The Fresh Market - Risk/Reward Improves, Still Not Appealing Enough

| About: The Fresh (TFM)


Shares have lost half their value as comparable store sales growth slowed down dramatically.

Store closures and high related costs have scared off investors as well.

Long-term appeal remains if the company executes well, I would like to see a better entry opportunity before picking up shares.

Last week, The Fresh Market (NASDAQ:TFM) released its first quarter results which came as a relief to the market. This came as its major competitor Whole Foods Market (NASDAQ:WFM) released a weak set of reports earlier this earnings season.

First Quarter Headlines

The Fresh Market reported first quarter sales of $431.0 million which was up by 17.6% compared to the year before. Sales growth was mainly driven by new store openings with comparable store sales increasing by 2.5%. The number of transactions rose by 1.8% while the transaction size increased by 0.7%.

The company reported net earnings of $16.6 million versus a $22.1 million profit the year before as store closings in Texas and California cost the company some $7.0 million on a pre-tax basis.

Gross margins were under pressure as the retail environment got more price competitive. Margins fell 90 basis points to 34.4% of sales amidst price competitiveness and cost inflation.

Operating expenses rose by 70 basis points to 22.9% of sales amidst higher pre-opening expenses. As a result of expenses related to store closures and the developments as discussed above, operating margins were down by 330 basis points to 6.4% of total sales. Excluding store closure costs operating margins would have come in around 8.0%.

Investors Presentation

Back in September, The Fresh Market issued an informative presentation at the Goldman Sachs retail conference. Ironically enough the company was still very upbeat about the prospects for the markets in Texas and California at the time.

A little over half a year ago the company cited a large market opportunity with the natural and organic channel being the fastest growing channel within the retail sector. Demand for fresh and healthy perishable food continues as the strong quality, customer service and neighborhood atmosphere experience of the company's stores should allure customers.

The company's stores typically hold about 10,000 stock keeping units, much less than some of its larger competitors which can be an advantage in densely populated areas.

The company foresees an opportunity for more than 500 stores going forward, operating in the ¨sweet spot¨ of quality and prices thereby creating ¨affordable luxury¨ for customers. At the moment, the company has the most stores in the Eastern parts of the nation.

Outlook For 2014

For the fiscal year of 2014, the company now anticipated comparable store sales growth of 1.5% to 3.5%. The company aims to open 23 to 24 stores with 12-13 openings planned in the second half of the year. On top of this, 4 or 5 stores are anticipated to be remodeled.

Important to notice, the total closure and exit costs related to the four store closures in California and Texas total $21 million. Of this some $7 million have been taken in the first quarter with the remainder of costs anticipated to be taken in the second quarter.

Valuing The Company

The company currently holds $19.1 million in cash and equivalents. Total debt stands at just $0.5 million although the company has $33.7 million in capital lease obligations on its balance sheet.

Trading at $30 per share, the company's equity is valued around $1.45 billion. Assuming annual revenues of around $1.75 billion the company is valued at 0.8 times annual revenues. The company would perform well if it is able to report net earnings of $50 million for this year after factoring in anticipated closure costs. Even then, shares trade at 30 times earnings.

Given the anticipated growth and capital expenditures required related to store openings, the company does not pay a dividend at the moment.

Tough Times For Investors

Investors in the company have completely missed out on the solid stock market performance in recent years. Shares have peaked at levels above $60 late in 2012. As a matter of fact, shares traded as high as $57 in August of last summer before losing half of their value.

A drop in comparable sales growth and unprofitable new store openings combined with increased competition in the industry put pressure on the shares. The latest warning of Whole Foods sent shares of The Fresh Market more than 25% lower for the year.

At current levels, shares trade just a few bucks below the IPO price of $32 in November of 2010.

Implications For Growth Investors

During the first quarter, the company opened 7 stores to end the quarter with 154 stores. This implies that the average store generates sales of $2.8 million during the quarter. Based on the company's long-term potential of 500 stores within the nation, revenues of $5 to $6 billion appear to be attainable.

The company reported net after-tax margins of 4-5% in recent years which is quite steep and appears unsustainable. Based on current conditions, net profit margins of 3% are more likely, which could still result in earnings of $150 to $180 million assuming the company operates 500 stores in the future.

To operate so many stores, additional investments of $1-$1.5 billion are required over the course of time. As the company grows its store base at a rate of 15% per annum it could take nearly a decade to achieve this store base. Operational cash flows should be able to fund the expansion over this time period.

Even if I am being generous and attach a 4% profit margin to those revenues, earnings of $200-$250 million appear realistic. Applying a generous 20 times earnings multiple to such a business leaves a $4-$5 billion valuation. This would imply a $100 price target a decade ahead in time, which implies annual returns of about 13%.

These appear to be very appealing long-term returns, yet it does assume a successful and profitable expansion. The fact that the company already takes charges of a hefty $21 million to close 4 stores makes you want to rethink the optimistic scenario. What if the company runs 500 stores and has a few underperforming stores, how high would ¨one-time¨ charges be in such a scenario?

For that reason I remain cautious, although I believe the risk-reward improves notably around $25 per share.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.