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A Fruitful Business for the Berry Family

In 1982, Ray Berry and his wife opened the first Fresh Market (NASDAQ:TFM) in Greensboro, North Carolina with the vision of creating an intimate premium grocery store that recalled an old world market featuring excellent customer service and high quality food. Today, The Fresh Market operates 100 stores across 20 states, with many locations in the Southeast, particularly Florida. In a November 2010 IPO, approximately one third of the company was sold by the founding family to the public for $22 per share. As an IPO in an arguably frothy stock market, with a compelling growth story in the hot natural/organic foods space, The Fresh Market has more than doubled in price to $45 per share as of this writing.

Thesis

At a significant premium to its most relevant comp Whole Foods (WFMI), The Fresh Market trades at over 2X sales and 50X 2010E earnings and is priced to perfection even using optimistic growth assumptions. As The Fresh Market expands beyond its traditional base of Florida, Georgia, and North Carolina, the company will have to execute rapid expansion flawlessly in order to meet the market’s lofty expectations and even then shareholders are probably not being compensated for the stock’s risk.

For these reasons, The Fresh Market’s stock is overvalued on both an absolute and relative basis, and is a good candidate for a short sale, with the caveat that shorting a growth stock based solely on valuation has its risks (Read: OPEN). On the other hand, this is no sexy “network effect” tech business with the possibility of bringing on new revenue streams, or even a company with decreasing incremental costs; it is simply a high-end food retailer at a very high-end price.

Growth Story

In the past ten years, The Fresh Market has tripled its store base to one hundred stores. Considering only three states, Florida (24 stores), Georgia (15 stores) and North Carolina (10 stores) comprise 49% of their store base, the rest of the United States offers ample ground for expansion (see store map below). An independent consulting group estimates that the U.S. consumer can sustainably support 500 stores before the concept reaches maturity. The Fresh Market caters to an affluent customer, so while mainstream grocers’ store counts number in the thousands, The Fresh Market’s delicious high quality foods are well out of the price range of most shoppers.

The Fresh Market

Operating History : Gangbuster Growth Tempered by Recession

The IPO Prospectus reveals The Fresh Market’s impressive performance and growth over the past 5 years (see table below). In the years at the top of the housing/credit-fueled consumer spending explosion (2005-2007), The Fresh Market grew store count by 45% (53-77 stores), while increasing same store sales in each year, achieving peak store sales per square foot of $533 for 2007. Following the collapse of the financial and real estate markets and the ensuing recession, The Fresh Market’s same store sales growth rates turned negative, but revenue and earnings increased due to increase in-store count which was up 28% (77-99) from the end of 2007 to the present.

This makes sense especially given the company’s concentration in housing market-sensitive Florida, which was and still is hit hard by the recession. As you can see from the first 9 months 2009/2010 comparison, The Fresh Market has rebounded somewhat in terms of same store sales. But annualizing the first 9 months of 2010, sales per square foot come to $457, still well below the 2007 peak of $533. (Note : There is surely some seasonality at work by leaving out the fourth quarter). Nevertheless, The Fresh Market appears to be recovering and poised to continue growing its store count as it expands into new markets. However, it would take a prolonged economic recovery to reach per store sales metrics of 2007.

click to enlarge

Source : IPO Prospectus, Page 25

Unsustainable High Net Margins Ending with Tax Status Change

From 2005-present, The Fresh Market’s operating margins have fluctuated between 4% and just above 6%, very nice for a grocer, while its net margins have been only 30 to 70 bps below that almost solely from interest expense. An astute reader may think something must be amiss in that The Fresh Market’s tax rate has essentially been nil. This is correct. Prior to becoming a public company, The Fresh Market was organized as a family-run S Corporation and was not taxed at the company level. Instead family members have paid taxes at the individual level using both dividends from the company and borrowings on the company’s credit facility. As The Fresh Market transitions from a family-run S Corp. to a publicly traded C Corp., its tax rate will increase dramatically from 0% to an estimated 39% using the prospectus’ own projections and Whole Foods’ tax rate of 40%. Here are the pro forma numbers from the prospectus, showing more realistic, slimmer net margins, which will be used in the valuation model:

Source : IPO Prospectus Page 26

Valuation Model

Using the financial information offered in the prospectus along with some growth projections, we can attempt to value The Fresh Market. Since we have a reasonable estimate of a mature store base and 5 years of operating data, a rough method of valuing the company is to predict the value of the mature company in today’s dollars, then estimate how long the company will take to reach maturity. For our most bullish of bull cases, we will assume the market can accommodate 600 stores producing $550 per square foot at net margins of a very healthy 4.5%. It should be noted that this store base is 20% higher than that of the independent consultants’ estimation, the net margins have never been obtained by The Fresh Market on a pro forma after tax basis, and that sales per square foot were $533 at The Fresh Market’s peak per store performance, when its stores were concentrated in a Florida economy on real estate steroids. Our less pie-in-the-sky projections can be seen in the table.

At its current market capitalization of $2.2B, The Fresh Market is currently valued at around 15X our base case maturity earnings projections and above all of our bear case projections, which are not too pessimistic. But let us be generous and bull-market investors and assume that The Fresh Market can indeed earn $300M one day and be worth $6B. How long will it take The Fresh Market to build out to 600 stores? It built around 10 per year in the previous years to get from 50 to 100. How many years will it take to go from 100 to 600?

