The Fresh Market - A Bidding War In The Making?

| About: The Fresh (TFM)

Summary

The Fresh Market has attracted interests from Kroger and various Private Equity firms.

Management is actively pursuing a sale or other strategic options.

Based on recent transactions, the price should be 20-40% higher.

Introduction

The Fresh Market (NASDAQ:TFM) is a specialty grocery store chain. Its store base has grown from 100 stores in 2010 to 180 stores in Q3 2015. The average store size is 21,000 square feet. Lately, a decline in same-store sales and a failed expansion into California has put the share price under pressure. The stock is trading around $23 and is down more than 60% from its all-time high.

A new CEO and president, Rick Anicetti, has been hired last year and has put the business under strategic and financial review. In February 2016, Reuters broke the news that Kroger (NYSE:KR) and Private Equity firms like KKR, TPG and Apollo (NYSE:APO) have proceeded into a 2nd round of bidding to acquire the company. The share price has jumped 30%, from $18 to $23, on the news.

Judging from comparable transactions, the share price still seems to be too low. Further upside of 20-40% per share might be achievable.

Comparable Transactions

Transaction

Safeway

Harris Teeter

PetSmart

Roundy's

Public Market* Median

Year

2014

2013

2014

2015

2016

Acquired by

Cerberus

Kroger

BC Partners

Kroger

n/a

EBITDA Multiple

5.5

7.9

9.1

7.0

7.4

Annual Quarterly Growth

0.2%

5.2%

6.0%

0%

3.0%

Click to enlarge

(Source: Yahoo Finance and other)

*Public Market Peers: Whole Foods Market (NASDAQ:WFM), Weis Markets (NYSE:WMK), Village Super Market (NASDAQ:VLGEA), KR, Sprouts Farmers Market (NASDAQ:SFM)

With $165 million in LTM EBITDA (giving no benefit to one-time store closure costs) and an EV of $1095 million, the company currently trades at 6.6 EV/EBITDA. Annual growth was 3.3% for TFM, and full-year growth is guided to be ~6%. The market currently values TFM below the price Kroger paid for Roundy's late last year despite the fact the Roundy's wasn't growing nor profitable. Hence, TFM should be able to command a higher price. Given 3-6% growth and very good profitability (operating margin 9% versus that of public peer group at ~3%), the multiple should be between 8x and 9x. This would imply a share price between $28 and $32 and 20-35% upside over the current price.

Business Valuation

Ignoring the bidding situation, what would the business be worth on a standalone basis?

Estimating maintenance capital expenditures at ~$45 million would yield free cash flow of $85 million, or a 7.7% free cash flow yield. Management has indicated that they see room to improve operating margins by 200-300 basis points. At the mid-point of 250 basis points, this would imply $111 million in free cash flow, or a 10% yield. Sales per square foot are at $475, while comparable-store sales are estimated at $513. This is due to the large percentage of young stores that have not fully ramped yet. With stores fully ramped, free cash flow would increase to $120 million, yielding 11%.

Risks

The board might decide against a sale of the company. If the sale falls through, the share price might retreat to $18, where it traded before the announcement, implying a downside of -22%.

Increasing Competition

Whole Foods and Sprouts Farmers Market are TFM's two main competitors. Lately, same-store sales have been very different. While WFM and TFM have experienced same-store sales declines (~ -1% and -3%, respectively), SFM was able to increase same-store sales by 5.8%. While some of the difference might be explained by geography (SFM is based in the southwest, TFM in the southeast) and business mix of perishable to non-perishable goods (60%/40% for WFM and TFM versus 50%/50% for SFM), it appears that SFM is winning market share in a competitive environment.

WFM (with its "365 by Whole Foods" small store format) and SFM are both planning to grow their store base, with SFM targeting TFM's markets in the southeast.

Still, TFM has the highest operating margin (6.94% versus 6.03% WFM and 6.35% SFM) and highest returns on assets (14.74% versus 9.62% and 9.91%) of this peer group, but is the smallest in terms of revenues ($1.1 billion versus $10 billion and $3.7 billion).

So clearly, there are risks from increased competition in TFM's markets, and it is unclear how profitable future store unit growth will be given the expansion plans of the competitors (store unit potential was indicated to be 500 in 2014).

It is at least doubtful that TFM could compete effectively against WFM and SFM. But then again, this is well reflected in the share price (EV/EBITDA 6.6 versus 7.42 for WFM and 13.71 for SFM). And new management seems to be aware of the situation and might be able to implement a better strategy to counter competitive threads.

Summary

In case of a sale of the company, a higher share price between $28 and $32 might be achievable within a short holding period, allowing for very large annualized returns.

Otherwise, at the current level, TFM offers a free cash flow yield of 11% and some growth in the range of 3-5% p.a.

But increasing competition threatens profitability and future store unit growth.

Disclosure: I am/we are long TFM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article does not constitute investment advise. I might initiate, add, reduce or liquidate the position at any time without giving any notice. Please do your own research.