The Fresh Market Inc (TFM)

[Wildbilly]

A Fresh Buy in a Heated Market


The Fresh Market: A Fresh Buy In A Heated Market
Jun. 2, 2014 3:19 PM ET | 4 comments | About: The Fresh Market (TFM)

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TFM over the next 72 hours. (More...)
Summary

Concerns over industry crowding have substance and company does not have strong competitive advantages, but market treatment seems overdone.
Strong industry prospects with natural/organic grocery expected to continue to grow low double digits to 2020.
Seasoned, talented, and invested management that has the right approach to growth.
Hardly off 52-week low, below all moving averages, and at 13.2x no-growth FCF, stock seems attractive both fundamentally and technically.
Intend to initiate concentrated position on day of publication.
In a prior article, I detailed why and how I would begin performing one hour of preliminary research on potential investments with an emphasis on reasons not to invest before delving any further into the idea. In this article, I will organize my findings on The Fresh Market (TFM).

The above paragraph is the generic spiel I've been using in all my articles lately, but this article is a bit different. Unlike, the other stocks I've checked out recently, I did not go into my TFM hour completely unfamiliar with the company. In February, I spent 3-4 hours researching and wrote on the stock, but never invested. My strategy has changed rather dramatically since then however, and so I will write this article independent of my old one rather than as a supplement.

Business Overview

The Fresh Market was founded in 1982 and operates 157 specialty/natural, small grocery stores in 26 states in the US.

Competitive Position

TFM competes with other specialty/natural grocers like Whole Foods Market (WFM), Sprouts Farmers Market (SFM), Trader Joes (private), and Natural Grocers by Vitamin Cottage (NGVC), as well as larger grocers expanding into the specialty market like Wal-Mart (WMT), Target (TGT), Safeway (SWY), and Kroger (KR). The specialty grocery industry is tough like almost all of retail, and getting tougher. It has gone from being seen as a niche market to now being in the crosshairs of giants like WMT and TGT. Target in particular seems to be making an aggressive push. I was in the store a few days ago and noticed lots of high quality, pre-seasoned, ready to cook meats, cheeses, nontraditional deserts like gelato, etc.

This niche-to-mainstream shift has really scared investors invested in the specialty grocers. The four publicly-traded firms have all declined a very similar amount since 10/25/13 (indicating the move in each stock is industry-related). The firms are down an average of about 43% in a little over 7 months.



The brunt of the decline came in early May when Whole Foods in its Q1 results missed on revenue, missed on EPS, missed on comps, lowered guidance, and attempted to reset longer-term market expectations lower. The other stocks were second-hand victims of the damage.

The market seems to believe there is little differentiating TFM but the company's management has a different take. From the company's Q1 conference call:

We have observed and recent extensive third-party customer research has confirmed that consumers come to us because of our unique combination of outstanding food quality, engaging customer service and an inviting store environment. We believe this combination provides us great flexibility and differentiates us from our competitors who compete on ingredients based product assortment, price or some combination.

So management believes that other companies compete on price and selling organic/natural products while TFM focuses on quality, customer service, and an inviting store format.

Overall, I have a mixed opinion on the company's competitive position. 'Quality, customer service, and an inviting store format' sounds like gushy PR. I feel like every retailer of any kind ever could and has probably used those terms to describe what sets it apart. In high school, I worked as a sales associate at Marshalls (TJX) and I couldn't even tell you how many times I was lectured on customer service at nightly meetings. You don't do retail without customer service.

On the other hand, I have heard very good things about the quality of the meats and cheeses in TFM's deli. Further, I do think a good deal of differentiation is derived from:

the company's store size (self-proclaimed to be small but actually right in the middle of the 5 specialty grocers I looked at)- 55% of WFM average square footage, 76% of Sprouts, 210% of NGVC, 210% of Trader Joes
smaller selection - 9-10k SKUs compared to 21k at Whole Foods
unique geographic base (US Southeast)
I certainly don't think TFM has a moat or even strong competitive advantages, but I don't think the company is as vulnerable as the market reaction seems to imply. The company is pretty small now. It does not need to put Whole Foods out of business to do well. Even at the target of 500 stores, the company would be small. This also presents a great deal of opportunity. 500 stores is over 3x the current store count.

I'd really like the chance to visit a store. The closest store is 50 miles away. I still plan on making the trip sometime this week.

This is the big negative about the long story, but I don't think it is as horrible a net negative as the market is pricing in.

Industry Prospects

From Intangible Valuation article and, in turn, SFM 10-K:

According to the Nutrition Business Journal, sales of natural and organic food have grown at a CAGR of 12.0% from 1997 to 2012, reaching a total market size of $54 billion in the United States and are expected to continue to grow to $113 billion in 2020, representing a CAGR of 11.3% from 2013 to 2020.

So the natural/organic industry in which TFM competes has grown at a double digit rate for close to 2 decades and is expected to continue to do so, at a slightly lower rate. The endpoint of $113B in 2020 represents 18% share (for the entire natural/organic industry, not just TFM) based on current US grocery sales of $620B and presumably less as the denominator should also be larger in 2020. That does not seem so unrealistic. Natural/organic seems like a pretty broad category. If these estimates materialize then TFM may be able to coexist profitably and grow with peers going forward. After all, TFM and peers have done just that in the past with the industry growing at a comparable rate.

