Over the past generation, the way Americans eat has changed dramatically. Whole Foods Market (NASDAQ: WFM) helped pioneer the shift toward natural and organic foods, and it produced strong growth for decades in meeting the new demand for premium food products. That encouraged competitors like Sprouts Farmers Market (NASDAQ:SFM) to step in and try to improve on the older company's business model.
Recently, though, natural-food specialists have seen increased competition from traditional grocers and other retailers, and that has sent shares of both companies lower. Now, value investors want to know which one is the better buy. Let's take a closer look at Whole Foods and Sprouts, comparing them on a number of metrics to see which one looks more attractive right now.
Valuation and stock performance
Whole Foods and Sprouts have both seen their stocks lose ground over the past year in response to tough conditions in the natural-foods grocery space. Sprouts is down 15% since May 2015, and Whole Foods has fared even worse, dropping 23% over the same time period.
Value investors are used to seeing their favored valuation metrics look a lot more attractive after share prices have gotten hit hard. But in this formerly high-growth area, earnings-based valuations are still relatively high even with the recent decline in both stocks. Looking at earnings over the past 12 months, Whole Foods carries a trailing earnings multiple of 22, and that compares favorably to Sprouts and its current price of 28 times trailing earnings.
When you project earnings expectations into the future, though, the disparity narrows considerably. Sprouts' forward earnings multiple is 22, while Whole Foods trades at just less than 21 times forward earnings estimates. Given its bigger share-price decline, Whole Foods carries a slightly cheaper valuation, but a lot of that depends on how much faith you put in Whole Foods' ability to bounce back from its recent setbacks.
Dividends and return of capital
When it comes to dividends, there's no contest between Whole Foods and Sprouts. As the younger company, Sprouts has never paid a dividend, instead plowing its spare capital back into its business. By contrast, Whole Foods pays a modest but not insignificant dividend that yields 1.7%, and the company has been good about boosting that payout gradually over the past five years.
However, both Sprouts and Whole Foods have responded to the drop in their stock prices by making share repurchases. For Sprouts, spending roughly $25 million in the fourth quarter of 2015 and $60 million in the first quarter of this year represented a sizable commitment for a grocer with a market cap of less than $4 billion. The larger Whole Foods has been more aggressive in returning capital to shareholders, spending nearly $1 billion on buybacks in the second half of 2015 and continuing to make repurchases in its most recent quarter. Whole Foods has a demonstrated edge in how it has deployed money in shareholder-friendly ways, even though Sprouts has quickly learned how to respond to changing market conditions.
The response most Sprouts shareholders would make to the two arguments above is that Whole Foods clearly has a successful past, but the future is up for grabs. Sprouts investors expect the company to have a much higher growth rate over the next five years, weighing in at roughly 16% compared to just 6% for Whole Foods. Yet recent results suggest those expectations might prove to be overly optimistic. In its first-quarter results, Sprouts managed to grow revenue by 16% from year-ago levels, posting a 4.8% rise in comparable-store sales and a 20% jump in its bottom line. Yet those sales gains were slower than most investors were looking to see. In addition, Sprouts chose to adjust its guidance to reflect the low inflationary environment and the timing of its new store openings. Given the reliance on new locations in driving Sprouts' growth, any long-term slowdown in the pace of building could eat into the company's ability to boost its top line.
Meanwhile, Whole Foods is going through an extremely tough time. In its most recent quarter, comparable-store sales fell 3%, accelerating from declines in the previous quarter. Overall revenue climbed just over 1%, and net income dropped 10% from year-ago levels. Only the aggressive buyback activity Whole Foods has implemented was able to hold its earnings per share constant. Yet Whole Foods is optimistic about its expansion plans, especially with the first location of its new 365 store concept having recently opened. The company hopes 365 stores will appeal to a new demographic, broadening Whole Foods' overall customer base and helping to support the brand identity the grocer has tried to establish over the past couple of years. Nevertheless, Whole Foods expects comparable-store sales for the year to fall at least 2%, and that could push out turnaround plans further into the future than investors would prefer.
Whole Foods and Sprouts are in the same industry, but their positions are almost completely different. For value investors who believe in the turnaround potential of a well-known brand, Whole Foods is an obvious choice. But for those who prefer smaller up-and-coming stocks with greater growth potential, Sprouts makes sense if you think the competitive pressures hitting the entire industry won't leave the smaller player scrambling for a foothold.
John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Dan Caplinger owns shares of Whole Foods Market. The Motley Fool owns shares of and recommends 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.