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Wednesday's Top Upgrades (and Downgrades)

By Rich Smith - Dec 18, 2013 at 2:20PM

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Analyst picks two winners in the upscale-grocery-store segment.

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're looking at one segment of the market in particular -- grocery markets -- and one analyst in particular that's decided to go shopping: Stephens.

Christmas shopping for grocery stocks
Stephens initiated coverage of the upscale "natural" grocery stocks this morning, recommending investors buy two of the smaller players -- The Fresh Market (NASDAQ: TFM) and Natural Grocers ( NGVC 2.06% ) -- but leave larger players Whole Foods Market ( WFM ) and Sprouts Farmers Market ( SFM 1.93% ) on the shelf. Why?

To try to figure this out, let's start with the name we know best. Whole Foods Market (market cap $21.2 billion) started the trend toward "whole paycheck" grocery shopping. It's so well known to investors that I suspect one reason imitators Sprouts and The Fresh Market chose to ticker their stocks as they did -- SFM and TFM -- was to try to bask in the reflected glow of the ticker symbol for Whole Foods: WFM.

After racking up compound-annual-earnings growth north of 50% over the past five years, Whole Foods remains a fast grower today. Consensus estimates from the analysts project that Whole Foods will continue growing earnings at an 18% clip over the next five years. And yet, with a P/E ratio north of 38, it's hard to argue the stock is cheap, or even fairly priced, so as to justify a buy recommendation. Accordingly, all Stephens will give it is an "equal weight" rating.

Wither Sprouts?
If Whole Foods' stock looks expensive, then Sprouts' P/E has grown right up into the clouds. The stock currently costs more than 111 times trailing earnings -- nearly three times the valuation at Whole Foods, despite having a growth rate only about 8 percentage points faster than the organic-grocery giant.

Other factors making Sprouts less attractive for investment: The company carries $380 million in net debt -- Whole Foods has more than $1 billion in cash and minimal debt -- and Sprouts pays no dividend, whereas Whole Foods pays a modest 0.9%.

While I'm not particularly enthusiastic about the valuations of either of these two stocks -- and agree with Stephens declining to recommend them -- I think Sprouts probably deserves an even worse rating than the equal weight the analyst assigned it.

And now for the nominees...
But what about the two stocks that Stephens likes?

Natural Grocers
Well, Natural Grocers carries a lower P/E than does Sprouts (87 times earnings). But it's much more expensive than Whole Foods on a P/E basis. Natural Grocers resembles Sprouts in that it pays no dividend and has similar expectations for growth (29% annually over the next five years).

Natural Grocers also carries more debt than cash on its balance sheet and, unlike either Whole Foods or Sprouts, is not currently generating free cash flow on its own to pay down that debt. Over the past 12 months, the company burned through $14 million -- a worse performance than we've seen at the company at any time in the last five years.

Paying a high price for earnings of such low quality sounds like a poor value proposition to me. So, I'm forced to conclude Stephens has made a mistake in recommending this one.

What about The Fresh Market, our final contender?

The Fresh Market
Here, we've got a stock with a projected 20% growth rate and trading at nearly 28 times earnings. On the face of it, therefore, this makes Fresh Market the closest thing we've seen yet to a "good value." But there are caveats.

For one thing, Fresh Market has missed projections twice in the last four quarters. This suggests we might want to take the 20% growth rate with a few grains of salt until the company starts to show it can achieve it consistently. For another thing, the profits Fresh Market is earning appear to be of a quality nearly as bad as those of Natural Grocers.

Free cash flow at Fresh Market, although positive, is only barely so. The company generated less than $10 million in FCF over the past year -- or about $0.14 in real cash profits for every $1 it reported "earning" under GAAP accounting standards. If valued on its FCF, therefore, the stock would be selling for not the 28 multiple to earnings that we see on the surface but a valuation of 200 times FCF. Even if the stock were to achieve its projected 20% growth rate, that would be a steep price to pay.

Bag these stocks?
In sum, Stephens has given us new ratings on four upscale grocers. The two it declines to recommend, Whole Foods and Sprouts, I can't see any reason to recommend either. The two that Stephens does recommend buying, Natural Grocers and Fresh Market, don't look like great bargains to me either.

I wouldn't buy a single one of them.

Fool contributor Rich Smith has no position in any stocks mentioned. His opinions are not necessarily those of the Fool. In fact, The Motley Fool recommends The Fresh Market and Whole Foods Market. The Motley Fool also owns shares of Whole Foods Market. John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Whole Foods Market, Inc. Stock Quote
Whole Foods Market, Inc.
Natural Grocers by Vitamin Cottage, Inc. Stock Quote
Natural Grocers by Vitamin Cottage, Inc.
$13.39 (2.06%) $0.27
Sprouts Farmers Market, Inc. Stock Quote
Sprouts Farmers Market, Inc.
$26.93 (1.93%) $0.51

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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