Whole Joe’s Food Trader AKA The Fresh Market
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Overview
The Fresh Market (NASDAQ: TFM) is Whole Joe’s Food Trader and a breath of fresh air in the grocery sector. It is not a pure organic retailer like Whole Foods (NASDAQ: WFM) and it is not specialty packaged foods, wine and beer like Trader Joe’s. TFM sells high-quality food and specialty items including wine and beer. Perishables are its forte (like WFM) and account for more than 66% of sales. It’s not a Kroger or a Safeway and could never be mistaken for a big box discounter like Pick’n Save or Save-a-lot. The Fresh Market stores are not echoing caverns with flickering fluorescent lighting, but tastefully arranged small intimate spaces.
There is a lot of optimism and probably some conscious comparisons to Trader Joe’s and Whole Foods built into the price per share. The Fresh Market is now at $52 per share and a PE of 44X. It’s up 41% in the past year. Whole Foods at $94 trades at a similar premium PE of 43X. Trader Joe’s is of course privately held but is the company everyone wishes would go public.
Fresh Market’s growth is not bad but it’s no Whole Foods ... at least yet
The company has been around since 1982, but only became public in late 2010. The 113 stores are mainly in the South with a few in the Midwest and a very small presence in the Northeast. All properties except one are leased and leases are for 10 to 15 years.
The business sells produce, meat, seafood, dairy and bakery in small-box well-laid out stores averaging just 21,000 SF (most super markets are up to 60,000 SF). The focus is on high-quality, high-margin product with attention to display and presentation. Rapid expansion has not been a priority with only 113 stores after 30 years in business. This immediately makes them a slower growth story than Whole Foods, which is aiming for 1,000 stores. TFM has increased the rate of store openings and since 2000 the base has tripled and is looking for a total of 500 stores in the same format -- which would be more than quadruples the 2012 base.
The smaller stores are certainly cheaper to build. A recent 42,000 SF Whole Foods store set to open this fall is coming in at $15 million total cost. The Fresh Market spends $3 to $5 million per store. Capital spending is covered by cash flow from operations, but the cash flow yield trails Whole Foods.
Free cash flow yield:
- Whole Foods: 3.5%
- The Fresh Market: 0.86%
Growth and Margins
Growth for The Fresh Market annual:
The company changed year-end to January in 2010, so January 2011 results benefit from an extra month. Revenue growth in 2011 was much improved and the trend continued into Q1 2012. The big gains in operating income and net are largely due to SG&A that was nearly flat in 2011 (January 2012).
The company only began paying taxes in 2012 and the growth in net is fairly impressive since $26 million in taxes were paid compared to a tax benefit of $1.6 million in 2010.
Comparable same store sales and growth in stores
The increase in revenue kept pace with the increase in number of stores at 13%. In spite of increasing the base by 13% and a 5.4% increase in same store sales, revenue lagged and sales at new stores must have been somewhat slow. The performance of stores not in the comp base is targeted at 80% to 90% productivity and there is no 1:1 relationship between percentage growth of revenue and percentage growth in new stores. However, as they fall further from 90%, revenue begins to lag same store sales/store growth percentages. When new stores come on line affects how productive they will be—there is some seasonality. Stores opened later in the fiscal year will add less and still be counted in the percentage increase. The summer season is slower than fall/winter that includes Christmas and represents higher revenue.
For the most part, Whole Foods growth in revenue usually exceeded the growth in the store base indicating new stores were productive. TFM’s growth is trading at WFM premiums but so far lacks the long track record of high growth deserving a premium. The Fresh Market’s Q1 2012 showed an impressive improvement in growth and margins and will keep the high price intact at least until they disappoint.
The Fresh Market margins
Considering most food stores are working with gross margins in the mid-20% and net margins 1%-2%, TFM margins are some of the best in the sector. The Village Super Market (NASDAQ: VLGEA), considered one of the more efficient grocery chains, does not come close with its gross margins at 27% and net at around 2%. The Village PE is 12X. The Arden Group (NASDAQ: ARDNA) has margins slightly lower than The Fresh Market and higher than most competitors. Like TFM, it sells produce, meat, dairy, seafood, bakery and specialty foods. However, growth is in low single-digits for 2011 making it far less attractive as an investment and the stores are visually less appealing.
Whole Foods margins for 2011 were the best it has done since 2008 and yet operating and net margins still do not beat TFM.
Whole Foods margins
TFM Q1 2012
Growth for Q1 2012:
Same store sales were 8.2% for Q1 2012. That growth was driven by an almost 6% increase in transactions, signaling that product offering, store execution, promotional programs, and overall concept are gaining traction with customers. Q1 stores increased to 116 from 113—around 3%.
