The Fresh Market

Company: The Fresh Market, Inc. (NASDAQ: TFM)                 

Share Price: $50.23 (5/8/12)

Shares Outstanding: 48.1MM

Market Capitalization: $2.4B       

Advocate: Short

Note: A little of the fat has been taken since this was written; the thesis remains intact

Summary:

The Fresh Market, Inc. (“TFM,” “The Fresh Market,” or, the “Company”) is an overvalued food retailer with a vulnerable competitive positive in the ferociously competitive food retail space.  Wall Street has been seduced by TFM’s perishable food business, ostensibly attractive store economics, and prospective growth potential.  The fervor has induced investors to bid the stock up to 38x 2012E earnings and 19x EBITDA: the highest valuations among food retailers. 

            Closer examination reveals that TFM’s business possesses no sustainable long-term competitive advantages that would justify a franchise business valuation.  Once more, the Company is about to face an onslaught of competition from well-heeled, adeptly managed competitors in several of its core markets.  As competition systematically pressures margins, investors will become increasingly unwilling to pay a premium for growth that will not translate into shareholder value.              

Business Overview:

TFM is a food retailer with 115 stores in 21 states.  Founded in Greensboro, North Carolina in 1982 by a former 7-11 executive, Ray Berry, TFM was conceived as a European-style neighborhood grocery store with a focus on premium perishables, including hand-trimmed steaks, fresh seafood, and individually selected produce.  In 2011, the Company did $1.1B in sales.  Perishables accounted for 66.4% of that figure.

            The Fresh Market stores carry 9,000-10,000 SKUs and average 21,000 square feet, versus 45,000 SKUs and 40,000-60,000 square feet for conventional supermarkets.  Company stores are concentrated in the Southeast region, with 28 stores in Florida, 15 stores in North Carolina, and 11 stores in Georgia.  In 2012, Florida stores generated 24% of total sales.  

            TFM cites Whole Foods, Kroger, Safeway, Publix, Harris Teeter, Wal-Mart, Target, Trader Joes, natural food stores, local farmers’ markets and smaller specialty food stores as its primary competition.  TFM went public in November of 2010.  As of January 29, 2012, the Berry Family beneficially owned approximately 41% of the outstanding common stock.   

The Bull Case:

Bulls believe that TFM’s smaller-box format coupled with its focus on high-quality perishables create a long-runway for profitable growth.  Because TFM stores are smaller than conventional supermarkets, the Company is able to adapt to a greater variety of retail sites and configurations.  This flexibility has allowed TFM to grow quickly: from 2006-2011, The Fresh Market expanded from 63 stores to 113.  The Company plans to open 14-16 stores in 2012.  Management believes that the U.S. market can ultimately support 500 stores, suggesting that TFM is still in its infancy.  The Company touts expansion as a “core competency.” In an October 2007 article in News-Record.Com, founder Ray Berry remarked, “It’s better to grow quickly…before someone else can figure out what you’re doing and copy it.”[1]

            Optimistic investors argue that The Fresh Market’s distribution strategy ensures an asset-lite business model that allows for easily scalable operations.  Unlike larger food retailers with significant investment in supply/distribution infrastructure, TFM outsources all inventory management, warehousing, and transportation to third-party logistics providers.  Consequently, the Company does not own any warehouses, distribution facilities, or transportation equipment.  With less fixed investment in supply/distribution capital anchoring the balance sheet, bulls believe that expansion is not bound by geographic proximity to distribution facilities.  TFM’s pending entre into the California market has elicited a particularly Pavlovian response from analysts.  Bulls views California as a fertile market for TFM’s high-quality perishables proposition.     

            The Street is also taken with the Company’s seemingly attractive margin profile and store economics.  Perishables are higher-margin than dry groceries:  from 2008-2011, TFM posted gross margins of 30.4%, 32.1%, 32.8% and 33.1%.  Management stridently cites its “highly attractive operating margins,” which have increased from 4.6% in 2008, to 7.5% in 2011.  The Company expects to drive further operating margin expansion through “scale efficiencies,” “improved systems,” “continued cost discipline,” and “enhancement to merchandise offerings.”  Fewer investments in tangible capital allow TFM to post ostensibly high returns on capital.  According to a Company presentation given in June of 2011, 2010 return on invested capital equaled 24%.  Using the Company’s formula, 2011 ROIC would total 30%.[2]   

            Finally, longs believe that the in-store experience will engender customer loyalty and transcend the divergences in regional and local shopping preferences that make successful inter-state expansion notoriously elusive for food retailers.  TFM cites its store environment as an important competitive strength.  According to management, Company stores are:

            “designed to delight our customers’ senses with an aesthetically pleasing environment.  

