Kroger (NYSE:KR), the largest grocery chain in America, will report earnings Friday before the markets open. Analysts expect them to deliver 43 cents per share in earnings on revenue of $20.5 billion. Both would be improvements over last year. While it continues to do battle with Wal-Mart (NYSE:WMT), I’m going to tell you why you should sell Kroger’s stock and replace it with Safeway (NYSE:SWY).

Free Cash Flow

Anyone who invests in the grocery business knows the margins are razor thin. That’s why free cash flow is critical to a store’s success or failure. It’s not enough to be growing same-store sales and revenues — grocers need to be generating free cash flow consistently to make a go of it.

While it’s great that Kroger has increased identical supermarket sales for 30 consecutive quarters, the most important number just might be free cash flow as a percentage of sales. That’s because a healthy business creates more free cash from a dollar of sales than an unhealthy one. Yes, Kroger’s record for growing sales is impressive; however, if it isn’t growing free cash at the same rate, it’s losing the battle.

Over the past five years, Safeway’s free cash flow as a percentage of sales averaged 1.82%. Kroger averaged 1.04%. Even though Kroger has a better record for revenue growth, Safeway manages to create more free cash flow, providing greater shareholder rewards through dividends and share repurchases. Don’t believe me — compare their yields. Even if Safeway’s shares appreciated to Kroger’s level, it still would have a higher yield.

In Procter & Gamble’s (NYSE:PG) annual report, it refers to free cash flow productivity, which is the ratio of free cash flow to net earnings. P&G strives for 90%. Taking the average of their best three years out of the past five, Safeway’s ratio is 97.5%, 1,680 basis points higher than Kroger. Put another way: For every dollar spent on operations, Safeway generates $1.21 in free cash to Kroger’s 75 cents. Same-store sales growth is good to have, but it’s not everything.

Valuation

Here we have a classic case of perception. Kroger is simply sexier than Safeway. At least, that’s the impression I get from comments made on finance guru Jason Kelly’s website. Safeway has cut its capital expenditures in recent years, choosing to invest some of that cash in its private label program. According to Kelly, Safeway’s O Organics and Eating Right brands are each worth $4 billion by themselves. If that’s accurate, you can be sure its enterprise value is higher than $11 billion.

But let’s return to Kroger’s valuation for a moment. Its average price-to-book ratio over the past five years is 3.2, 60% higher than Safeway, and its current enterprise value is 5.3 times EBITDA, compared with 4.6 times for Safeway. So, the question for me is not so much whether Safeway warrants a lower valuation but rather whether Kroger deserves a higher one. Given the difference in free cash flow, I’m inclined to believe Kroger shouldn’t be valued higher despite its revenue growth.

Bottom Line

Ironically, it’s because Safeway’s stock’s performed so abysmally the past decade that I favor it over Kroger. If you invested $10,000 in both stocks in 2001, today you’d have $14,216.19. In that time, Kroger almost broke even while Safeway lost more than half its value. Reversion to the mean suggests these stocks could cross paths in the coming years. It’s not a guarantee, mind you, but it’s certainly a possibility.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.