Grocery Stock Roundup: Pass on Grocery Outlet, Keep an Eye on Sprouts Farmers Market

Here's my up-front admission: Grocery stores are nowhere near my favorite investment theme. Food and basic staple retailing is an old and hypercompetitive business with low (rightfully, in my opinion) profit margins. Plus, the industry has been facing disruption from the likes of Amazon in recent years, with other big box stores like Walmart and Target also investing heavily in digital grocery and delivery.

That has put pressure on shares of Sprouts Farmers Market (NASDAQ: SFM) even though the organic grocer has been steadily growing its real estate footprint and picking up new traffic at existing stores along the way. Share declines paired with business growth has meant the stock has been flirting with something resembling a value investment, even in spite of my disinterest in the boring grocery space. Meanwhile, recent IPO Grocery Outlet (NASDAQ: GO) is priced as if it's a high-flying technology stock, not a deep-discount food retailer.

Guess which one I think is the better buy.

A woman standing in a produce aisle at a grocery store.

Image source: Getty Images.

Sprouts keeps making progress against the current

Amidst continued intense competition, Sprouts put up good numbers again in the third quarter of 2019. Total sales were up 8% year over year to $1.4 billion, driven by a 1.5% increase in comparable sales at existing locations with the balance made up of new stores (on track for 28 openings to bring the total near 350 by year-end).

Sprouts' expansion is coming at a cost, though. Adjusted earnings are down 11% through the first three quarters of 2019. Higher general and admin expenses are the culprit, having increased 11% and outpacing sales growth of 8% year to date. While existing Sprouts stores are still posting positive comps, the metric is slowing down. The 1.5% rate posted in Q3 compares with an average 3% increase over the last two-year stretch. New CEO Jack Sinclair will need to address that issue as openings are contributing less to overall growth as Sprouts gets bigger over time.  

Debt on the balance sheet taken out to pay for the expansion has also doubled in the last three years and now sits at $515 million. That will also be a metric to keep an eye on, especially if comps sputter. Nevertheless, some of the uncertainty is priced in. Sprouts stock trades for just 11.6 times trailing 12-month free cash flow (money left after operating and capital expenditures are paid). That makes Sprouts one of the cheapest grocery chain stocks around.  

Who's confused about Grocery Outlet?

Grocery Outlet has been hot since its publicly traded debut this past summer. Through Q3, total sales are up 12% to $1.9 billion, driven by a 5.3% increase in comparable sales and an expected 30 new store openings in 2019 (for a total of over 300). Adjusted net income (not using adjusted earnings, as share count is distorted by the recent IPO) is up 20% to $45 million as a result. Those are huge increases for a "boring" grocery store operation.  

Grocery Outlet also used some of its IPO proceeds to clean up its balance sheet. Total debt is down to $463 million after Q3 -- compared to $709 million last year -- giving the chain the wiggle room it needs to execute its aggressive expansion goals (it wants to eventually operate thousands of its treasure hunt-style stores). However, Wall Street has priced Grocery Outlet's stock at a steep premium. Price to 12-month free cash flow is 92.2 -- making it the most expensive name on the grocery block using such a metric, and more than double what other growth names like Costco are going for.  

At these levels, Grocery Outlet stock reminds me of Sprouts when it debuted in 2013. Expectations were high for Sprouts, too, and even though the company has mostly delivered on its expansion efforts, shares have still fallen by half ever since reality has settled in, replacing the initial over-optimism. Even the freshest and most organic product selection around still makes it, at the end of the day, just a grocery store.  

This time around with Grocery Outlet it's all about heavy discounting, something along the lines of being the TJX Companies or Ross Stores of groceries. Maybe I'm missing something here, but as good as Grocery Outlet has done since going public, it just seems too expensive -- toting a sky-high valuation with many years' worth of growth already baked in. Sprouts, on the other hand, seems like the better of the two options with a fair amount of pessimism accounted for in the stock price. Though grocery store stocks are nothing exciting, Sprouts remains on my watch list for that cheap valuation.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Nicholas Rossolillo and his clients have no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Costco Wholesale and The TJX Companies and recommends the following options: long January 2020 $115 calls on Costco Wholesale and short January 2020 $180 calls on Costco Wholesale. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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