                  Elements of this environment include colorful product presentations, ceramic tiled floors,

                  darkened ceilings, incandescent lighting, classical music and various aromas including flowers,

                  coffee and freshly baked goods.”[3]

TFM’s store aesthetic is advertised as a crucial differentiator from its competitors and an important ingredient in the Company’s long-term recipe for success.

Peeling Back the Curtain on TFM’s Purported Competitive Advantages:

Careful deconstruction of each of the aforementioned bullish arguments reveals that TFM’s purported competitive strengths are less tenable than bulls believe.  At a minimum, they do not justify the franchise-business valuation currently ascribed to the Company. 

            Competitive Advantage Myth # 1: Smaller-Box Store Format

            Having smaller stores does not fortify a moat around TFM’s business.  One of the defining competitive advantages of a big-box food retailer is the capacity to stock all of the grocery/sundry items that a shopper may need, ensuring one-stop shopping.  The “convenience proposition” is a major reason food retailers carry so many SKUs.  This, in turn, erects meaningful barriers to entry for prospective competitors lacking the resources required to open a big store and operate a volume-based business.  You don’t hear about a lot of supermarket start-ups; good luck taking on Wal-Mart and Kroger.           

            In contrast, the barriers to entry for a smaller, specialty food retailer, say an imported cheese shop or a farm-fresh produce market, are less daunting.  Because these businesses are not competing with the giants for the entire grocery basket, they need less selling space.  Consequently, the menu of potential real estate locations will always be larger for smaller, specialty retailers than it is for the big boys.  This food retailing maxim presents an institutionalized competitive disadvantage for TFM because it will consistently face threats from food retailing entrepreneurs that only need a couple thousand square feet (or less) of selling space. 

             And when these stores do open, they are likely to take direct aim at The Fresh Market’s perishables basket.  A small, independent food retailer cannot beat Wal-Mart or Publix on the price of canned soup or frozen corn.  And with a greater number of non-traditional food retailers entering the dry/packaged grocery space (see the discussion on Target below), the race to the bottom on price will only intensify (wait until Amazon figures out a way to jump in the mix).

             To be viable, smaller food stores must compete where they can win, which will increasingly mean differentiated perishables.  In the 2011 annual report, TFM notes the movement toward “…healthy eating choices and fresh, quality offerings, including regionally and locally sourced products.”[4] This trend will not go unnoticed by enterprising epicureans with an itch to own their own business.  Case-in-point: Carolina’ Farmin’, a Southern Market focused on fresh seafood, produce and baked goods, that opened in 2011 in Wilmington, NC, TFM’s backyard.  Carolina Farmin’ strikes at FM’s bread and butter: perishables.             

            In 2011, TFM’s average customer transaction size was $30.92, suggesting that most shoppers are not checking off their entire grocery list at the store.  Shoppers are coming in for specific items, namely quality perishables.  To maintain the $30.92 basket, TFM will have to vigorously contest competitors with low barriers to entry due in part to one of TFM’s purported competitive advantages: the need for less space.

            Competitive Advantage Myth #2-Asset Lite Distribution Model

            TFM contends that its outsourced distribution model is a competitive advantage because it will allow the Company to expand without concern for proximity to owned supply/distribution facilities.  Two observations cast doubt on the durability of the competitive advantage afforded by this strategy: 1) this model reduces future pricing flexibility resulting from economies of scale; 2) since 1982, TFM has been reticent to open stores too far from its predominant third-party logistics provider.

            TFM does not own warehouses, distribution facilities, or transportation equipment.  The Company is not making capital investments in supply/distribution infrastructure that will help it compete on price later.  Instead, TFM invests in product.  The business is built on the premise that shoppers will pay a premium for quality perishables.    

            Most large food retailers invest in price by making significant capital outlays to vertically integrate their businesses.  Consider that Whole Foods operates 4 seafood processing and distribution facilities, 10 regional distribution centers focused on perishables distribution, 5 regional commissary kitchens, 7 bake house facilities, and 2 produce distribution facilities.  With this infrastructure in place, expansion makes sense because the marginal cost to supply/distribute product to ten stores is not much greater than two stores.  And as fixed costs are absorbed by increased volume, big-box stores can price aggressively.   

            TFM contends that as it expands, it will benefit from economies of scale “in sourcing products” and can leverage  “existing infrastructure, corporate overhead and fixed costs to reduce labor and supply chain management costs as a percentage of sales.”[5] Given that TFM has made no material capital investments in supply/distribution infrastructure, it is unclear what “existing infrastructure” the Company intends to leverage through expansion. 

            Further, to maintain the “neighborhood” grocer feel, TFM must consistently source products that satisfy local and regional tastes.  At the same time, the Company posits that its distribution strategy enables the business to “grow our geographic footprint and operate profitably in new markets without a need for critical mass in any one market.”[6] Without achieving critical mass in a market, how can TFM achieve meaningful economies of scale through local sourcing?  And if local vendors are cutting TFM a deal for bulk buying, what is to stop Whole Foods from moving into town and getting a better deal for tripling the order?  (An aside: these are questions that I would have liked to hear management address; perhaps there are logical answers- but other than my first phone call, my subsequent 15+ plus calls to Investor Relations were not returned).

