As I wrote a quarter ago, The Fresh Market (NYSE:TFM) is a highly-valued growth stock in the food retail space, and one where the company is starting to see some real pushback from the market as to the company's margin structure and competitiveness. I didn't expect all of the concerns to get resolved in one quarter, but the company's willingness to increase promotions and accelerate store builds seems to be exactly what the Street does not want to hear right now. As I suspect there's a good chance of these shares getting even cheaper, investors may want to keep on eye on this name as a growth stock increasingly trading at a reasonable valuation.
Second Quarter Earnings Don't Deliver
Although The Fresh Market did basically okay in terms of top- and bottom-line performance relative to expectations, this is a story where analysts and investors are increasingly digging into the details and not coming away very pleased.
Revenue rose 11% this quarter and comp-store growth rebounded to 3.4%. In particular, a recovery in traffic (up 1.8% versus 0.6% in the first quarter) should be welcome given the concerns about comps after the first quarter.
Margins, though, remain a worry. Gross margin improved 10bp from last year, but slid more than a point sequentially. While store occupancy costs certainly played a role, I think investors are going to be quite troubled by management's comments about more intensive promotion activity – while the increase in revenue sold via promotions was not large (22% versus 21% last year), the Street has really seized on margins as a key topic here. To that end, the company's 19% operating income growth and 40bp expansion in operating margin was below where many analysts were looking.
At the risk of belaboring the topic, margin performance and guidance really is taking all of the attention these days. Whole Foods (NYSE:WFM) has made a big deal out of their corporate strategy of “reinvesting” into produce margins, and its latest comp number was quite a bit stronger than The Fresh Market's (7.5%, with 4% traffic/transaction growth). Likewise, Wal-Mart (NYSE:WMT) and Kroger (NYSE:KR) have been aggressively marketing their new emphasis on quality, value-priced produce assortments, and this is really the tentpole for The Fresh Market's merchandising strategy.
But it's not just about what The Fresh Market is selling – it's also about the cost of growth. I don't think it will surprise readers to learn that there are costs involved in opening new stores, as you don't go from opening the doors for the first time to 100% capacity overnight.
Managing growth is a key factor for growth retailers (including The Fresh Market, Natural Grocers (Nasdaq:NGVC), and Sprout (NYSE:SFM)), and while the Street certainly recognizes that The Fresh Market must continue to open new stores to meet its long-term growth targets, there's also a worry that management is going to push too hard and lose discipline with respect to expenses and new store economics. To that end, margin guidance and the accelerated store construction schedule clearly has the Street worried.
The Bottom Line
I am inclined to lean the other way, as I don't believe there is any reason to believe that The Fresh Market has abandoned what was previously a disciplined, returns-focused model for store growth. Now I am a little more worried about competition from Whole Foods and Wal-Mart, and I think management needs to re-prove that it can offer a shopping experience distinct enough to draw in customers even as these rivals improve their pricing and assortment (respectively).
Many growth stories hit bumps along the way, and it looks like The Fresh Market has its own. At this point I believe it's more a “rite of passage” than a sign of future trouble. To that end, mid-teens long-term revenue growth still supports a fair value in the neighborhood of $47 and if this pullback goes too far, I just may pick up shares in what I still believe to be a quality long-term growth story.
Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.