Recently, I declared that I would be ending my CAPS pick for Whole Foods (Nasdaq: WFM ) . In a nutshell, I believe Whole Foods is an excellent business, consistently outperforming competitors by a wide margin, but as a result, its stock is, at best, fairly valued, and may be anticipating higher growth than is reasonable.
One comparison I noted was The Fresh Market (NYSE: TFM ) , which appears far more richly valued and with less good reason. An intrepid reader emailed me with some good points disputing The Fresh Market's overvaluedness, but on a deeper look, I still think the current stock price is far from justified. At the risk of inspiring another Foolish counterargument, I've decided to go so far as to make a CAPS underperform call.
Fresh, or just underripe?
Despite its recent IPO, The Fresh Market has been around for almost thirty years, so it isn't exactly a new company. But by some estimates, it's certainly growing like one. Net income, sales, and total number of stores have all doubled or come close to it since 2006.
But where is all of that growth coming from? The net income gains can't really be explained through higher pricing power or leaner operations. The company's operating margin has ranged between about 4% and 6%, which admittedly is a respectable margin for the grocery industry.
The real source of Fresh Market's climbing profits is its surging sales growth. But again, that's not due to any sort of premium pricing strategy or competitive advantage. It's largely due to the fact that the company has been aggressively expanding, from 53 stores in 2005 to 100 at the end of 2010, a compound growth rate of 13.5% compared to a sales growth rate of 16.2%.
That seems to at least leave some room for same-store sales growth, but not quite. It's true that comps have increased almost every year, but so has store size. Sales per square foot, a better measure of efficiency and profitability has actually been steadily declining over the last few years. For 2010, The Fresh Market only managed sales per square foot of $481, far lower than the industry average of $613, and even lower than that of a lumbering giant like Safeway (NYSE: SWY ) . Even SUPERVALU (NYSE: SVU ) has higher sales, and they've been seeing revenues decline every quarter for a few years now.
It would be tempting to excuse the low sales per square foot in light of the company's high operating margin, but once again, The Fresh Market doesn't stand up to the competition. Whole Foods has nearly the same operating margin and twice the sales.
These expectations go to 11
Despite profit growth built more on the back of store growth than improving performance, investors are expecting a tremendous amount from Fresh Market's stock. As a reader pointed out to me, the current sky-high P/E of 140 is affected by certain one-time charges related to the company's IPO. However, excluding those charges, Fresh Market would still have a P/E of 42.6, slightly higher than that of Whole Foods.
The company's PEG ratio, which attempts to normalize earnings growth, stands at 1.86, implying it is grievously overvalued. A Fresh Market investor is essentially paying twice as much for the same earnings growth as a typical grocery investor.
The risks are plenty
There are currently only about 100 stores, and management believes the concept could support at least 500. So while earnings growth is being driven almost entirely by store growth, there's no real sign of saturation coming any time soon. That means profits can continue to grow at this pace for a while. It's worth noting that sales per square foot have been recovering slightly over the last couple years as well. Even if that metric declines, the company just needs to grow total square footage at a faster rate, and it might not come back to bite them for a few years.
However, part of the bull case for The Fresh Market revolves around its small store size, allowing it to slip into markets bigger grocers like Safeway aren't equipped to handle. At some point, Fresh Market's expanding stores will become incompatible with that thesis, and the company's comparable store sales growth will begin to evaporate. And when that happens, investors might regret their lofty expectations.