                  As per the claim that TFM can leverage “corporate overhead,” the Company lists only a single corporate office, its headquarters in Greensboro, North Carolina.  It is not as if there are five regional offices, each carrying high annual lease, insurance, and tax payments. 

            Perhaps the strongest countervailing evidence that TFM can leverage fixed operating costs through growth is depicted below:

            SG&A Expense as % of Sales         

                  2007: 22.6%           # of Stores in 2007: 77 / 2007 Sales: $728.4MM

            2008: 22.7%

            2009: 22.2%

            2010: 22.1%

            2011: 22.3%           # of Stores in 2011: 113 / 2011 Sales:    $1.1B

Since 2007, TFM has grown sales by $379MM (52%) and increased the store count from 77-113.  At the same time, SG&A expense as a percentage of sales decreased by only 30 bps.  In grocery, every basis point counts.  Still, the disconnect between the increase in sales volume, and the marginal decrease in SG&A expense as a percentage of sales, weakens the Company’s claim that expansion will yield positive SG&A leverage.      

            An additional expense headwind is the increased costs associated with being a public company.  A Nov. 2011 article in CFO.Com[7] estimated that being public adds, on average, $2.5MM to a company’s cost structure.  TFM’s modest SG&A % improvement came before the Company ever had to spend a dime on public company expenses.   

            The second observation that conflicts with TFM’s position that an asset-lite model affords greater flexibility, and thus is a competitive advantage, is the fact that a large majority of Company stores are within a relatively close proximity to its primary logistics provider.  Obviously, one cannot fault management for choosing locations that allow for convenient supply and distribution logistics.  This is good business.  Still, the Company’s dependence on one logistics provider raises questions whether it will be able to successfully open stores outside the geographic range of its main supply chain cog.  

            TFM’s primary logistics provider is Burris Logistics (“Burris”), a private company with facilities in the following locations: Atlanta, GA; Elkton, MD; Federalsburg, MD; Haines City, FL; Harrington, DE; Jacksonville, FL; Lakeland, FL; Lyndhurst, VA; New Castle, DE; Orlando, FL; Philadelphia, PA; Rocky Hill, CT; and Springfield, MA.  As the list indicates, Burris’ facilities are concentrated in the southeast and east coast.  In 2011, Burris Logistics warehoused and distributed products that accounted for 58% of all merchandise purchased by the TFM.  The Company notes that much of this inventory is stored at a single warehouse.  The large quantity of perishable inventory leaves little room for distribution errors. 

            Clearly, Burris is familiar with The Fresh Market and has developed best practices tailored for the Company’s stores—otherwise, TFM would not use Burris to warehouse and distribute 58% of its merchandise.  Thus, perhaps it is not a coincidence that 82 of the TFM’s 113 stores are within 100 miles of a Burris facility.  When deciding where to open a new store, one wonders how important proximity to a Burris facility has historically been in management’s calculus.

            In the annual report, TFM states, “We expect that Burris Logistics will have sufficient capacity to accommodate our anticipated growth through the medium term and that we have various alternatives, including Burris Logistics, available to us for long-term growth.”[8]  What exactly constitutes the “medium term” is an important consideration for investors.  Looking to the impending California expansion, Burris Logistics has no storage facilities.  Transitioning to new logistics providers presents serious operational challenges for a management team that has thus far relied heavily on a single company for primarily regional support.  In California, or elsewhere, anything other than a seamless transition will weigh on operating results.

Competitive Advantage Myth #3- Stated Returns on Invested Capital

A 2010 investor presentation claimed that 2010 ROIC totaled 24%.   

However, the Company’s formula did not include capitalized operating lease debt, which is TFM’s preferred method for financing locations.  If stores aren’t capital, TFM should comped against farmers’ markets, not supermarkets.  Adding capitalized operating lease debt to the company’s ROIC formula drops 2010 return on invested capital to 8.6%; 2011 return on invested capital totals 11.2%.  2010 and 2011 pre-tax returns would be 14%, and 18.5%, respectively.  An 18.5% pre-tax return on capital is respectable; but it rarely commands a 38x multiple.  For reasons stated below, defending these returns is about to get more difficult. 

Competitive Advantage Myth # 4-Store Aesthetic

TFM believes that its “aesthetically pleasing environment,” is a competitive strength.  Company stores are designed to “delight customer’s senses,” with “classical music,” “ceramic tiled floors,” “colorful product presentations,” “darkened ceilings,” “incandescent lighting,” and “various aromas, including flowers, coffee and freshly baked goods.”

