Vital Farms (NASDAQ:VITL) just posted a stellar Q2 result, with $147.39 million of revenue (yoy growth of 38.46%) and a 39.13% gross margin. However, both gross and operating margins have likely reached their peaks, and sales growth may not be as exciting in the following quarters. All of these would translate into compression in the company’s forward P/E valuation, reflected in the recent pullback in stock price. Given the fading near-term momentum of the company, I’d initiate a “HOLD” rating on the stock and may shift to “SHORT” if the stock price rose back to its highs around the 40s.

Brief Review of the Amazing Performance in 2024

Vital Farms had a fantastic return profile in 2024, with a 198.66% increase in stock price in the first half. Such a surge mainly comes from the forward valuation side, with the company’s P/E multiple increasing from 28.68 to its peak of 44.61. Many would say a P/E multiple of 40x would be obviously overpriced for an egg-selling business, and put on a short position simply for that reason. Such action would never be justified as rational: the market is not stupid 90% of the time, and it most likely gives companies high valuations for a reason. This leads us as investors to answer the questions of “what happened in the first half that, despite the macro noises, resulted in such a high P/E multiple”, and “whether the underlying reason supporting valuation still exists in the second half and beyond”.

Stellar YoY Revenue Growth

Despite negative growth in the butter business due to the discontinuation of tub butter SKU in late 2023, the company’s core segment, the egg business, faced significant revenue growth this year, with 27.46% growth in Q1 and 39.99% in Q2, resulting in the overall growth of 24.13% and 38.46%. Note that in contrast to the 50% price, 50% volume growth last year due to the shortage of supply of eggs, the majority of growth this year is driven by volume, with low single-digit price growth. I see this as normalization on the price side, while volume growth benefited from last year’s egg shortage due to Avian Influenza.

Gross Margin seemed even more Exciting

Ending FY2022 with a gross margin of 30.23%, VITL entered a period of extremely rapid margin expansion. Its gross margin was 34.40% in FY2023 and took another leap to above 39% in the first half of FY2024. While scale, productivity, and pricing mechanisms certainly helped boost the margin, I’d say the biggest tailwind came from the YoY fall-off in commodity prices. The fall-off in prices of corn and soybeans in particular contributed significantly to such expansion.

Looking into the Second Half and Beyond

More Moderate Revenue Growth

As the CFO guided in Q2’s conference call, revenue is “expected to be evenly split between the first and second half of the year”. Incorporating this with the company’s guidance of “at least 590 million revenue” and its ability to beat guidance by more than 1% in the prior years, I forecast Vital Farms’ annual revenue to be $600 million, slightly above guided revenue as Vital Farms benefit from the recent soar in commodity egg price in the US. Given the seasonality of the business, revenues in Q3 and Q4 are expected to be $138.73 million and $166.41 million respectively, translating into YoY growth of 25.63% and 22.53%, down from 38.46% in Q2.

While Vital Farms has proven itself to be a 20%+ grower since IPO, I’m not that certain about the growth trend into 2025 and 2026. Egg Central Station, the facility Vital Farms relies heavily on, is now estimated to have $800 million of revenue capacity, upward revised from $700 million the management guided in Q4 2022, due to favorable price mix and productivity expansion. While such a 14% expansion in revenue capacity is great, I don’t expect Vital Farms to continuously push revenue capacity at this rate, as price growth has now normalized to 4.9% and around 2.5% in 2024 from 16.43% growth in 2023.

The new Egg Central Station (the second one located in Seymour) with a $350 million revenue capacity would not be completed until the end of 2026, for the most positive estimate. Combining all this information, I expect revenue to be around $900 million in FY2026 for my very optimistic forecast, translating into a 2024-2026 CAGR of 22.5%, much slower growth than this year’s expected figure. Note that the company guided $1 billion in revenue in FY2027 as the long-term goal, and my estimation of around $900 million in FY2026 already implies that the company would significantly beat its long-term target.

Compression in Margin

Compression, or let’s say, normalization in gross margin is where I see the biggest risk coming from. As mentioned earlier, Q2’s stellar gross margin benefited tremendously from the fall-off in corn and soybean prices in the first half. As inflation continues to ease and prices go back to the historical average level, I expect Vital Farms to benefit much less from such macro-benefits in the second half and years beyond. Any potential uptick in commodity prices would adversely affect the margin performance.

Note that the long-term gross margin guidance remains at 35%, which seemed way too low under two consecutive quarterly prints of 39%+ gross margin, and yet the management has not changed that guidance (at least for now). In fact, in Q2’s conference call, the CFO admitted the potential margin compression in the second half,

Look, when we look at commodity cost, in my estimation, Q2 was probably the biggest year-over-year benefit and fall-off of commodity costs. So the margin benefit that we get from that probably peaked in Q2.

