Specialty grocery retailer The Fresh Market (TFM) tumbled more than 19% on Friday last week after reporting disappointing third-quarter earnings and cutting its earnings guidance for full fiscal year 2013. TFM now expects earnings between $1.42 per share - $1.47 per share versus previous guidance $1.5 - $1.55 per share.
My first impression of this big drop was a "WOW". TFM has always been a nice company with very clear and strong business model. The grocery market is a brutal world with low profit margins and highly competitive environments. Given the high P/E ratio, TFM is providing investors good growth rate around 15%-20% per year. And of course, TFM's brand name occupies a significant amount of its market value. Even after Friday's plunge, TFM's forward P/E ratio is still around 25-26.
Some companies never get cheap. A P/E ratio of 10 is never going to attach to great companies. My article about HIBB explained that even during the darkest period of the 2008 financial crisis, HIBB was still able to stand at a P/E ratio of 14-15. TFM on the other hand, also enjoys stock price premium privilege. I'm going to explain why TFM's tumble created a very good buying point for long-term investors.
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First, let's see what the numbers said about TFM last week.
In the third quarter of fiscal 2013, net sales increased 13.4% to $364.5 million and comparable store sales increased 3.1%, compared to the fiscal quarter ended October 28, 2012. Net income in the third quarter of fiscal 2013 was $11.1 million, compared to $10.9 million in the corresponding period in fiscal 2012. Diluted earnings per share in the third quarter of fiscal 2013 were $0.23, compared to diluted earnings per share of $0.23 for the corresponding prior year period.
What disappointed the investors in this report is that the diluted earnings stayed flat when compared to the same quarter previous year. This was caused by a higher than expected cost of goods and higher capital expense. Comparable Sales was up 3.1% versus last quarter. Sales isn't bad. Here, I want to point out that the weather this year has not been so great for plantations in the major vegetable regions. Although TFM does not provide income numbers for specific products, we can figure out that the bad weather though out the year could have impacted the recent earnings report.
Craig Carlock, President and CEO said that TFM is going to open 22 new stores by year-end. According to TFM 2012 annual reports, every Store is going to cost about 3-5 million dollars, and generates 8-10 million dollars for the following year. Provided with the numbers, we can figure out that TFM is going to invest no less than 100 million dollars on new stores this year. In order to open new stores, TFM raises debt. There is not much long-term debt on the current balance sheet. However, current liability is roughly about 100 million dollars. TFM needs to pay interests to short-term debt as it accelerates to open stores. Short-term debt also puts pressure on the earnings ahead. 22 stores newly open this year may provide a rough gross income about 200 million dollars by the end of fiscal 2014. Calculating with this year's profit margin, we will have a rough net income of 6-7 million dollars or $0.12- $0.14 per share. Assuming the worst case,(say all the other stores' sales stay flat) EPS for fiscal 2014 will be around $1.52 - $1.60 per share.
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So I calculated a rough EPS for the fiscal year 2014, but how do we evaluate TFM using this number? Ok, let's analyze the business model a little bit.
TFM sells perishables and non-perishables food to the "Baby Boom" target population that will likely make more grocery shopping trips more often than younger generations. In addition, TFM refines its in-store shopping experience to lure "happy" customers. (If you have doubts about this strategy, take a look at PriceSmart (PSMT). (PSMT is smart to make itself as "local" as possible to fit in places where they open stores. The key is to increase profit margins by introducing local products and better than expected shopping experience.) TFM is now growing just as fast as PSMT did a few years ago. For the fiscal year 2012, about 65% - 66% of TFM's income came from perishable products and 34-35% came from non-perishable products. As a result, TFM had little in inventory and account receivables. Nobody is going to refund perishable food anyway. This means TFM has very healthy cash flow to support its expanding strategy. TFM sells fresh stuff. The key is fresh.
The grocery industry does not need any technological innovations so we don't have to worry about large expense related to its current properties and equipments. Hence, differentiating services and products becomes the key of success.
According to the earnings report last week, TFM's RoE was 27.14% versus previous average RoE 39.49%. It was a big drop, but it is still a lot better than competitors like WFM and KR. With a 15% - 20% revenue growth rate driven by new stores and existing stores sales expanding, TFM can use its retained earnings to support the aggressive expanding strategy. (I call it aggressive because by this pace, TFM will own more than 200 stores in 4 years) Peter Lynch once said you need to watch closely to the companies that grow in a stalling industry. TFM is definitely the case. Since TFM has disappointed Wall Street investors, it's likely that analysts will start downgrading TFM.
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Back to the numbers I calculated. Let's get it old styled. I have three methods to evaluate TFM.
1. Using projected EPS X projected annual growth rate.
· EPS $1.52 X 17% = $25.84 a share
2. Using Pretax EPS / corporate bond rate (average bond rate)
· EPS $2.33 / 0.085 = $27.411 a share
3. Adding possible retained earnings without opening stores
· Assuming no stores will be opened after fiscal year 2013 and all the current stores' sales will stay flat.
· TFM will be able to cut 100 million dollars as capital expenses (there won't be a reason to use such a leverage)
· 100 million dollars current liabilities creates about 1 million dollars interest expense. (according to 2012 annual report) So 1 million / 48.22 (total shares outstanding) = $0.0207 per share
· EPS $0.0207 + $1.52 (projected 2014 EPS) = $1.5407 per share
Interesting isn't it? It looks like TFM will be a good buy when it reaches about $30 a share.
We know that huge amount of retained earnings will be released to investors once TFM reaches saturation point that it will stop to expand aggressively. But if it stops to grow next year, it will only add $0.0207 to the earnings per share to the earnings ahead.
A fair valuation by then would be $1.5407 X 15 (I would lower the P/E ratio to 15) = $23.11 a share. So I would say, $23 dollars a share is the very bottom line for TFM. Why would they stop using leverage to grow? The interest expense is tiny compare to the new stores opportunities. According to the presentation picture above,TFM's ROIC is 25% in Q2. Ironically, interest expense is only about 1-2%...
We can see that TFM isn't building long-term debt because its current business can support its expanding strategy just fine. TFM's interest expense has been decreasing since 2011. Last year they paid 1.01486 million dollars on interest expense versus 5.3080 million dollars in 2009. With such a low interest rate in the U.S, short-term debt seems like a smart move.
Please keep in mind that EPS has always outpaced revenue growth for good companies. For example, WFM, a major competitor of TFM, had revenue of 9 billion and 12.9 billion dollars in 2009 and 2012 respectively. For the net earnings during the same period, WFM's EPS had raised up from $0.74 per share to $1.49 per share. That's about a 100% upside! All we have to figure out is that how long TFM will keep expanding. If you think it will grow for at least 3 years, then it's absolutely a good buy if it drops further more. Remember, even after it stops to grow, TFM can still repurchase its shares and remodeling existing business to sharpen its profit margins.
I would wait for TFM to skid further into 2014. I hope I will get a fresh bite on it.
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. (More...)
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