Savvy retailers recognize that bricks and mortar locations are no longer merely a distribution channel through which to sell product.  Instead, they must provide the customer with a unique experience.  TFM is smart to recognize the effect that music, lighting, and visuals have on the customer’s perception of the brand and products.  The vibe in a TFM store is certainly more pleasant than a Wal-Mart.

However, the notion that music, lighting and general store aesthetic provide a long-term competitive advantage for TFM is a stretch.  A shrewd entrepreneur with an i-pod and a good architect could replicate TFM’s environment.   With a continued emphasis on “in-store experience” permeating the retail ethos, TFM should expect that competitors will turn a keen eye to the details.  It is doubtful that TFM’s customers will be “sticky,” because of the store aesthetic. 

Near-Term Competitive Pressures:

Determining that TFM does not have sustainable, long-term competitive advantages does not make it a timely short.  Rampant growth and increasing same-store sales are the kryptonite of premature short sales.  In 2010 and 2011, TFM’s comps increased 5% and 5.4%, respectively.  Since 2007, sales have grown from $728.4M-$1.1B and net income grew from $30M-$51MM.  If earnings continue to move higher in-line with analysts’ estimates, multiple won’t contract.  Thus, below I will summarize some of the potential catalysts for disappointing comps/earnings that will alter the market’s perception of the story.   

Increasing Competitive Pressures in 2012-2013

A flurry of new store openings/remodels by competitors in TFM’s core markets will intensify competitive pressures in 2012-2013.

Florida

?Publix: Downtown Miami-April 2012

In April 2012, Publix opened a new location in the Omni area of downtown Miami.  The new location features an expanded “GreenWise” section, which is Publix’s category for organic and natural foods.  Each aisle at the new Publix has a GreenWise section, versus the typical Publix, which generally only has one section dedicated to the GreenWise format.  A quote in the Miami NewTimes Blog on April 6, 2012, noted: “This new addition [Greenwise] definitely helps many downtown and midtown residents from having to drive all the way to Fresh Market or Whole Foods for a dose of green offerings.”[9] The Fresh Market has a store in Miami. 

?Whole Foods: Pembroke Pines, FL-March, 2012

 Whole Foods opened its first store in Pembroke Pines, Florida in March of 2012.  TFM has one store in Pembroke Pines.  The new Whole Foods is located 4 miles from The Fresh Market store.   

?Whole Foods: Downtown Miami-Estimated 2013

Whole Foods is slated to open a 35,000-square foot location in a mixed-use development in downtown Miami in 2013.  TFM has one store in Miami.  The new Whole Foods will be located 14 miles from The Fresh Market Store. 

A quick note on Whole Foods’s expansion: after a lull during the Great Recession, Whole Foods is accelerating stores openings:

Whole Foods New Store Openings:

2007: 21

2008: 20

2009: 15

2010: 16

2011: 18

2012: 24-27

?Trader Joe’s: Naples, FL-February 2012 (and beyond)

Trader Joe’s opened its first Florida location in Naples in February of 2012.  With its differentiated, premium products, Trader Joe’s will compete for TFM’s customer.  Trader Joe’s has a cult-like following and is controlled by the Albrecht family, owners of the ALDI Chain. The Albrechts are top-notch food retailers and Trader Joe’s is renown for its operational prowess and pricing discipline (the Company prices perishables by unit, rather than weight, to increase efficiency).  The Fresh Market has one store in Naples.  The new Trader Joe’s is located 5.5 miles from The Fresh Market Store. 

There is reason to believe that the Naples location will be the first of many Trader Joe’s in Florida.  The Albrecht grocery model typically involves leveraging investment in supply/distribution infrastructure to support a large number of regional stores.  In December of 2011, ALDI announced plans to build a regional warehouse in Royal Palm Beach, Florida to support 20 planned new ALDI stores in Palm Beach County.  

Florida is an attractive market for Trader Joe’s due to the older demographic and wealthy coastal enclaves.  An August 2010 CNNMoney article on Trader Joe’s stated: “The distribution process helps determine where the company opens its stores.  Texas and Florida have cities that boast customers that Trader Joe’s covets, but insiders say that current distribution infrastructure makes it difficult for the company to efficiently get products to those states.”[10] 

Unlike a Wal-Mart or Target, which may have a difficult time getting zoning in affluent Florida communities, Trader Joe’s is highly desired.  The West Palm Beach Downtown Development Authority recently put together a marketing film called “What would I trade for Trader Joe’s.” In the video, city officials reel off all of the sacrifices that they would make in return for a Trader Joe’s opening in downtown Palm Beach.  Trader Joe’s debut in TFM’s backyard is an unwelcome development.    

