Big Valuation/Small Miss Wrong Combo For The Fresh Market

By Stephen D. Simpson, CFA | November 29, 2012 AAA

What's going on in the wake of the third-quarter earnings report from The Fresh Market (Nasdaq:TFM) will be altogether familiar for veteran investors. Here we have a great growth company, perhaps one of the best growth plays today on the mass-affluent customer category, but with a stock that carried nosebleed valuations. Q3 earnings showed a hiccup in store traffic and margin leverage, and the stock got pummeled. Although I still like the growth story at The Fresh Market just fine (as well as the stores themselves), I'm still a long way from liking the stock.

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A Third Quarter That Really Wasn't That Bad
It's a fact of Wall Street life that high valuations mean high expectations, so I suppose it's not altogether rational to view the company's results through a wholly objective lens. Even with that said, though, this wasn't a bad quarter.

Revenue rose 22% and actually slightly beat the average sell-side estimate, but comps were up 5.6% and about a full point shy of expectations. Not only was this a meaningful deceleration from last quarter (up 8%), but volume growth had been tracking at 5% or better for three quarters, and it grew just 3.3% this quarter (while the average ticket grew 2.3%).

Margins were likewise mixed. Gross margin growth of over a point was quite good, but operating income rose 23% and operating margin expanded only 10 basis points. SG&A, as a percent of sales, was one point higher than expected (due in large part, it seems, to higher pre-open expenses), and that thumped the margin number.

SEE: Understanding The Income Statement

Does Whole Food Make It Sting More?
While it's not entirely fair to compare Whole Foods (Nasdaq:WFM) to The Fresh Market, it's done all the time anyway. In terms of their recent quarters, it's not a comparison that favors The Fresh Market.

Whole Foods saw comps up 8.5% in its last quarter, with traffic up 7%. Not only did gross margin improve by a similar amount (80 basis points versus 110), but it's two points higher than the gross margin of The Fresh Market overall, and likewise operating margin was stronger.

Is There Really a Problem Here?
I understand that The Fresh Market's high valuation means there's virtually no room for error and that every mistake will look much larger. That said, I'm not sure there's a real problem here.

Yes, the traffic decline is not good, but I'd argue that having 127 stores in 25 states makes them more vulnerable to quirks or weather issues in a given quarter. Likewise, the company's more limited grocery assortment gives it a few less merchandising levels to pull relative to Whole Foods, Trader Joe's or other retail alternatives like Costco (Nasdaq:COST) or even Kroger (NYSE:KR).

So, too, on the margin issue. It takes money to open new stores, and while the higher-than-expected expenses are not welcome, it shouldn't exactly come as a surprise to experienced retail investors.

If there is a problem, it may be in the unexpected resignation of company CFO Lisa Klinger. The Fresh Market is probably, conservatively, only one-quarter of the way through its store growth potential, so it's a little disconcerting to see a top executive leave for other opportunities. It also doesn't help matters that, as near as I can tell, Klinger enjoyed at least a solid reputation with the company's analysts.

SEE: Earning Forecasts: A Primer

The Bottom Line
The Fresh Market is targeting the same demographic that has done so well for companies as varied as Starbucks (Nasdaq:SBUX), Whole Foods, Nordstrom (NYSE:JWN), Cheesecake Factory (Nasdaq:CAKE) and lululemon athletica (Nasdaq:LULU). That's not to say that these companies have all had identical experiences and trajectories, but the point is that The Fresh Market is fishing in fruitful waters.

All of that said, I still have no particular love for the stock. Even with extremely robust growth assumptions, I just cannot build a cogent model that suggests this stock is undervalued today. While I know that growth investors will scoff at that, I just can't get comfortable with the downside risk of paying so much for what is, legitimately, a very strong consumer growth story.

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

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