But now there are some new grocers on the block for investors ready to challenge the industry giant. This year both Sprouts Farmers Markets (NASDAQ: SFM) and Fairway Market (NASDAQ: FWM) went public. Now you get to decide if you should stick with Whole Foods or get into these smaller (and possibly better) stocks.

The New York grocer
Fairway operates Fairway Markets. Each store has a selection of fresh, natural and organic products, prepared and specialty foods, and conventional groceries as well. The company has 13 stores in the New York metropolitan area.

For the first quarter of this year, net sales increased 21% to $187 million. Net sales overall increased by $32 million and were driven by new store openings. Adjusted earnings before interest, taxes, depreciation, and amortization increased 12% to $12.7 million. Same-store sales increased 1.4%. This marked the company's first report as a public entity after completing its initial public offering on April 22.

Going forward, Fairway has room to grow. Later this year, the grocer will open its 14th location in Nanuet, N.Y. In 2015, Fairway will be the anchor fruit tenant of the $12 billion Hudson Yards project. The company is also in negotiations regarding two new locations; one in Manhattan and another outside of the city. To facilitate this growth, the company is opening a new production center that can support approximately 30 stores in the New York area.

While I like the company's growth prospects, to me Fairway is not expanding fast enough. I would like to see more stores in the development pipeline. Without more store openings, it will be tough to justify a forward P/E of 113. Part of what might be holding the company back is its $256 million in debt and only $70 million in cash. The balance sheet is a little more leveraged than I would like.

This stock is sprouting
Sprouts Farmers Markets' shares more than doubled in the company's trading debut this month. The company went public at $18 per share and closed at $40.11 on its first day of trading. Sprouts operates 163 stores in Arizona, California, Colorado, New Mexico, Nevada, Oklahoma, Texas, and Utah. I like how the company has clustered its operations in the Southwest and can distribute goods to its stores much easier.

Sprouts' strategy is to lure customers into its stores with competitively-priced produce. After getting shoppers into the stores, the goal is to get them to buy prepackaged items such as food and natural-health supplements that have higher margins. The company plans to continue growing, and now has $333 million from its IPO to finance an expansion. According to the Wall Street Journal, Sprouts sees the potential of having 1,200 stores in the U.S. The company plans to expand its store count by 12% annually over the next five years. Chief executive officer Doug Sanders said,

We're in the early innings of this and there's a lot of room for expansion across the country.

Sprouts is achieving results with its stores. Last year, comparable-store sales rose 9.7%. The gross margin last year was 29.5%. In the first quarter of this year, revenue grew 16.2% from last year's first quarter.

In looking at its shares, Sprouts has a trailing P/E of 194. On the balance sheet, there's $802 million in debt and only $65 million in cash. Sprouts is in the same position as Fairway with a leveraged balance sheet and trading at a high P/E.

The market leader
Whole Foods is the leading natural and organic grocer on the market, with more than $12 billion in sales last year. The company has 355