North Carolina

“ain’t it just like a friend of mine…to hit me from behind…”-James Taylor

?Whole Foods: Wilmington-Spring 2012

Whole Foods is opening its first store in Wilmington, North Carolina in May 2012.  TFM has one store in Wilmington.  The new Whole Foods is located 6.8 miles from The Fresh Market store. 

?Whole Foods: Greensboro-April 2012

Whole Foods opened its first store in Greensboro in April 2012.  TFM has two stores in Greensboro.  The new Whole Foods is located 4.6 miles from one TFM store; it is 3.4 miles from another TFM store.  

?Whole Foods: Charlotte-August 2012

Whole Foods is opening its first store in Charlotte in August 2012.  TFM has two stores in Charlotte.  The new Whole Foods will be located 3.2 miles from one TFM store; it is 14.5 miles from another TFM store.

?Carolina Farmin’:Wilmington-Second Half 2012

Carolina Farmin’ is a “southern market” specializing in fresh, local products.  It will compete for TFM’s customers.  The store is planning to open its second location in the Wilmington area in the second half of 2012.  TFM has one store in Wilmington.  The current Carolina Farmin’ store is 6.7 miles from The Fresh Market store.

?Trader Joe’s: Winston Salem-August 2012

Trader Joe’s is opening its first store in Winston-Salem in August 2012.   TFM has one store in Winston-Salem.  The new Trader Joe’s will be located within 6 miles from The Fresh Market store.

Other Markets

?Whole Foods: Franklin, TN-May 2011

Whole Foods opened its first store in Franklin, TN in May of 2011.  TFM has one store in Brentwood, TN.  The new Whole Foods is 8.6 miles from The Fresh Market’s Brentwood, TN store.

?Whole Foods: Virginia Beach, VA-Early 2013

Whole Foods is opening its first store in Virginia Beach, VA in early 2013.  TFM has one store in Virginia Beach.  The new Whole Foods will be located less than one mile from The Fresh Market store.  Jeff Metzger, publisher of FoodWorld, a supermarket industry newspaper, noted in the PilotOnline.com (July 29, 2011) that Whole Foods will compete most directly with Fresh Market because it has a similar high-end customer. 

?Whole Foods: Glen Mills, PA-March 2012

Whole Foods opened its first store in Glen Mills, PA in March 2012.  TFM has one store in Glen Mills. The new Whole Foods is located 2 miles from The Fresh Market store.   

?Trader Joe’s: Albany, NY-2012

Trader Joe’s will open its first store in Albany, NY in 2012.  TFM has one store in Albany.  Trader Joe’s will be located 3.8 miles from The Fresh Market store.  

?Whole Foods: Albany, NY-2013-2014

Whole Foods will open its first store in Albany, NY in 2013-2014.  TFM has one store in Albany.  The Whole Foods will be located within 5 miles of The Fresh Market store.

?Whole Foods: Tulsa, OK-2013

Whole Foods will open its second Tulsa, OK store sometime in 2013.  TFM has one store in Tulsa.  The new Whole Foods will be located within two miles of The Fresh Market store. 

?Whole Foods: Savanna, GA-2014

Whole Foods will open its first Savanna, GA location in 2014.  TFM has one store in Savanna.  The new Whole Foods will be located 3.9 miles from The Fresh Market Store. 

A Comment on Location

As the list indicates, Whole Foods and Trader Joe’s are moving into markets in which TFM currently operates.  More importantly, they are opening stores in relatively close proximity to existing TFM stores: almost every new Whole Foods or Trader Joe’s is going to be within 4-8 miles from an existing TFM store.  This is not a coincidence. 

In small-middle-market cities (i.e. Charlotte, Tulsa), there is a finite amount of desirable real estate for high-end grocers.  Compared to Wal-Mart or Target, Whole Foods, Trader Joe’s and TFM cater to a more affluent customer.  Given that affluence tends to be highly concentrated in these cities, high-end grocers will inevitably operate within close proximity.  And because convenience is critically important in grocery, these companies cannot and will not take big risks on location.   They go where their customers are.       

In a market like Winston-Salem or Virginia Beach, TFM would presumably prefer less competition rather than more.  After all, every zucchini purchased at Trader Joe’s makes TFM shareholders poorer.  That is, unless you ask The Fresh Market.  Commenting on the Tulsa, Oklahoma supermarket landscape in a February 2, 2012 article in TulsaWorld, TFM spokeswoman, Lara Bronstein remarked:

“We have a distinctive concept that rarely competes directly with other food retailers. With smaller, more intimate stores, classical music and soft lighting, with the aromas of freshly baked bread and coffee, our stores simply provide a unique shopping experience that customers cannot find anywhere else.”[11]  

If I were a TFM shareholder, this degree of competition neglect would concern me,  not to mention that this statement directly contradicts the 10-K, which enumerates a laundry list of competitors.  (As an aside, TFM should put out an APB ordering senior personnel to refrain from divulging Company strategy: they don’t want the competition to figure out that baked bread and Mozart are the secret).           

