The Fresh Market - the leader in grocer operational efficiency
“Of course, there are plenty of ways we could define what makes a business either good or bad…Obviously, any of these criteria, either alone or in combination, would be helpful in evaluating whether we were purchasing a good or a bad business… For instance, what if we found out that it cost Jason $400,000 to build each of his gum stores (including inventory, store displays, etc.) and that each of those stores earned him $200,000 last year. That would mean, at least based on last year’s results, that a typical store in the Jason’s Gum Shops chain earns $200,000 each year from an initial investment of only $400,000. This works out to a 50 percent yearly return ($200,000 divided by $400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital…which sounds better—a business that earns a 50 percent return on capital or one that earns a 2.5 percent return on capital? Of course, the answer is obvious… You would rather own a business that earns a high return on capital than one that earns a low return on capital!”
Joel Greenblatt – The Little Book that Still Beats the Markets
There dozens of ways to assess businesses. Profit margins, revenue growth, cash flow yields, etc. In the retail business, common metrics include revenue and profit (or free cash flow) per square foot (or store). By dissecting retail businesses into “per store chunks,” it’s easier to compare multiple businesses.
But we’re not here to write white papers on the excellence of a business. We’re here to find excellent businesses that equate to excellent investments. And Greenblatt provides us the proper metric to assess business excellence from the investor’s perspective: Returns on Capital (ROC).
While Greenblatt prefers Returns on Capital, it’s not the only useful operational efficiency metric. Buffett and Munger commonly stress Returns on Equity (ROE). I don’t necessarily prefer one or the other, but the ease of calculating Book Equity (and by calculating, I mean reading it off of the 10K) leads me to drift toward ROE more often. Additionally, I’ll also look at Returns on Assets (ROA) to cross-check my ROE values.
As to what should be used for “R,” I often “triangulate” earnings (net income, pre-tax income) and cash flows to find a normalized number that I feel comfortable with. Why do I triangulate these values? There can be flaws to only using cash flows or only using net income. Free Cash Flow, for instance, has its drawbacks. I’ll use Whole Foods and The Fresh Market as 2 examples of how this is so.
Whole Foods is a big fan of stock-based compensation. Every year, Whole Foods gives stock to nearly all employees. Why does this matter for cash flow? Well, the SEC requires that stock compensation is subtracted from net income. But in the cash flow statement, it is added back because it is a non-cash expense. If you’re calculating free cash flow by using OCF and CapEx, without adjusting for stock based compensation, you’re arguably using an inflated number. In the case of Whole Foods, roughly 12% of the FCF value is attributed to stock-based compensation –$57M dollars for FY 2013. If this were a one-time expense, I wouldn’t sweat it so much. But this is an annual expense that Whole Foods deals with every year. Neglect to back this out of Free Cash Flow results in an inflated analysis.
But in the same way that Free Cash Flow can lead to false perceptions of cash-producing value investments, it can also coax investors into passing on investments that may be more attractive than meets the eye. The Fresh Market only realizes a small amount of Free Cash Flow per dollar of Operating Cash Flow. Why is this? Because much of their cash received from operating activities is reinvested right back into the business. Out of $140M generated in Operating Cash Flow in 2013, $122M – nearly all of it – went back to store upgrades and new store openings. Is that a bad thing? Well, if the expected returns on those investments are going to be rather high (which we’ll see in just a minute, they are) then investors should be happy with the heavy reinvestment.
But this doesn’t mean that you can’t use some sort of Free Cash Flow metric for a company like TFM, at all. Instead of subtracting CapEx from OCF, you could subtract Depreciation from OCF. This would give you a number that could resemble “steady-state” or a multi-year average. Considering that The Fresh Market’s Depreciation is roughly half of CapEx, Free Cash Flow would be much higher. We’ll call this value “FCF_dep.”
Ok. With all that jazz being said, let’s dive back into the purpose of this blog post – operational efficiency as measured by ROE and ROA.
Using Operating Cash Flow as a measure of returns:
WFM ROA, ROE: 18%, 24%
TFM ROA, ROE: 30%, 55%
Using FCF_dep as a measure of returns:
WFM ROA, ROE: 12%, 17%
TFM ROA, ROE: 18%, 33%
Using adjusted net income as a measure of returns:
WFM ROA, ROE: 10%, 14%
TFM ROA, ROE: 14%, 26%
Whole Foods not only lags Fresh Market in these metrics – it is getting dusted in these metrics. Now do you see why it’s not necessarily bad that TFM is investing in CapEx? Sure, the Free Cash Flow number is low right now, but more high-returning stores can mean big profits in the future.
And as for the valuation perspective of these two companies, P/OCF of WFM is about 14. P/OCF of TFM is about 11. And remember – that’s using an “inflated” OCF value for WFM.
But The Fresh Market is just some tiny little half-hearted grocer with overpriced items, right? Of course! Rather than selling a bunch of high-margin and low-margin items, The Fresh Market is focusing on the high-margin items. This leads to industry-leading ROx metrics. Does this mean that TFM won’t be a customer’s one-stop-shop for groceries, and will lower revenue potential? Sure. Does that mean that The Fresh Market can’t be a good investment? Hardly…
Now, I’m not advocating one company over another as to which is the better investment. Full disclosure – I’ve invested in both companies over the past month. But if we’re going to perform an analysis as to which company is better, I’ll take my turn to advocate the Joel Greenblatt method, and assess these companies on metrics that indicate market-beating shareholder returns.