The Not So Fresh Market

| About: The Fresh (TFM)
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After disappointing guidance, The Fresh Market (NASDAQ:TFM) slumped 13% due in a large point to very high expectations for the grocery chain. Sure the organic and fresh grocer plays in a compelling secular trend, but it also faces a tough competitive environment with several companies raising significant funds to expand regional footprints. Not to mention the sector leader has made a big deal about driving down prices to produce growth.

The company operates 136 stores in 26 states and expects to open 21 to 22 stores this year with a high concentration in Q3. With the U.S. supermarket listed as a $600 billion industry, Fresh Market has plenty of room to grow. The Nutrition Business Journal estimates that spending on the natural and organic sector has been growing at a rate of 10% annually with sales only reaching $43 billion in 2011. That growth rate would produce a total of just over $51 billion in 2013, but a number that wouldn't even reach 10% of the total grocery sector spending.

Based on the slumping stock, the question is whether the company has a fundamentally flawed business or if investors had unreasonable expectations. The earnings call beat to death the concept of slow openings for new markets especially in the Houston area, but is the company losing out against all the new competition? Unless something else changes, the stock could have the similar downside as the 2012 selloff that began with an initial slump that was followed by another 20% drop in the next 3 months.

Comp Sales Solid, But Sector Lows

Just looking at the top line and investors will question the growth rates of the company. It only reported net sales that grew 13.3% over last year and inline with industry behemoth Whole Foods (WFM). If it can't grow faster than the company with nearly 10 times the revenue, than it will have a difficult time with fickle investors.

The comp sales for Q2 2013 came in at 3.4%, which was inline with estimates. The interesting part is that the numbers are far below competitors such as Sprouts Farmers Market (NASDAQ:SFM) and Natural Grocers (NYSE:NGVC) that had comp sales that exploded 10% higher. Even large cap and market leader Whole Foods reported comp sales that reached 7.5%. So while Fresh Market is generating solid numbers, it is far below the gains by the sector. Not good numbers for a stock trading at a premium valuation with competition increasing.

The sector is becoming more focused on two-year comps and it provides a great review of more long-term trends to smooth out overly strong or weak periods. After all, a high comp period last year can make a high hurdle to cross in the future without suggesting the company is weak. The below table provides a summary of the one and two year comps reported for the sector:

Again it appears the company was within the industry trend last year, but fell off this year. Fresh Market is making a move into the Health & Beauty sector in an attempt to match the offerings of competitors so maybe that is playing a factor on the lower comps.

2013 Expenses

One key to any retailer is to not lose focus on the long-term when short-term costs pile up. Opening new stores are costly in the short run, but can provide long-term profits. The company spent a great deal of time of the Q2 earnings call describing significant costs that are being absorbed in the end of 2013 in order to funnel huge store expansion in Q3 this year and early next year.

The company expects incremental preopening costs of $1.5 million to $2 million in the second half of the year due to 10 to 11 stores opening in Q3 and another 4 stores in Q4. In addition, the new CFO called out that the tax rate will be higher this Q4 than last year due to a reduced tax rate last year and the insurance reimbursements from Hurricane Isaac that occurred in Q4 last year and won't reoccur.

The CFO used these expenses as a partial excuse for reducing the earnings range for the year to $1.50 to $1.55. Analysts were expecting the company to reach $1.59 so clearly the increased costs and lower revenues were not factored into expectations.

Competitive Threats

The competitive threats appear greater and greater each day. Both Natural Grocers and Sprouts Farmers Market have completed successful IPOs in the last year to fuel expansion. In my market in Oklahoma, all three smaller concepts have entered the metro area in the last year to join a long-time existing Whole Foods store. Now all three are believed to be working on another store in the area. The market will be swarmed with stores from all of the competitors and the ability to generate strong comps will be tested.

The situation reminds us of the early times in the Home Depot and Lowe's arm race when both home improvement leaders went from one metro store to five or more. The companies originally took market share from the local home improvement stores, but eventually started cannibalizing existing stores.