Other Competition

Wal-Mart’s emergence as the dominant food retailer in the U.S. has permanently altered the competitive landscape.  To compete with Wal-Mart, large grocery stores must offer what Wal-Mart doesn’t.  This often means an increased focus on perishables and natural foods, areas where Wal-Mart has not traditionally been strong.  Large chains, such as Publix and Kroger, are working to increase their perishables and natural foods business to differentiate from Wal-Mart. 

The advent of online retailing has also forced non-traditional food-sellers into the grocery business.  As a greater number of products become available on the internet, retailers have adapted by stocking products that are less likely to be purchased online.  Food is near the top of the list, particularly fresh food. 

In June 2012, Target will complete a remodel of 90 stores across the United States in order to increase fresh food selections.  Approximately 1000 Target stores across the U.S. currently offer an expanded food layout.  By the end of 2012, the number is estimated to reach 1,100.  At these Target stores, 10,000 square feet is allocated to food retail.  Even drugstores are getting into the mix; in 2010, CVS redesigned 200 stores in major cities to add food items. 

To drive traffic, retailers must stock products that a customer cannot, or will not, purchase online.  The trend toward increased fresh food offerings in non-traditional grocery stores should continue to gather steam.

Other (potentially) Unwelcome Developments in 2012-2013:

Development of the Port of Miami and the Port of Manatee

In 2014, a massive project to widen the Panama Canal should be completed.  The project has major implications for global trade because the Canal’s wider shipping lanes will allow bigger container ships and cargo vessels to reach the Eastern United States. 

In order to make their ports more attractive destinations for the anticipated increase in cargo, two major Florida ports have made meaningful investments in improved infrastructure.  Consequently, these ports will have a greater capacity to facilitate the import and transfer of perishable foods, potentially improving supply chain efficiencies for food retailers seeking to enter the perishable food business or augment their offerings.      

Port of Miami   

The Port of Miami is currently undergoing a $150MM Deep Dredge project to increase the Port’s depth to 50 feet.  According to Jim Hertwig, CEO of the Florida East Coast Railway, the only other east coast ports with a 50-foot depth are Baltimore and Norfolk.  Greater depths allow bigger vessels to utilize the port, which can drive down the prices of container slot fees by 30-40%.  Cheaper slot fees make it more economical for large cargo ships to serve the state of Florida, and other regions of the southeast, through the Port of Miami.  The Port of Miami is already a major gateway for perishable goods.  Deeper shipping lanes and lower costs could meaningfully increase perishable volume imports. 

Importantly, other investments in distribution infrastructure at/near the Port will make transfer of the perishables quicker and more efficient.  Along with the dredging project, the Port of Miami is also completing improvements to its Intermodal Container Transfer Facilities, or “On-Dock Rail.” On-Dock Rail allows importers (i.e. food retailers) to move imports directly from the Port to an on-dock rail, thereby avoiding the traffic congestion endemic to highway transport.  As a result, product can be moved quicker.  Mr. Hertwig noted, “We can have cargo delivered in two days to Atlanta and Charlotte, and in three days to Nashville and Memphis.”[12]

Port of Manatee

A Feb 20, 2012 article in the Herald-Tribune chronicled important changes to another major Florida port: the Port of Manatee.[13]  In January of 2012, Carlos Buqueras, the former director of marketing at Port Everglades, became the Executive Director of the Manatee County Port Authority.  One of Mr. Buqueras’ stated goals as director is to build distribution centers for big box retailers and expand the Port of Manatee’s role in the perishable food trade. 

Mr. Buqueras has a proven record of success.  In his role at Port Everglades, Mr. Buqueras was instrumental in helping land the distribution center for ALDI, which paved the way for ALDI’s expansion into South Florida (one wonders whether Mr. Buqueras will be a similar advocate for Trader Joe’s-another Albrecht family-controlled company).  The Port of Manatee is well-positioned to carry-out Mr. Buqueras’ vision.  In recent years, the Port has built a new berth to handle bigger ships, dredged an entryway to an accessible 40-foot depth, and connected its own rail line to CSX Corp tracks.       

 The direct effects of these developments on TFM’s business are not precisely knowable.  But one can bet that the improved efficiencies in the distribution network will not be lost on large food retailers seeking quicker, cheaper modes of perishables distribution.

