The Fresh Market Facing Its First Real Challenge

By Stephen D. Simpson, CFA | May 29, 2013 AAA

Every company has growing pains, and what separates the long-term winners from the flash-in-the-pans is how management responds to those challenges. The Fresh Market (NYSE:TFM) continues to post very strong returns on capital and has a sound business plan that looks to exploit more affluent shoppers' desire for high-quality produce that they cannot find in conventional supermarkets. For now, though, the company's comps growth appears to have stalled and a renewed emphasis on produce from major competitors threatens the company's value proposition to the customer.

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A Decent Result, But Growth Challenges Aren't Going Away
With another soft quarter of comp-store growth, I think it's very hard to wave away the growth challenges that The Fresh Market is facing. Weather may have played a role, but I don't think it's wise to underestimate the possibility that the competitive efforts of rivals like Whole Foods (NYSE:WFM) are having an impact.

Revenue rose 13% this quarter, which was a little weaker than the average estimate. Comps growth was just 3%, though, and continued a pattern of deceleration that has being going on for several quarters now. Within the comps, traffic was up just 0.6%, with a high ticket making up the remainder.

While growth has slowed, the company is seeing better profitability. Gross margin improved 60bp for the quarter, while operating income rose 14% and operating margin expanded 10bp. At the risk of looking a gift horse in the mouth, I would point out that the company is getting a boost to margins from a slower pace of new store openings.

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How Much Are Competitors Curtailing Growth?
Many retailers cited bad weather for poor sales in the first fiscal quarter of this year, but I would have expected The Fresh Market to see more benefit from its large store concentration in Florida and North Carolina (where weather was relatively better).

This leads me to what is probably the number one concern now among investors and analysts – whether The Fresh Market is falling prey to a stronger focus on produce from its competitors. Whole Foods has been quite clear about its intention to “reinvest” margin leverage into lower prices in its produce section. Likewise, conventional retailers like Wal-Mart (NYSE:WMT) and Kroger (NYSE:KR) have also made refreshed, remodeled, and expanded produce sections a priority.

This can't be helping The Fresh Market. While the company has a selection that's hard to beat, I have my doubts about whether the casual weekend shopper will make the extra trip to The Fresh Market if and when they can find an improved selection (and/or price) at these other stores. While the company arguably does have the margin and ROIC leeway to compete a little harder on price, I'm not sure how investors would respond to such a move.

A Sensible Plan Exploiting A Real Niche
Although I believe the company is facing some near-term turbulence from the actions of its rivals, I like the business plan that The Fresh Market is pursuing. The company has made returns on capital an explicit priority and generates solid margins in a notoriously margin-poor industry. What's more, the company seems content to live within its means; while I suspect the company could borrow money and open stores at a much faster rate, management seems disinclined to spend beyond what its operating cash flow can fund.

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I likewise believe that the company has identified a real market opportunity (fresh produce) and one that can drive loyal customer acquisition. Rivals like Wal-Mart and Kroger can't do everything, and I do wonder how truly committed they are to their own produce sections. Then there are rival supermarkets like Target (NYSE:TGT) that barely even appear to be trying. That leaves Whole Foods as a looming unknown – if Whole Foods really wants to compete with The Fresh Market on price, they'll be a formidable threat, though I do believe there's enough business to go around for both of them.

The Bottom Line
I've long lamented the accept-no-disappoint valuation at The Fresh Market, and it looks like that sky-high valuation has played a role in this stock being a notable underperformer over the past year (even with the 10% post-earnings rise). With that underperformance, though, the valuation no longer looks quite as unreasonable as before.

My expectation of 15% long-term revenue growth is pretty demanding, as is my expectation that The Fresh Market will be uncommonly successful at generating free cash flow down the line (a free cash flow margin of over 6%, or double the peer group average). Even with that, my fair value target of around $45 is below the current price. That said, legitimate growth stories rarely trade at a discount to fair value, and while there are certainly risks now that the company cannot re-accelerate comp-store growth, more aggressive investors may want to consider this name.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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