The big question will be whether the organic and fresh concept can take market share by making the stores more convenient or will it eventually beat up each other. Back to the Oklahoma example, the metro area began 2012 with only one Whole Foods store so naturally going to that store was inconvenient for most consumers. Fresh Market added a location during 2012, but that store was still too far away for most and a 10 to 15 minute drive from my home. Now though, Sprouts opened up a store three miles down the road and has become a favorite destination for meat and produce. Natural Grocers opened up a store maybe 4 to 5 miles away making it another option especially when traveling in that direction. A bad sign for the grocery departments at the nearest Target and Wal-Mart. Ultimately it appears the independent grocery stores won't be able to compete with the quality of the fresh and organic chains and the pricing and convenience of Target or Wal-Mart.

For comparative purposes, the store counts of the four concepts are listed below:

The interesting part is that the combined concepts only have a little over 700 locations and Whole Foods alone has established a goal of 1,000 domestic stores. This provides an interesting view of being able to grow for an extended period.

Margin Pressures

The company made a big deal on the earnings call about increasing promotional activities. This activity led to 22% of sales coming from promotional activities, up from 21% last year. While not a huge difference, it was yet another sign that the company pressed hard to achieve the industry low 3.4% comp sales for the quarter.

With the company pushing forward with growth plans for new stores, it is very possible that the high gross margins could be at risk as well. The company now generates a gross margin of around 34%, which leads the pack of the small players. Industry leader Whole Foods has made some grumblings about being more aggressive on pricing to match competition so it could lead to compression of margins at Fresh Market or again leave comp sales at industry lows.

As the chart below shows, Fresh Market generates much larger margins than Natural Grocers that is around 28% and Sprouts at 30% (not listed):

TFM Gross Profit Margin Quarterly Chart

TFM Gross Profit Margin Quarterly data by YCharts

As a note, grocery chain leader Kroger (NYSE:KR) has a gross margin of only 20%.

Valuation Stretched

After the selloff, Fresh Market has a compelling valuation compared to the industry. As a whole, the fresh and organic sector could be considered pricey. Whole Foods trades at 30x forward year earnings, yet it is only expected to see earnings grow around 14% this year and 18% next year. Likewise, Natural Grocers trades at a phenomenal 62x forward year earnings. New IPO Sprouts leads the pack with an incredible 100x current earnings. The data doesn't show a consensus forward earnings estimate yet, but it will undoubtedly start at stratospheric levels.

TFM PE Ratio (Forward 1y) Chart

TFM PE Ratio (Forward 1y) data by YCharts

A disconnect appears in that the grocery market is naturally difficult to expand at an extremely fast clip yet this whole sector trades as if growth over 20% for the long-term is all but certain. When these scenarios collide with reality, the stock plunges of 13% will occur on a more frequent basis. Even worse was the 40% decline that occurred after the last earnings miss following disappointing Q3 2012 numbers.

As investors continue to fret over the potential for margin pressures in order to grow at higher growth rates, the stock is likely to head back to the forward multiple of 20x earnings.

Stock Action

The stock action last week is eerily reminiscent of the same scenario when the stock plunged following the weak numbers at the end of 2012. As the chart shows, the stock plunged below the moving averages and continued to decline over the next three months. A good chance exists of a repeat scenario this time around.

Conclusion

With industry low comp sales and growth rates, The Fresh Market isn't likely to rebound from the weak guidance for 2013. Analysts appeared extremely concerned about the slow openings in new markets and higher promotional activities. Until the company proves the market wrong, the stock has significant downside risk. A repeat of the lows from early 2013 would see the stock drop another 20%. At $38, the stock would trade at roughly 20x fiscal 2015 (January) earnings. Remember that those earnings estimates face being downgraded if the pricing pressures from Whole Foods come to pass.

The stock has long-term potential once it trades down to a more reasonable price based on pricing normalization. If the fresh grocer can improve store openings especially in new markets, the large amount of openings in the second half of the year could eventually lead to a rebound. The stock though should struggle until the market gets more evidence of a return to industry comp sales rates without facing lower margins in order to achieve those higher growth rates.

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.

Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.