            A Gross Margin Story:

            The Fresh Market styles itself as a premium perishables seller; the GUCCI of grocery.  Because the business is not built to be a volume-driven, low-cost operator, the ability to capture gross margin dollars is paramount.  See the table below:

                                                                  Gross Margin %

                        2007                            2008                            2009                            2010                            2011

Kroger:                         24.4%                           23.8%                           23.1%                           22.2%                           20.8%                                                              

Safeway:                        30%                             29.5%                           29.9%                           29.5%                           28.2%

Ingles:                           22.8%                           21.8%                           22.9%                           22.5%                           22.2%

Harris Teeter:                30.1%                           30.3%                           30.6%                           29.9%                           29..6%

Whole Foods:               34.8%                           34%                             34.3%                           34.8%                           35%

TFM:                            30.5%                          30.4%                          32.1%                          32.8%                          33.1%

TFM is near the top of the grocery heap; clearly one of the reasons for the premium valuation.  But, drilling into the figures brings a few important issues to light. 

            First, Whole Foods appears to be beating TFM at its own game.  Whole Foods has posted better gross margins in every year since 2007.  Given Whole Foods’ scale and operational prowess, an investor would be hard-pressed to argue why TFM is better positioned than Whole Foods to defend gross margins.  As a corollary, it is worth contemplating whether it makes sense for TFM to trade at a premium to Whole Foods on almost every metric.

            Second, in Q4 2011, TFM benefitted from the initial recognition of gift card breakage in the amount of $1.4MM, for a total of $1.6MM in gift card breakage revenue in 2011.  After 30 years in the grocery business, management had finally gathered enough historical information to confidently estimate gift card breakage; just in time for the Company’s first full reporting year as a public company.  The Company noted that subsequent gift card breakage revenue will be less than the 2011 figure.  

             The accounting for gift card breakage releases previously reported gift card liabilities into revenue, with no offsetting expense.  It is effectively pure profit.  The initial recognition of gift card breakage added 10 bps of margin to TFM’s reported gross margin percentage for 2011.       

            It is also interesting to note that trajectory of two balance sheet asset accounts:  “Prepaid Expenses and Other Current Assets,” and “Other Current Assets:”  See the table below:

                                                            2009                            2010                            2011                           

Prepaid Expenses and Other Current Assets                  4.7MM                        $4.9MM                      $5.5MM

Other Assets (non-current asset)                        $231K                 $1.9MM                      $3.4MM

Neither the S-1 nor the 10-K, defines these accounts or explains what is in them. 

Likely, these asset accounts consist, at least in part, of capitalized expenditures that do not qualify as current period expenses.           

            In 2011, TFM spent $87.5MM on capital expenditures, compared to $42MM in 2010.  Aside from more store openings (8 in 2010 vs. 13 in 2011), the Company noted that the increase in capital expenditures was primarily related to an increase in “…merchandising initiatives, and equipment upgrades and enhancements to existing stores.”  The Company added that the increase in capital expenditures in 2011 was also due to higher than normal spending on “certain projects, including the purchase of land,” and that new store capital expenditures also included “several buildings constructed, versus our typical leasehold improvements.”[14]   

              TFM’s balance sheet has line-item accounts for “Land”, “Buildings,” “Store fixtures and equipment,” “Leasehold improvements,” “Office furniture, fixtures and equipment,” and “Construction in progress.”  Each expenditure that the Company cited as contributing to the rise in 2011 capital spending would seem to logically fall into one of these balance sheet accounts. 

            For example, capital spending on “equipment upgrades,” and “enhancements to existing stores,” would probably be capitalized in the “Store fixtures and equipment” account, or “Leasehold Improvements” account.  Capital spending on “buildings constructed,” would likely be capitalized in the “Buildings” account.  And capital spending on land would be capitalized in the “Land” account.  The point is that each type of expenditure that the Company cited for the large increase in 2011 capital spending appears to have a corresponding balance sheet account to carry the capitalized expense.

            The one exception is “merchandising initiatives.” It is likely that at least some component of the “prepaid expenses and other assets,” and/or “other assets” account consists of capitalized “merchandising initiatives.” It is not clear what constitutes a capital investment in “merchandising initiatives.” Neither the 10-K nor the S-1 provides commentary.  It stands to reason that if “merchandising initiatives” were not being capitalized, then they would be expensed.  And if they were being expensed, they would probably show up in the cost of sales line, hurting gross margins.  

             Harping on $1.4MM in gift card revenue (10 bps), or a couple hundred thousand in “merchandising initiatives” expense, may seem like splitting hairs on $1.1B in revenue.  But for TFM, gross margin is crucial because it measures the success of the perishables business.  

            Gross margin is a difficult place for a food retailer to butter their bread.  Consider that from 2010-2011, TFM increased sales by $127.6MM, or 13%; concomitantly, the Company expanded gross margin by only 30 bps.  High variable costs (i.e. food) and fierce price competition keep incremental margins tight.  Assuming no other costs, TFM would have made $382K in incremental profit on $127MM in additional sales.  

            Of course, if the incremental capital required to generate the additional $382K is small, then the economics become more palatable.  Recognizing this, most large food retailers invest in infrastructure.  As they scale their operations, they can drive volume by pricing a wide range of products aggressively.   They may only earn pennies on each sale, but they don’t have to invest much incremental capital to earn those pennies (they hope).    

