One company that has caught my attention with its promising growth prospects is Vital Farms (NASDAQ:VITL). It has shown remarkable potential to surge beyond industry standards, and I’m placing a “buy” recommendation on it. This conviction is driven by their strategic expansion in distribution networks and the possibility of increasing their stock keeping units (SKUs) per store. While there’s a hint of short-term volatility due to upcoming promotional activities in the latter part of 2023, I see a silver lining in the company’s long-term growth trajectory.

Getting Acquainted with Vital Farms

In the realm of US consumer brands, Vital Farms stands out as a notable contender. Collaborating with numerous family farms, the company has earned a prime spot as a leader in pasture-raised eggs in the United States. What’s intriguing is that all of their revenue, totaling 100%, originates domestically in the fiscal year 2022.

Insights into Recent Triumphs

The second quarter of 2023 brought about some truly impressive results for Vital Farms. The surge in revenues and the noteworthy expansion of EBITDA margin propelled their performance to new heights. With a 21% increase in prices and a 6% rise in volume, the company’s total revenue soared by 28.4%, reaching a remarkable $106.4 million. This exceeded the consensus estimate of $105.2 million, taking the market by pleasant surprise. Moreover, the 630 basis points (bps) expansion in EBITDA margin surpassed the street’s expectations of a 400 bps increase. It’s worth noting the substantial leap in free cash flow (FCF) as well. A stark transformation from the -$7.4 million FCF burn in the first half of 2022, VITL generated an impressive $14.6 million in FCF.

Navigating the Growth Phases

As I examine the roadmap ahead, it’s evident that Vital Farms is poised for growth in two distinct phases. The near-term horizon might experience fluctuations, especially in the fourth quarter of 2023. The second quarter of the fiscal year demonstrated robust performance; however, it grappled with erratic ordering patterns from retailers. This was likely a response to the gradual resolution of egg shortages caused by bird flu-related issues. Although this hiccup led to a mid-single digit decline in 2Q23 volumes, the good news is that the retail landscape is anticipated to normalize by the third quarter. It’s intriguing to observe that as of the earnings call, with about five weeks into 3Q23, normalization hasn’t fully materialized, indicating a weighted growth anticipation for 4Q23.

Tackling Promotional Challenges

The competitive environment in the egg category has seen heightened promotional activities. This could momentarily hinder growth prospects. However, there’s a silver lining – Vital Farms intends to amplify trade and marketing expenditures in 2H23 without aggressively adjusting pricing. Given the company’s market leadership stance, this could work in their favor, allowing them to maintain slightly higher prices. Notably, despite a challenging business climate, VITL managed to boost its market share by 150 basis points YoY, a testament to the resilience of its premium positioning.

Setting the Stage for Long-term Growth

One of the many drivers of Vital Farms’ anticipated long-term growth is the expansion of their distribution network. Their presence in 24,000 stores, a 10% expansion, hints at untapped potential. Additionally, the opportunity to enhance SKU penetration in each store is ripe for exploration. A compelling comparison to their primary competitor showcases the room for growth – VITL’s customers stock only half the number of SKUs.

A Positive Outlook for Valuation

The trajectory of VITL’s valuation is poised to take a positive turn. Positive FCF generation is expected to usher in a new valuation paradigm, with investors considering robust FCF growth. It’s noteworthy that the company boasts a robust balance sheet, boasting net cash of over $80 million. These factors are likely to lend support to VITL’s valuation.

Evaluating the Risks and the Road Ahead

Naturally, in the investment arena, it’s imperative to assess both the valuation and potential risks. My valuation model projects a value of $19 for VITL in FY24, reflecting a substantial 65% increase. This estimation is rooted in my expectations of mid-teens growth for FY24 and FY25, aligning with management’s FY23 guidance. A 15% growth rate seems achievable, given the impressive trajectory thus far. Currently trading at 22x forward PE, VITL seems fairly valued, especially when compared to its larger counterpart, Cal-Maine Foods (CALM), trading at 25x forward PE. As VITL demonstrates an ability to enhance margins and perform on par with CALM, there’s potential for valuation multiples to shift.

Summing Up the Story

To encapsulate my stance, I hold an optimistic outlook for Vital Farms. The company’s prowess in leveraging distribution expansion and SKU growth positions them to outpace industry norms. While short-term hiccups may arise, the robust performance in recent times, fueled by price and volume enhancements, underscores the company’s strength. Despite challenges like erratic ordering patterns and intensified promotions, Vital Farms’ premium positioning and market leadership stand them in good stead. The expansion of their distribution network and SKU reach provides a strong foundation for growth. Add to this the allure of positive FCF and a resilient balance sheet, and you have a recipe for promising valuation prospects.