Josh Arnold wrote an article earlier this month on SA arguing intelligently that Fred's (FRED) is overvalued based on estimates of future growth. I want to argue that Fred's valuation isn't crazy based on comparables.
Investors can think of Fred's as two interrelated businesses. Its general merchandise business has struggled of late. It also has a pharmacy business, which has performed well and provides the chances for exceptional growth due to changes in the healthcare sector, such as the Affordable Care Act. Recognizing this, management launched a Reconfiguration Plan with the goal of moving the general merchandise business to higher gross margins while accelerating their growth in pharmacy and healthcare services.
As management notes in their 2012 Annual Report:
With an established growth strategy for Fred's markets, along with a continued aging population and the healthcare reform changes being implemented in January 2014, we believe there will be exciting opportunities for pharmacy growth in the coming years. Accordingly, we have begun to roll out one of the most important initiatives in the history of our pharmacy department, the Fred's specialty pharmacy program. Specialty pharmacy is the fastest-growing segment of the pharmacy industry. The $80 billion plus specialty pharmacy market is expected to grow at a rate exceeding 15% per year during the next three-to-five years, with over 50% of new drug approvals by 2015 coming from the specialty category.
The pharmacy plan will work in tandem with the general merchandise plan, which will begin with reallocation of space to higher margin automotive, hardware and seasonal merchandise. The plan looked promising when I read the annual report:
We tested the reconfiguration plan last year by reallocating space in 78 stores to expand our automotive and hardware department. We were very pleased with the results of this test, as these stores produced a 30%-to-40% increase in comparable store sales in the expanded department and, on average, each of the test stores performed 150-to-200 basis points above the balance of our chain in terms of overall comparable store sales.
The update given on the Reconfiguration Plan during the May 30th earnings call was encouraging.
As of today, we have reconfigured an additional 101 stores with our expanded hometown and automotive and hardware, bringing the total number of stores to 175. We are pleased with the results of the 175 stores -- that the 175 stores are delivering, with automotive and hardware comparable store sales increase of 15% and 43%, respectively. Additionally, these stores, overall, are outperforming the balance of the chain in comparable store sales. Looking ahead, we have identified an additional 150 stores that will be reconfigured beginning in late Q2 with completion anticipated in Q3.
Fred's also has an initiative related to opening discount tobacco shops within the store to drive traffic, since the company argues tobacco is a reason customers will patronize Fred's rather than competitors. This initiative is also going well:
As we have discussed in past calls, we have executed initiatives to improve tobacco sales, which generate strong customer traffic to our stores. Tobacco sales have performed exceptionally well as a result of these initiatives in place and we expect the positive performance to continue throughout the year.
Despite a transformation on track, bears like Josh Arnold argue intelligently that Fred's is simply too expensive based on estimates of future growth. But I think Fred's valuation looks reasonable compared to what a private buyer is willing to pay for Alco Stores (ALCS), which is currently being bid on by private equity. Alco is comparable to Fred's poor general merchandising business. It doesn't have Fred's pharmacy growth business. In SEC filings, Alco Stores cites Fred's as a comparable peer--so I don't think I'm off base in comparing them. Fred's is bigger, but they are both broad line retailers seeking to do business in smaller markets. So how does Fred's valuation compare to Alco Store's in the context of the private market?
5 Yr Rev CAGR
(Source: Capital IQ)
While Fred's has only appreciated about 6% over the last 52 weeks, Alco Stores has appreciated about 116%. Clearly, Fred's is undervalued compared to what private buyers are willing to pay for Alco Stores. Of course, there is probably a premium for control built into Alco's current valuation. Also, one could argue that Alco deserves a higher multiple because it is smaller and thus has greater growth opportunities. But Alco's growth opportunities are constrained by the fact that its strategy, according to the 10-K, is to build stores only in areas without competition from other national brands. Besides, based on the latest 10-K, 36% of Fred's sales mix comes from pharmaceuticals. Clearly, revenue from the pharmacy business deserves a higher multiple than Alco's general merchandise business. Anecdotally, having been in both stores, I think Fred's has greater brand value. I'd shop at Alco if it was most convenient, but I can't imagine deciding to go to Alco over a nearby competitor. In my opinion, there isn't anything special about Alco.
Although on some metrics Fred's can look overvalued, I think market participants who like Fred's story are rational to stay in the game at this point, given what the private market is willing to pay for Alco Stores.