The Fresh Market Is A Breath Of Fresh Growth

By Stephen D. Simpson, CFA | November 29, 2011 AAA

It's almost traditional (if not quite cliché) to take Wal-Mart (NYSE:WMT) to task for ruining that pastoral ideal that was the American Main Street shopping experience. More recently, neo-hippies have done battle over whether Whole Foods (Nasdaq:WFM) has "gone corporate" by forcing many smaller organic specialty stores out of business, and catering every bit as much to the Audi and soccer mom set as the patchouli and hemp-shirt set.

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With that backdrop, it may seem daft to try to enter the market with yet another food market concept. Even with a market already full of choices, companies like Aldi, Trader Joe's and The Fresh Market (Nasdaq:TFM) are showing that customers still aren't completely satisfied with the retail landscape. While The Fresh Market is going to have to prove that it can manage its growth (and make it a profitable growth), this is one of the most interesting retail growth stories going on today.

A Third Quarter with Growth and Challenges
For the fiscal third quarter, the company grew sales about 12% with a little more than half coming from square footage growth, and the rest from a 5.5% improvement in same-store comps. That's solid performance for a company that does not cater to the "everyday low price" or discount shopping experience crowd.

Profitability was somewhat more worrisome though. Gross margin slid about 60 basis points, and that seems to be the key talking point out of this quarter. Some of this erosion came from higher commodity prices (especially in proteins), while the company also took a hit from higher promotional costs and dead rent from store openings. The company regained some of this through its operations, though, and GAAP operating income rose about 11% and operating margin was basically static. (For related reading, take A Look At Corporate Profit Margins.)

The Challenge of Managing Growth
Ok, talking about "growth and challenges" is something of a cop-out, as every company has challenges and most have some growth. Still, managing significantly better-than-industry growth is more challenging than some investors realize. As a company grows, its logistical challenges increase ((something natural foods distributor United Natural Foods (Nasdaq:UNFI) has had to address)).

At the same time, building new stores drains cash out of a company very quickly - something seen both by Whole Foods and Wild Oats back in the day. And while that new store rollout is going on, there's the issue of making sure the old stores are well-tended and properly maintained (something that has also challenged Whole Foods on occasion).

So it's impressive to see that The Fresh Market only need to grow SG&A by about 10% this quarter, but keeping the right scale of internal operations will be a challenge. It's also worth mentioning that this company's cash margins and returns are stronger than they look, as share-based compensation and deferred taxes take a bite out of reported earnings.

What's the Upside?
Skeptics sometimes dismiss The Fresh Market as a poor man's Whole Foods, but that assessment seems wide of the mark and perhaps a bit oblivious to the different shopping experiences. At the same time, it's not like The Fresh Market has no competition - even in its home state of North Carolina, there is the very small (but growing) would-be rival Earth Fare. Outside of that is the aforementioned Trader Joe's, a bunch of other small regional chains and the ongoing (if inconsistent) attempts by stores like Kroger (NYSE:KR), Safeway (NYSE:SWY) and Ruddick's (NYSE:RDK) Harris Teeter to appeal to the same broadly-defined customer group.

How big can The Fresh Market get? Well, Whole Foods has about 300 stores and Trader Joe's has about 365. Kroger is 10 times that size. While matching Kroger (or Safeway) is not very likely, it's hard to see why it couldn't eventually match and exceed Trader Joe's current store count. That's quite a lot of room for sales expansion.

The Bottom Line
There are certainly some above-average retail growth concepts out there right now, with Vitamin Shoppe (NYSE:VSI) and lululemon (Nasdaq:LULU) coming to mind. Like LULU, The Fresh Market carries a hefty valuation that is absolutely predicated on ongoing beat-and-raise performance. Growth investors may yet find there's still a wave worth riding, but value-oriented investors will have a hard time loving The Fresh Market during this stage of its life. (For related reading on retail, see The 4 R's Of Investing In Retail.)

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

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