Source: The Fresh Market.

The Fresh Market (UNKNOWN:TFM.DL) stock was falling by 1.8% on Thursday after the market close, as the company missed earnings expectations for the quarter ended on October 26 by $0.01. On the other hand, sales were better than expected, so the company is still delivering solid growth in spite of declining margins.

The top line
Net sales during the third quarter of fiscal 2014 increased 15.1%, to $419.5 million. The number came in ahead of Wall Street's forecasts -- analysts were, on average, expecting $413.2 million in revenues according to data compiled by Thomson Reuters. Same-store sales increased 3.3% during the period, driven by a 3% increase in the number of transactions, and a 0.3% increase in average transaction size.

The Fresh Market opened six new stores during the quarter, including stores in New Jersey, Virginia, Tennessee, Florida, California, and its first store in the state of Iowa. As of the end of the quarter, the company operates 164 stores in 27 states.

Margins and earnings
Gross margin was 32.9% of sales during the quarter, compared to 33.5% in the third quarter of fiscal 2013. This decline was primarily due to the company's decision to absorb cost inflation and continue promotions in key product categories, partially offset by an improvement in occupancy cost as a percentage of sales. 

Demand for natural and organic foods remains remarkably strong; however, competition is materially increasing in the sector, both from specialized players and traditional retailers. This means companies in the space have limited pricing power, which is having a negative impact on gross margin, especially in the context of rising inflation.

Selling, general, and administrative expenses as a percentage of net sales declined 40 basis points, to 24% of revenue, versus 24.4% in the same period last year. This was due to lower pre-opening costs, as the company opened six new stores during the quarter versus 10 new stores in the same quarter in 2013, and leverage of corporate and store operating expenses. These improvements were partially offset by an increase in incentive compensation expense.

Reported operating income was 5.8% of sales, compared to 5.2% of sales in the year-ago quarter. However, figures for the latest quarter include a net benefit of $2.9 million due to adjustments to previously recorded store closures and exit costs. Excluding these items, adjusted operating income was $21.4 million, or 5.1% of sales.

GAAP earnings per share came in at $0.31, an increase of 34.4% versus $0.23 per share in the third quarter of fiscal 2013. This includes $0.04 per diluted share in net benefits from adjustments to previously recorded store closure and exit costs.

Adjusted diluted earnings per share increased 17.6%, to $0.27 during the quarter. The number was marginally below Wall Street's forecasts of $0.28 per share according to data compiled by Thomson Reuters.

The Fresh Market generated $30 million in cash flow from operations during the quarter. Capital expenditures absorbed $24.1 million of that money, of which $21.9 million were related to store openings and remodeling. The company paid the remaining $3 million balance on its revolving credit facility during the period, and it has no long-term debt as of the end of the quarter.

Moving forward
Craig Carlock, President and CEO, highlighted the fact that The Fresh Market is prioritizing revenue growth at the expense of profit margins:

We are pleased with our fiscal third quarter results. We generated a 3.3% increase in comparable store sales as we benefited from our efforts to drive customer traffic and grow basket size in a more competitive environment. We delivered a 17.6% increase in adjusted earnings while proactively choosing to absorb rising cost inflation and continuing to promote key product categories that we know our customers value most. As we look to the fourth quarter, we are focused on providing exceptional food shopping experiences to our customers during the holiday season.

The Fresh Market expects fiscal 2014 adjusted earnings per share of between $1.56 and $1.64. This excludes anticipated store closure and exit costs for approximately $0.17 per share. Reported earnings per share are expected to be in the range of $1.39 to $1.47. Wall Street analysts are, on average, forecasting earnings per share of $1.57 for the full year. This outlook is based on an expected growth rate in same-store sales of 2.5% to 3.5%, and the opening of 20 new stores during the full year.

Margin pressure seems to be an industrywide phenomenon, and The Fresh Market is not immune to the competition. However, the company is putting revenue growth over profitability, and things seem to be working according to plan judging by the strong sales performance. In spite of the challenging environment, things don't look that bad for investors in The Fresh Market stock.