            TFM has a different approach: higher-quality perishables = higher gross margin.  This works as long as TFM’s perishables are perceived as differentiated, high quality, and widely unavailable.  TFM says as much on pg. 7 of the 2011 10-K:          

            Our pricing decisions are driven by the limited direct overlap between our product                   offerings and the products offered by most conventional supermarkets…. where our             products are recognizably distinct from those offered by our competitors, such as our          produce, meat and seafood, we aim to price them at a premium that is commensurate with              the product’s higher quality 

If TFM’s products are no longer “recognizably distinct” from competitors, the jig will be up.  And when the bleeding starts, it will show up in the gross margin line.  Accordingly, it is worth focusing the microscope on every single dollar that is capitalized and shoveled into a balance sheet account called “Other Assets.”            

            Valuation:

            Price: $50.23 (5/8/2012)

            Shares Outstanding: 48.1MM

            =Market Capitalization: $2.4B

                        +net debt: $386MM            

            =Enterprise Value: $2.7B

            TFM trades at 38x earnings and 19x EBITDA.  Consensus 2013 net income is $78.3MM, or $1.62/share on $1.5B in revenue.[15]  The top-line estimate is plausible.  In 2011, TFM averaged $10.3MM in revenue per store; up from $10.2MM in 2010, and $9.6MM in 2009 (≈3.5% CAGR).  If TFM opens 15 stores in 2012 (mid-point of 14-16 estimate),15 stores in 2013, and maintains the 3.5% growth rate, sales per store in 2013 would total $11MM, for $1.5B in sales.  Food inflation alone should buoy sales. 

             But to earn $78.3MM in 2013 net income, TFM needs to post a 5.1% net profit margin.  By food retailing standards, this figure would obliterate the ten-year trailing average net profit margins of competitors:

                        10-year Average Net Profit Margin-TFM Competitors

                                                      Whole Foods: 2.8%

                                                      Weis Markets: 2.5%

                                                      Harris Teeter: 2.2%           

                                                      Ingles: 1.2%

                                                      Kroger: 1.1%

                                                      Safeway: .6%

Going back to 1992, Whole Foods has never posted a net profit margin higher than 3.7%.  TFM’s 2006-2011 avg. net profit margin is 2.9%.[16] Meeting 2013 estimates would likely make TFM the most profitable company in food retail. 

            A less rosy scenario seems more probable.  TFM’s comparable sales per square foot are below 2006 levels: $529 in 2006 vs. $501 in 2011. Retesting 2006 levels by the end of 2013 will be a challenge.  TFM benefitted from less competition (there were at least 6 fewer Whole Foods in middle market cities than there will be by the end of 2012), and a booming economy in core markets (i.e. coastal Florida).  A pleasantly perfect storm for a high-end perishables seller.  

            The picture is different today.  Competitors are disrupting core markets, TFM is expanding further from its regional base, and perishables are becoming more ubiquitous.  An earnings miss or weaker than expected Comps in 2012-2013 will alter the market’s perception of the story.  Multiples will re-rate lower.  A 3.5% net profit margin (still near best-in-class) on $1.57B in 2013 sales gets to about $55MM in income.  A 20x multiple (≈20% premium to the 20-year trailing average S&P food retail index P/E ratio) yields an equity value of $1.1B, or ≈55% downside.  The 20% P/E premium may prove generous.

            For a sanity check, and a reminder on just how far from grace TFM could fall, see the comparable multiples below.

              Whole Foods

                     NTM Sales: 1.2x     

               NTM EBITDA: 13.8x

                     NTM EPS: 34x

                    Kroger

                    NTM Sales: .22x

                    NTM EBITDA: 5x

                    NTM EPS: 10x

                   Safeway

                  NTM Sales: .24x

                  NTM EBITDA: 4.7x

                  NTM EPS: 10.3x

            Harris Teeter

                  NTM Sales: .41x

                  NTM EBITDA: 9x

                  NTM EPS: 15x

                  Ingles

                  NTM Sales: .35x

                  NTM EBITDA: 5.8x

                  NTM EPS: 9.4x

                  Roundy’s

                  NTM Sales: .32x

                  NTM EBITDA: 5.6x

                  NTM EPS: N/A

The exact multiple, or the magnitude of the earnings disappointment, is ultimately less important than what that results will signal to investors: competition is catching up.  Unlike a fashion retailer, which can introduce new styles, or a restaurant chain, which can revamp its menu, TFM will have less room to adapt.  Unless The Fresh Market can meaningfully change the way that people shop for food, the Company will be hamstrung.  This does not mean that business will grind to a halt.  But it should cause the stock price to meaningfully correct from current levels.