This is not the type of business where each incremental unit costs less to produce. New stores cost the company around $4M. Opening 500 stores would cost The Fresh Market around $2B. Since the company, intends to use all after tax/maintenance free cash flow to fund new store openings, we can estimate the pace at which The Fresh Market can open new stores by projecting its future cash flows. Pro forma net income for the first nine months of 2010 was $25M, or $33M annualized. Giving an unscientific $5M bump for seasonality comes to $38M and adding back $30M of depreciation which appears overstated, reveals around $68M for an estimate of operating cash flow or $680K per store. The VERY rudimentary model below estimates 13 years for a build-out to maturity.

While this model is certainly not without flaws, 13 years is an adequately bullish estimate of the time it would take for The Fresh Market to sextuple its store base. In my opinion, it is downright euphoric, considering the difficulties of rapidly expanding a business. Assuming all goes smoothly and The Fresh Market does indeed grow to become a 600 store national grocer within 13 years and it commands a P/E of 20 as a mature company, an investment at its current market capitalization of $2.2B will have returned 177% over the period, or 7.5% annualized. Think about that for a second. With extremely generous assumptions, The Fresh Market will have merely been a respectable investment, but certainly not a home run. Or put another way, is 7.5% per year enough to compensate an investor for the the The Fresh Market's risks which include food price inflation, increasing competition, and expansion execution? If The Fresh Market takes longer to expand the returns investors to investors will be much lower. Using the same bullish maturity value and 20 years, results in an annualized return of about 5%.

Historical Context: Whole Foods
Whole Foods currently operates 300 stores. They too once had 100 stores in 20 states (just like The Fresh Market) all the way back in 2000. While its taken 10 years for Whole Foods to triple its store base opening 20 new stores per year, we assumed 13 years for The Fresh Market to sextuple its at 38 new stores per year. Sure Fresh Market stores are smaller and perhaps there are more suitable locations, but can the company grow much more quickly? Compare those figures to the 10 per year the The Fresh Market has opened in the past 5 years and 14 in their year of greatest expansion (2006-2007). Also note that the idea of straight-up, unstopped expansion pays no heed to the effects of the business cycle, and the inelastic demand for The Fresh Market's expensive gourmet food.

According to its annual report for the year 1999, Whole Foods made $42M in net income from 100 stores and traded between $37-58 on 26M shares outstanding for a market cap of $962-$1.5B ($using 1.5B around 35X earnings compared to TFM's 55X). Using $58/share ($15 adjusted for splits and dilution) Whole Foods has given shareholders a 300% return and 14% annualized in the past ten years excluding dividends: a great growth investment. But The Fresh Market trades for $2.2B, 50% higher than Whole Foods' 2000 market cap. Another way to put this is that The Fresh Market would have to more than duplicate Whole Foods' last ten years of growth to be the home run that was Whole Foods. Remember, that The Fresh Market would have to open its smaller stores stores at nearly double the rate of Whole Foods to maintain similar growth in revenue and earnings. All the while, The Fresh Market has the go-go days of the housing bubble behind it from which it benefited disproportionately with so many stores in Florida, and the company enters new geographies with increasing competition (Trader Joe's, Whole Foods, upmarket brands of traditional supermarkets). A repeat of the Whole Foods story is simply not probable and at today's valuation will not provide a repeat of WFMI's returns.

A More Likely Scenario : Slowing Growth and Increasing Competition

While it would be nice if The Fresh Market could be a $6B dollar company one day, it is much more likely that the company will encounter increasing difficulties to maintain its impressive growth rates as it expands out of the Southeast and into markets where competitors have stronger footholds. With half their stores in three states, expansion into new territories, is unlikely to drive significant synergies or economies of scale, perhaps leading to margin decline. Look back at the historical financials and notice that operating margins above 5% were not realized until store count growth slowed during the recession. Shareholders buying in at these prices will end up disappointed in the long term. Furthermore, The Fresh Market and other premium grocers like Whole Foods have been excellent growth stories over the past decade and enjoyed very high returns on capital employed. But do these companies possess any sort of long term competitive advantage? Good natural food is good natural food. In the long term, competitive pressures may decrease industry wide-margins which are higher than traditional groceries.

Near Term Catalyst : End of Lockup Period for Family

While this analysis may convince you that The Fresh Market is overvalued, it is another thing to convince you to short the stock. The trade is easy to put on as a retail investor with easy borrow (Short Ratio of 8 according to shortsqueeze.com) and decent liquidity, but markets can be irrational for years, why short TFM now? The answer lay in The Fresh Market’s ownership, which is concentrated in the hands of the Berry family and other insiders to the tune of 63%, including around 10% owned by family members who do not work for the company. Following a 180-day lockup period after the November IPO (around May), insiders with the most knowledge of the company and its prospects will be free to sell their stock on the open market. Considering the family agreed to sell 1/3 of their company to underwriters for $20.50/share in November, it will be awfully tempting for family members to cash out at today’s prices in the $40’s. Selling in May and going away would be a good choice for them. This selling pressure may give the stock a much needed reality check. Also, in any sort of equity correction, overvalued high-flying growth stories are vulnerable to particularly harsh declines. See Whole Foods price history as an example.

Risks to Short Thesis

The biggest risk to the thesis is that you are shorting a growth stock with a small public float and into heavy upward momentum. If you are very bullish on the equity market, this trade is not for you, unless perhaps paired against the less expensive, still growing WFMI. Even if TFM is overpriced, a valuation correction still may not happen and the supposed onslaught of insider selling may never come. The Fresh Market may engage in some sort of transaction to lower its tax rate and/or raise capital to build stores more quickly than expected. Also, possibilities for international growth or acquisition were not taken into consideration. The analysis also failed to take into account the effects of inflation on the company's operations, be they negative or positive.

Disclosure: I am short TFM.

Source: The Fresh Market: Good Candidate for a Short Sale (With One Caveat)