Revenue growth accelerated and operating income again improved from controlled SG&A costs. With same store sales up 8.2% and new store additions at 3% the stores not included in comps were doing better business this quarter than in 2011. In addition to increasing same store sales, TFM saw new store productivity at 97%. This level was due to the favorable timing of new stores with several late fourth quarter 2011 and two first quarter 2012 openings. However, they continue to be somewhat imbalanced in new store opening timing year-over-year and there is the potential for short-term quarterly variations in productivity.
The 8.2% same store sales increase was from a 5.7% increase in transactions and a 2.5% increase in average transaction size that indicates they are seeing new and repeat customers who are using The Fresh Market as their primary grocer. Cost deflation in perishable departments is creating opportunity for consumers to trade up in quality or quantity. In their produce department costs are decreasing year-over-year but the product is larger and higher quality and can be promoted at reasonable pricing yielding very strong comparable store sales growth. The store realizes volume increases without sacrificing margins for promotional pricing. The produce looks good and sells well.
TFM quarterly margins
Gross margins were helped by the relationship they have with their distributor. The business is based on an up-charge by the case and the case rate depends on volume. When the volume builds with new stores and increasing comp sales the per case charge declines. They expect to maintain current gross margins in 2012.
Lisa Klinger - EVP and CFO:
...[W]e're striving to increase our gross margin dollars. So that's really the key. We're looking for the appropriate pricing, again whether that's the right retail on our high cost situation or the right promotion on something where we're able to take our cost down in order to drive the appropriate level of sales growth. So, it's not one sacrifice for the other. We're looking for the combination that gives us the best outcome from the gross margin dollar perspective.
Operating margins increased slightly as SG&A as a percentage of revenue declined to 21.7%. Costs decreased for salaries at the store level as expense was leveraged over higher sales.
Guidance
For 2012, earnings per share is estimated between $1.28 and $1.34 -- an increase of approximately 20% to 25% with fiscal 2011 diluted earnings per share of $1.07.
They plan to open 14 to 16 new stores (including three in California) with openings evenly split between the first and second half of the year.
Same store sales should be in the 4.5% to 6.5% range, reflecting the strong first quarter performance and current expectations for the remaining three quarters. That means the next few quarters may not be as good as Q1 and if business slows enough (summer) the price per share could correct. Q1 is a high point for them on several metrics including growth, comps and margins. If they disappoint, the price may come down.
They are expecting operating margins to improve 20 to 40 basis points over last year's margin of 7.5%. The improvement primarily reflects gross margin expansion. There will be some increase in operating costs and taxes that cannot be fully quantified and could negatively affect guidance.
In the fourth quarter of this year they will need to cycle on the initial gift card breakage income of $1.4 million, which was about $0.02 per share – 2012 may come in lower and impact EPS. There will be higher equity and cash incentive compensation as the full program cost over three years is realized. TFM will have higher public company expenses with an expanded Board of Directors and SOX 404 compliance fees. Last year the effective tax rate was 36.6% and in 2012 they anticipate 37.5%.
California start-up costs include the GAAP rent expense, the personnel investments, and the relocations that are going to start hitting in the second and third quarter ahead of the sales.
There are substantial one-time issues they will be cycling through the rest of 2012 that are yet to come, that can be offset if sales momentum and gross margin expansion continue. If they don’t we can look for some disappointment from the market.
Conclusion and estimates of required growth necessary for current valuation
The Fresh Market is in that rarified space of market enthusiasm generally reserved for Whole Foods. As WFM continues to hit new highs, so does TFM.
There is little doubt that The Fresh Market is a great business. It has some of the best margins in the sector and has a lot of space to grow. Same store sales are accelerating and it appears that shoppers are beginning to do more of their complete shopping at the stores rather than picking up items just fresh for the day. Transactions per ticket are higher.
TFM has been returning value on invested dollars and the ROIC was 20% for 2011 with a cost of capital of 10%. There is a lot of optimism priced in to the shares. It may be warranted but the shares are selling at an extreme premium and if the company disappoints on back half guidance, the correction is likely to be extreme as well. In order to justify the price per share, the growth for the next 5 years would have to be 32% tapering to 8% by year nine and terminal growth at 3%. Revenue would be $9 billion and have to increase nearly 8-fold. Growth in the store base will provide half of that—the other half will have to come from same store sales increases.
It’s a lot to ask of a company. Looking at revenue per store averaged across the base, TFM does $10 million per store. In ten years that would have to be $18 million and almost double current revenue per store. Inflation at 2-3% will be a small part of that and the rest will have to come from more and larger transactions. If the operating leases are considered debt ($258 million) then growth needed is 35%.
There is going to be a time or two when earnings and same store sales slip and do not meet expectations. The back half of 2012 may be an opportunity as new compliance costs and higher taxes take a bite out of margins. Rather than buy near the top and high premiums it makes sense to keep The Fresh Market under surveillance and look for opportunity at better valuations.
LeKitKat has no positions in the stocks mentioned above. The Motley Fool owns shares of Whole Foods Market. Motley Fool newsletter services recommend The Fresh Market and Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.
