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Shares of The Fresh Market (NASDAQ:TFM) are selling off after the specialty grocery retailer failed to meet high expectations for the second quarter.

Investors and analysts are disappointed with the full year earnings outlook on the back of higher store opening expenses.

I think the current valuation remains a bit rich, even after the sell-off, and therefore remain on the sidelines.

Second Quarter Results

The Fresh Market generated second quarter revenues of $354.8 million, up 13.3% on the year before. Growth was supported by a 3.4% increase in comparable store sales. Revenues came in a bit short of consensus estimates of $356.8 million.

Net income rose from $13.3 million to $15.6 million, as diluted earnings per share rose by 17% to $0.32. Earnings came in exactly in line with consensus estimates.

Looking Into The Results

The Fresh Market's revenue growth was mostly driven by new store openings which explained three quarters of total revenue growth. The resulting 3.4% increase in comparable store sales growth was boosted by a 1.8% increase in the number of transactions and a 1.6% increase in units per transaction.

Gross profit growth slightly outpaced revenue growth as gross margins increased by 9 basis points to 34.19% of total revenues, as a result of lower occupancy costs.

The company has seen solid operating leverage as selling, general and administrative expenses fell by 40 basis points to 23.3% of total sales. Last year, the Fresh Market took $1.1 million in legal expenses for the period, which reduced expenses by 30 basis points of sales.

All in all, operating income rose by 40 basis points to 7.3% of total sales.

Looking Into The Remainder Of The Year

For the full year of its fiscal 2013, The Fresh Market anticipates to open 21-22 stores, with 10-11 openings planned in the third quarter.

As a result of the store openings in the third quarter, the company anticipates to incur meaningful occupancy and pre-opening costs for the remainder of the year.

Full year comparable store sales are seen up between 3.0 and 4.5%. Operating margins are seen flat or up a little bit.

All in all, The Fresh Market sees full year earnings between $1.50 and $1.55 per share. Consensus estimates for full year earnings stood at $1.57 per share.

Valuation

The Fresh Market ended its second quarter with $16.0 million in cash and $45.0 million in total debt, including capital lease obligations. This results in a modest net debt position of around $29 million.

Revenues for the first six months of the year came in at $721.4 million, up 13.1% on the year before. Net earnings rose by 15.8% to $37.8 million. Full year revenues are seen between $1.5 and $1.6 billion as earnings should come in around $75 million.

Factoring in losses of 10%, with shares exchanging hands at $48 per share, the market values The Fresh Market at $2.3 billion. This values operating assets of the firm at 1.5 times annual revenues and 31 times annual earnings.

The Fresh Market does not pay a dividend at the moment.

Some Historical Perspective

Shares of The Fresh Market were sold to the general public back in November of 2010. Shares were eventually offered at $22 per share, above the $18-$20 preliminary offering range. Shares have never seen levels in their twenties again and peaked around $60 in Autumn of 2012.

Shares sold off to $40 in April of this year. After witnessing a recent run-up, they are currently exchanging hands at $48 per share.

Between the calendar year of 2009 and 2012, The Fresh Market has increased its annual revenues by a cumulative 36% to $1.33 billion. Net earnings tripled to $64.1 million in the meantime. For 2013 both sales and earnings are predicted to show continued growth.

Investment Thesis

The Fresh Market has seen much interest from the investment community after its public offering in 2010. The specialty retailer, which focuses on high-quality and fresh food, is a Wall Street darling as it has shown rapid growth.

The company now operates 139 stores. The low current store base gives The Fresh Market enough potential to show rapid growth going forward. The company plans 21-22 openings for the full year, with another 10-11 openings planned for the current quarter.

The plans support the Fresh Market's long-term growth profile of increasing the annual store base by 15%, reporting 3-5% growth in comparable sales, and boosting earnings even further by positive operating leverage.

The drop in earnings growth for the rest of the year is largely due to expenses being incurred by stepping up the pace of store openings in the third and fourth quarter of the year.

The current valuation, at 30 times annual earnings and 1.5 times annual revenues, implies the market is still confident in The Fresh Market's long term earnings thesis. Yet the pace of store openings is requiring a lot of capital expenditures. Growing comparable sales is much more effective and requires much less cash. Yet the current growth rate of 3.4% is at the low end of the company's target of 3-5% growth.

Despite the sell-off, I do not think shares are an obvious buy at these levels. The valuation is a bit rich to my taste. I remain cautious and remain on the sidelines.

Source: The Fresh Market: Not Appealing Enough, Even After A 10% Sell-Off