Further, the maintenance of the butter business, which is expected to grow in the second half, would also put pressure on the gross margin.

Given these data, management guided H2 gross margin to be “about our long-term guidance, just not to the same degree that we had in the first half of the year”. And I expect the gross margin to continuously normalize in 2025 and 2026, staying around 35% as macro noises fade. 35% gross margin certainly seems much less exciting than the 39%+ ones, and we need to take that into account in the estimation of forward multiples like P/E NTM.

I’d also like to talk a bit about the Adjusted EBITDA margin in the H2. The management guided elevated marketing expenses of 5%-6% of revenue in the H2 to advertise the brand. Taking this factor into calculation, my Adjusted EBITDA margin forecast would be 9.71% in the H2, down from 17.72% in the H1. The Long-term (2027) guided Adjusted EBITDA remains at the 12%-14% range, and the FY024 full-year expected 13.95% adjusted EBITDA margin certainly seems elevated from that level, given the gross margin factor mentioned earlier. My opinion is based on the assumption that the company would maintain its 2027 long-term financial target, and the management showed no sign of changing that target in Q2.

Recent Rise in Egg Prices – Is Vital Farms a Compelling Stock to Buy?

People paying attention to the commodity egg market might have noticed the recent uptick in the US egg spot price, from its low in May ($1.54) to $4.33, nearing its high at the end of 2022 due to Avian Influenza. So, will Vital Farms benefit from this hype in the commodity egg market? Well, my answer to this is yes, but to a much lesser extent when compared to egg sellers like Cal-Maine.

A Brand VS. A Commodity Egg Selling Company

The first thing we need to understand here is that Vital Farms is a brand, and to establish itself as a brand with stable pricing and high customer loyalty, the management uses multiple strategies, including contract pricing, to mitigate the impact of the fluctuation of commodity egg prices on its own growth. These practices result in relatively stable revenue growth with consistent premium pricing, while also benefiting less from industrial tailwind. As the CEO mentioned in the Q2 conference call:

the economics of what we’re doing in our gross margin got a little bit of tailwind again from that elevated commodity egg cost. It did not impact our price/mix. That’s our own strategy. That’s completely separate from what’s going on in the broader market. And we’re not seeing – and historically, we have not seen big changes in the trajectory of our growth or our gross margins relative to what’s going on in the broader commodity category. We don’t respond to commodity price changes in the moment.

So, the impact on margin would be very much limited. It might help with revenue growth, though, as a rise in commodity egg prices would make Vital Farms eggs (whose prices would not increase that much) more attractive to consumers, but again, to a limited extent. Investing in Vital Farms would mean you are buying the brand’s long-term ability to maintain its image as an ethical pasture-raised egg seller, selling eggs at a premium to its competitors while maintaining high customer brand loyalty, not because of some temporary industrial tailwind related to commodity eggs.

In short, if you do think the surge in commodity egg prices in the US will continue in the foreseeable future and want to benefit from this, then go and buy Cal-Maine’s stock. That is the one you should look for if you want to benefit from the surge in egg prices as they do sell eggs at their commodity prices. Evidence would be the stock’s 47% gain in 2022 and 77% increase in sales in 2023 with a doubled gross margin (primarily due to higher egg selling prices), the last time nationwide avian influenza hit. Vital Farms, however, only had a -17% stock return that year, with around 10% and 16% price-driven sales growth in 2022 and 2023)

I’ll not buy Cal-Maine, though, as I’m not an expert in the egg market, and I don’t really know which direction the egg prices are going. I mentioned Cal-Maine simply to inform those interested in this trading opportunity. (By the way, I did see an egg expert posting comments on the last few Seeking Alpha VITL articles, check on those if interested)

To Conclude

Given the fading business momentum on the gross margin side, I propose that the margin is likely to peak in the first half of 2024 and may regress to the company’s long-term target of 35% gross margin and 12%-14% Adjusted EBITDA margin in 2025 and 2026. Sales growth may be impacted by the rising commodity egg prices, but to a much lesser extent than Cal-Maine, and there’s also the revenue capacity constraint at Egg Central Station to consider. Pulling all these together, I’d initiate a “HOLD” rating on the stock, despite trusting the long-term value of Vital Farms’s brand.

This article is mainly written to inform investors of what happened to the company’s financials & why a stock that had such a magnificent run in the first half suddenly began to plunge even with Revenue, EPS beat + raising guidance in Q2 (excluding macro factors), so valuation part may not be as significant as my other investment ideas. It may be more reasonable to focus on the business momentum and trends rather than valuation. But based on historical P/E NTM, I do expect P/E NTM to be around 24x in a benign market environment in a one-year timeframe, and around 20x in a market with more “hard landing” narratives (bear case).