VITL - Vital Farms Q2 2023: Strong Performance With Positive FCF Support Bull Case

2023-08-16 10:58:32 ET

Summary

• I see potential for growth in distribution and SKU penetration, which supports my buy rating.
• The company reported strong Q2 results with higher revenue and EBITDA margin expansion.
• Near-term volatility is expected due to promotional activities, but long-term growth prospects remain positive.

Overview

My recommendation for Vital Farms ( VITL ) is a buy rating, as I believe VITL can continue to grow above industry rates by capturing share, given ongoing growth in distribution and the potential to increase SKUs per store. However, I also acknowledge that there is near-term volatility as there will be more promotional activities in 2H23.

Business

VITL is a national consumer brand that works with hundreds of family farms and is a leading player in the US for pasture-raised eggs. VITL operates in the US with 100% of its revenue coming in domestically in FY22.

Recent results & updates

In 2Q23 , VITL reported a strong quarter with top-line gains driven by pricing and volume that resulted in an astounding expansion of EBITDA margin. With price growth of 21% and volume growth of 6%, total revenue increased by 28.4% to $106.4 million, which was higher than the consensus estimate of $105.2 million. The 630 bps increase in EBITDA margin was also higher than the 400 bps increase expected by the street. The $14.6 million in FCF that VTL generated is a huge improvement from the -$7.4 million FCF burn that the company experienced in 1H22.

Based on my reading, there seem to be two stages of growth for VITL that will impact share price movement, I believe. The near future should be a bit more volatile in terms of growth, with a greater emphasis on 4Q23. While the second quarter of FY23 showed strong performance, it was hampered by the erratic ordering patterns of retailers in response to the rising availability of eggs in the industry as bird flu-related shortages eased. Management believes this had a negative impact on 2Q23 volumes in the mid-single digit range. The good news is that they are seeing things normalizing at the retail level in 3Q. Given that management has about 5 weeks to look through 3Q23 at the time of the earnings call and they are still calling for "normalizing", it means things have not fully normalized yet. This is also why I said growth in volume would be weighted in 4Q23.

Management has also brought up the issue of overly promotional activity in the egg category. Given the return of available supply, I believe that competitors are making moves to protect their market share. This could be a short-term drag on growth. On the bright side, management has stated that while they will increase trade and marketing spending in 2H23, they will not chase aggressive industry pricing. Since I consider VITL to be a market leader, I think they can get away with slightly higher prices by taking this course of action. The fact that VITL increased its market share by 150 basis points year over year despite a more challenging business climate lends credence to this view, as it demonstrates the strength of the company's premium positioning and its skewed customer base toward those with higher incomes.

As you might recall, we anticipated this dynamic at the beginning of the year. In this environment, Vital Farms grew our dollar share significantly by about 150 basis points relative to the same period last year. ( 2Q2023 earnings call )

The expansion of VITL's distribution network is just one of several factors that, in my opinion, will contribute to the company's long-term growth. The fact that VITL has expanded to 24,000 stores, a 10% increase, suggests that the company has room for further expansion. There is also room for growth in the potential SKU penetration that VITL can achieve in each store. When compared to VITL's primary competitor, VITL's customers stock only half as many SKUs.

Our largest branded competitor has more than 2x the number of items on shelves than we do in a conventional grocery store. (2Q2023 earnings call)

Finally, I think with VITL generating positive FCF, the stock will now enter a new valuation paradigm where investors will take strong FCF growth into account. Notably, VITL has a very strong balance sheet with net cash of $80+ million. These positive aspects of the business should support VITL's valuation.

Valuation and risk

According to my model, VITL was valued at $19 in FY24, representing a 65% increase. This target price is based on my growth forecast of mid-teens in FY24 and FY25 while meeting management’s FY23 guide. My mid-teens growth assumption is based on my expectation that VITL will grow faster than the industry (i.e., capture share). Given the strong performance so far, I think 15% growth is not demanding.

VITL is now trading at 22x forward PE, which I believe is a fair multiple as it should trade at a discount to its main competitor, Cal-Maine Foods ( CALM ), which is trading at 25x forward PE. CALM is a relatively bigger business with a larger revenue base and higher net margins. Over the long run, as VITL shows that it can continue to improve margins to CALM’s levels, multiples could rerate. But I prefer to stay conservative due to the near-term volatility that I expect to happen.

The near-term risk is that VITL misses guidance as the normalization of volume takes longer than expected and the increased promotional intensity reduces demand for VITL by more than expected.

Summary

I have a positive outlook for VITL. I anticipate VITL's growth to outpace the industry by capitalizing on distribution expansion and increased SKU penetration. Despite short-term volatility, VITL's recent strong performance, driven by pricing and volume gains, showcases its resilience. While challenges like erratic ordering patterns and heightened promotional activity exist, VITL's premium positioning and market leadership position it favorably. The expansion of its distribution network and SKU penetration further underpins its growth potential. Positive Free Cash Flow and a robust balance sheet enhance VITL's valuation prospects.

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