The Upside Case for Family Dollar Stores

The One-Liner:
Family Dollar Stores (FDO) is benefiting from the "best of both worlds." It is positioned to grow in both negative recessionary and positive recession-"less" scenarios.

Detailed Summary:
Family Dollar is in this "win-win" situation because its earnings is again benefiting from any government stimulus initiatives. While earnings growth from "food stamps" may be morally questionable to some, an investor would be prudent to take advantage of this. Finally, FDO is opening stores, upgrading existing ones, and updating product mix. All of these activities will make it a more attractive place to shop as the recession eases.

3rd Quarter Results
Positives for most recent quarter:
* $0.62 per diluted share versus $0.46 per diluted share (a 35% increase compared to last year)
* 1.843B in Net sales compared to $1.702 billion (up 8.3%)
* 1.2M shares acquired at an average cost of $32.00

Negatives for most recent quarter:
* SG&A (Selling, general and administrative expenses) up $528.2 million, or 8.3%, due to higher incentive compensation and insurance premium costs (this cost is higher despite leverage of costs against higher sales)
* Inventory up $1.035 billion, or 3%

Outlook for next Quarter (Q4)
According to management, net sales are expected to increase between 4% and 6%. Comparable store sales are expected to increase 2% to 4%.

Management provided an EPS forecast of $0.39-$0.43 (compared to $0.38 Q4/2008) a potential 13% growth in earnings from a quarterly results comparison.

Outlook for 2009

For the fiscal year ending August 29, 2009, full-year EPS will be between $2.03-$2.07 as compared with $1.66 in the previous year. This is a management-provided forecast of 24.7% growth rate for the year.

Top Down (Macro) Assessment on Outlook:

The investor needs to accept that the American consumer is heavily in debt because its net worth has declined due to a decline in home prices. This is already well-known and was the main driver for the stock sell-off in Oct/08-Mar/09.

Consumption rates declined and, more importantly, for the first time in a long time, savings rates are up. The stock market is pricing in an end to a recession. The market, however, is assigning a growth in consumption, which is not likely to be a driver in the technical end to the recession (please see my blog for more information on why the recession is technically defined to end).

This savings increase trend is not short-term. Government stimulus is short-term. It is what helped FDO produce higher-than-average earnings in 2008 and in its last quarter. More significantly, this trend illustrates that consumers are using whatever government assistance they obtain to shop at Family Dollar. Therefore, I would assign a more optimistic 2009 EPS of $2.07 for the company.

Company Valuation (Intrinsic Value):
A fair value for FDO is $31.04. This was calculated using its average EPS from 2000-2008 of $1.35 and an average growth rate in that same period of 7.2%. This value is also supported by the company's ability to generate over 323M in operating cash flow, pay $103M in CapEx, and $54 in dividend payments in its most recent quarter.

Assumption: FDO is able to maintain a minimum earnings growth rate of 7.2%.

Target Price:
Removing negative earnings growth values from calculations last 8 years (to simulate a "best of both worlds" scenario ascribed in my investment thesis), I arrive at the following range of target prices:

Margin of safety Target Price
50% $23.24
25% $34.85
20% $37.18
10% $41.82

Note: The margin of safety was applied to a best-case average EPS of $1.37 and a growth rate of 12.71%.

I arrive at a baseline target price of $32.53 (by averaging worst-case and best-case prices) and an upside target price of $37.18.

This target price represents an upside of 22% as of the closing price on Aug 10 2009, a forward P/E of 18, and an average PEG of 1.42. Short-term, the target price is conservative, since the PEG is 0.72 when a 1-year growth rate is used (2008 to 2009).

Support/Entry Price - Portfolio Management:
FDO is attractive at current prices, and even more attractive at prices below $25. At that level, investors gain a 50% margin of safety against past and forecast growth rates for which my target price is based.

Reasons supporting Target Price:

1. Company is investing in a chain-wide store technology to capitalize on the government stimulus package initiative of food stamps. This is achieved by supporting the acceptance of credit cards and food stamps.

2. Initiative to replace old Look and Feel with a more intuitive one (by improving in-store signage and merchandise adjacencies in ways that make more sense)

3. As of March, 2009 approximately 15M households relied on food stamps (up 19% year-over-year for the same period).
This year’s stimulus program is effectively about 13% higher for the FDO customer. Management noted food stamp
transactions increased from April 2009.

4. Technology upgrade in FDO stores continues to serve expanding population base of food stamp recipients (~60% of our stores are capable of accepting food stamps as opposed to 25% in 2008). By early 2010, all stores are scheduled to support this.

4. Management enthusiasm. Management provided a Q4 earnings forecast increase, even though last year's one-time stimulus impacting results in June/July 2008 quarter would make this year's comparable a challenge.

5. Adjustments in "key traffic driving categories" and on "basic needs" will sustain customer traffic.

6. Back to School "kick" to revenue will be counted in Q4. If FDO is able to capture market share and generate greater sales (at the expense of higher-end retailers, and other retailers like Walmart (WMT) or Target (TGT).

7. Finally FDO is selling at $30.60, which is a forward P/E of 14.8 (2009 EPS forecast is $2.07). Given the earnings acceleration for this year over last is expected to be higher (a 24.7% growth or a PEG of 0.6), FDO is under-valued in the short-term.

Risks:
1. Change in product mix may impact gross margins negatively and a poor execution may result in higher costs.
2. Recession eases significantly enough that consumers shop instead at up-scale competitor stores.
3. Market risks (general decline in appetite for risk results in investors paying less than assumed P/E levels.

Source: Third Quarter conference call as posted on Seeking Alpha.

Disclosure: Author holds a LONG position in Family Dollar Stores on his KaChing virtual portfolio (a site with over 380,000 registered users). This portfolio is also followed by 560 users.

Comments

[malach hamo...:]

closeout operations like FDS require a constant supply of overstock merchandise which can then be turned quickly.

Last year, when the retail economy suddenly collapsed, FDS and its counterparts in soft goods - Ross Stores, TJX, were able to capitalize on the mass of surplus goods and move a lot of merchandise at bargain prices.

As retailers and suppliers acclimate to the new, low-spend economy, they're not as likely to get stuck with the mass of seasonal goods which must then be unloaded to discounters and close-out kings.

How this will affect FDS in not certain, but it probably won't help.

Aug 11 08:17 AM

[captainccs:]

On Aug 11 08:17 AM malach hamovess wrote:

> closeout operations like FDS require a constant supply of overstock
> merchandise which can then be turned quickly.

This piece was about FDO, not about FDS

Aug 11 09:09 AM

[captainccs:]

A "Detailed Summary" is an oxymoron.

Aug 11 09:10 AM