I find this very comforting. If industry growth were not so promising/redeeming, I probably would rule out an investment in TFM based solely on the lack of material competitive advantages mentioned above.

Insiders

Executives are paid extremely well at TFM:

(click to enlarge)
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(Source: Morningstar)

The total of $7.56M for 2013 represents a whopping 5.4% of 2013 operating cash flow. That's a lot compared to other companies I've looked at, however, a few comforting points:

Management is actually really talented and seasoned
Much of the pay is in stock and executives hold large direct stakes in the firm as a result that they have supplemented with voluntary purchases recently
I mentioned this in my last article, but I am genuinely impressed with TFM's management team. The company seems return-oriented and VBM seems to be ingrained in the corporate culture, unusual for a company of its size. Most small companies struggle to comply with US reporting standards, but TFM seems to go above and beyond. This time around, I really took notice of how careful management is being in expanding. In his article, Intangible Valuation correctly referenced Peter Lynch. In my mind, Lynch is the guru of investing in small restaurants and retail companies. I read his books and one of the major lessons in the retail analysis section is that promising companies get into trouble most frequently when they try to grow too quickly. Too many new stores too quickly can mean subpar lease terms, site selection, neglect of existing stores, and so on. It's just not smart. I am impressed by how much effort and patience management at TFM is putting into expansion. Most of the prepared remarks in the Q1 conference call detailed site selection and deal structuring. The company recently retained a real estate analytics firm to perform a white space analysis and management is now pursuing built-to-suit lease terms in order to decrease risk and transfer part of the initial capital burden to the lessor.

The company's CEO, Craig Carlock, has been CEO for over 5 years and been with the company for 15 years. Chairman Ray Berry founded the company in 1981 and served as CEO from 1981-2007.

Carlock and a few others have made direct investments recently and Carlock has direct holdings worth $6.7M, or 2.35 years of total compensation based on his 2013 take. That seems very significant.

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(Source: SECForm4.com)

Timeliness

This is becoming an increasingly critical factor in my investment decisions. I care a great deal about entering stocks at relative lows in order to secure myself in case the rest of my thesis does not play out. Deep below all moving averages, and attractively positioned in its 52-week range, TFM seems quite timely:

(Source: FinViz.com)
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Performance & Valuation

Operating cash flow has grown 14.5% annually since December 2009 and 26.2% in the last year. Revenue has grown 15.3% annually since December 2009 and 15% in the last year. Most recently, in the company's Q1 results, comps increased 2.5% Y/Y. The company also reaffirmed its full year 2014 guidance:

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(Source: TFM Investor Relations)

Particularly impressive is the continued stability in comps growth. It looks like the company is performing well.

EPS is greatly understated because depreciation exceeds maintenance capex by a good margin. Trailing operating cash flow is $150.64M. Intangible Valuation came up with no growth FCF of $112M. At a quote of $36.05 with 48.4M diluted shares outstanding, TFM has a market cap of $1.48B. P/FCF is 13.2x. Carlock mentioned 12-15% unit growth going forward. If the company can increase FCF by the midpoint of 13.5%, the stock seems slightly undervalued, but that is probably too conservative. Comps have been improving and are guided to continue to improve and the resulting operating leverage, along with some fat the company has identified for trimming, should enable FCF growth of 15-18%. In that case, the stock looks very cheap. Indeed, the analyst consensus is for 16.9% over the next 5 years and Value Line estimates earnings growth of 16%. I was also surprised to see this in the VL report:

(Source: Value Line)
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You don't see estimated gains like that in a Value Line report very often and these estimates are:

Calculated with the stock at $34.93. From the current quote of $30.65 to the midpoint of $92.5 in 2018 represents 32% annualized returns. I'd be happy with even half of that.
Calculated on April 25, before the company reported its excellent Q1 results, which may result in VL making more bullish assumptions in the next update.
Even if headwinds materialize and the company is only able to do 10-11% FCF growth (lower than estimated industry growth and company's guided unit growth), the stock is probably fairly valued at this price.

Conclusion

After scanning through several companies, it looks like I've found another rare stock suitable for a concentrated entry right now. The Fresh Market is an excellent company with strong growth prospects and seasoned, talented, and invested management that has been pulled down on concerns that the specialty grocer industry is getting too crowded. As a result, shares are extremely timely now near a 52-week low and the stock also looks attractively-valued fundamentally at 13.2x no-growth FCF. The only major negative I am seeing is that the company is not as differentiated and its business not as protected as I would like to see. I am skeptical of retailers in general and there does seem to be some substance to the market competition concerns, however I think the market reaction is overdone and the long thesis redeemed by every other element. I am comfortable entering into a large long position and will do so this morning (Monday 6/2).

http://seekingalpha.com/article/2249223-the-fresh-market-a-fresh-buy-in-a-heated-market?uprof=44