The Challenge Facing The Fresh Market

The morning was not kind to investors in The Fresh Market (NASDAQ: TFM  ) . A Goldman Sachs analyst downgraded the company from neutral to sell, citing competitive pressure and rising costs. The stock was down 4.5% in early morning trading, having recovered slightly from a deeper morning fall. Fresh Market has been fighting an uphill battle against Whole Foods Market (NASDAQ: WFM  ) , which dominates the "organic retailer" brand in the U.S.

Trouble ahead, trouble behind
Fresh Market's gross margins have come under pressure as product costs have risen and the company has decided not to pass those costs on to consumers. According to the business, the biggest increases have come in meat, seafood, and dairy, all popular categories. It's a squeeze that many retailers have seen, and Whole Foods has experienced a bit of the same. Gross margin at Whole Foods fell 51 basis points last quarter, also due to rising costs.

The difficulty for both businesses is that in order to compete, they've had to start actually competing. When Whole Foods and Fresh Market were the only organic games in town, they could charge an inflated premium for their goods. As costs went up, there was no drawback to passing on those increases -- where else could you find the same foods? Now, both companies are trying to compete with an increase in organic and natural foods sales from traditional retailers, and that means competing on price.

The Goldman analysis points out the combination of those effects. Fresh Market -- and Whole Foods, which is down today, as well -- are subject to the rising costs of produce, but they have to control the cost to consumers. Due to the importance of their products' sources, they can't just jump suppliers in the same way that traditional grocers can for traditional goods.

Boneless chuck, for instance, is up 24% over the past year. That's a hit that both companies are feeling as they try to shake their "cost prohibitive" associations. It's a fine line to walk, and right now it's biting into the bottom line.

Looking at the long game
The Fresh Market has had other concerns, as well, with its expansions into California and Texas not going as smoothly as it had hoped. Those missteps took cash right out of the bottom line, as Fresh Market closed some stores and is spending to open others. It seems clear that Fresh Market has a plan, but it is still shaky on execution.

There's a chance that everything will turn around, if the business can make its new market strategies stick and adjust its pricing to buffer fluctuations in product cost. That's going to require a very different approach to those new markets and some sort of flexible pricing model for its existing stores. On the plus side, business has grown at the chain, so it's clear the demand is there. Fresh Market just needs to figure out how to turn that desire into earnings.

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