Family Dollar Is Very Overvalued

| About: Family Dollar (FDO)

Wal-mart and Aldi to Stop Dollar Stores Growth, Especially Family Dollar's

This morning Family Dollar (NYSE:FDO) reported another in a string of street disappointing earnings and the COO has left. The contention over a turnaround in operations will continue, but I believe that the discussion is not anywhere near as germane as increased competition.

A few weeks ago Aldi announced that it would open 50% more stores in the US over the next five years, as it wants to become the largest discount grocery chain in the US. That move increases an 80 store pace to 130 per year, and the square footage growth rate to an 8.4% CAGR for the next five years. While always a competitive threat sort of flying under the radar of the US supermarket wars from the vantage point of many investors and sell side analysts, recent announcements in the UK show its competitive power. There Aldi and Lidl, a similar operator, are in the midst of forcing a number of UK supermarket operators, including Wal-mart's ASDA chain, to substantially lower prices on their core private label offerings, which are a higher percentage of their sales than for US operators.

This development means that it is time to reassess the situation of the food sellers in the US, specifically in this note, Family Dollar, the most vulnerable in the dollar store sector.

At Wal-mart's Fall 2011 analyst meeting the company said that it would accelerate the rollout of its Neighborhood Markets, 40,000 square foot grocery stores that could penetrate urban settings that do not allow for supercenters. This meant that it would not grow its Wal-Mart Express concept, which is basically a dollar store. With this, the sell side, at least, did a collective sigh of relief for the long-term growth rate of the dollar stores.

But I believed that the Neighborhood Markets would be a longer -term negative for the dollar stores. Dollar store growth is spearheaded by their increased consumables offering, though somewhat less for Dollar Tree than for Dollar General and Family Dollar. Therefore, food and household products pricing vs. their competitors is key.

As a retailing analyst, I know that consumers have historically reacted to pricing differentials above 5% between the same sorts of stores, and about 8% can cause some really important market share shifts. Indeed, we have seen Kroger gain significant market share from other chains such as Safeway and Supervalu, with prices that I believe have averaged about 6-8% below other traditional chains. I have seen that pricing has gotten to be even more of an issue since the recession, and that increased taxes and slow/no economic growth has intensified the market share shifts from any differing percentage of relative prices. Looking at the economic position of the lowest 50% of our society, the historical and future effect of relative prices is even greater.

In late 2010 one good sell-sider pointed out that dollar stores were taking some market share from Wal-Mart because of the higher cost per trip for small items because by increased gasoline cost, even though Wal-Mart and Target were lower priced than the dollar stores. It seems very reasonable that any gains made from that are ripe for reversal in the next few years because some of the biggest sales gains at the dollar stores have come from higher income consumers ($60 K and up) who are doing more shopping at dollar stores. It is reasonable to believe that these consumers have more access to cars than other dollar stores customers and can, even in urban settings, travel further for cheaper prices.

I have not seen a major pricing differential study for Wal-Mart vs. the dollar stores in the last 2-3 years, but I am fairly sure that Dollar General's consumable prices are 3-5% above Wal-mart and that Family Dollar's prices are at 5-7% above. I judge these differentials to be big enough to make these stores somewhat vulnerable on relative prices to Wal-Mart. Additionally, I can point to Target's history of fairly scrupulously keeping its relative prices on like consumables at only about 3% over Wal-mart's.

Another factor mentioned in the long-term growth of the dollar stores is sales to baby boomers who will retire without sufficient nest eggs. Here, the availability of a pharmacy at the Neighborhood Markets will be a big factor shifting market share to Wal-Mart, and the small sizes of many dollar store locations would make addition of a pharmacy prohibitive.

In a December of 2011 analysis I made some assumptions on the displacement of dollar store square footage, which was generally projected to be growing at a 6.5% CAGR, by the growth of Wal-Mart's Neighborhood Market and by Aldi, whose all private label l concept has prices 4% below those of Wal-Mart. I also assumed that consumables pricing would be key for dollar stores vs, non-dollar store competitors.

News in the last quarter of 2012 showed that my relatively grim outlook for dollar stores was too optimistic. Wal-Mart data from their recent investor conference in Arkansas showed that Family Dollar, and to a lesser extent Dollar General, will be facing a much tougher competitive environment faster than I had expected in my previous notes. My WORST CASE for dollar stores scenario had been that a Neighborhood Market, (NYSE:NM) (35-40,000 sq. ft.), would displace 6 dollar stores (8-10,000 Sq. ft.). Wal-Mart told analysts in October that the NM format has the equivalent sales of 10 dollar stores. So, a Neighborhood Market is roughly twice as productive in sales per square foot as a dollar store.

Now Wal-Mart said that the approximately 15,000 sq. ft. Wal-Mart Express has the equivalent sales of 3 to 5 dollar stores (at prices about 4% ABOVE Aldi's). At an 8000 sq. ft. average dollar store, Wal-Mart Express' sales per square foot would be anywhere from 60 to 166% greater than the average dollar store. If these relationships hold, it is a HUMONGUS advantage for Wal-mart.

Not surprisingly, Wal-mart said that it was accelerating NM expansion to 700+ stores by FY17 vs. a previous estimate of 500 stores by FY16. Management said that the NM was very effective against dollar stores on assortment; it's having a pharmacy, and, of course, price. I would look for the next year's meeting to reveal have some big expansion numbers on the Wal-mart Express concept, which is only 20 units now.

And now we have Aldi saying that it will ramp up its openings to an 8.4% CAGR for the next four years.

While Aldi is a completely private label food store and does not have the HBA and discretionary offerings of a dollar store, it is still a very formidable competitor for a dollar store. Their offering are good quality, they have historically gone into the same sorts of strip centers as dollar stores with the same approximate square footage. Given the fact that Wal-Mart's sales per square foot are so much higher than those of a dollar store in both of their smaller concepts, at an approximate 3-4% pricing advantage vs Dollar General and 5-7% advantage vs, Family Dollar, the extra 4% price advantage for Aldi should, by my seat of the pants, allow for an Aldi store to have the same relative sales vs. an average dollar store as does Wal-mart Express and Neighborhood Market.

Note also that the market for retail real estate is relatively good for Wal-Mart and Aldi with C malls in trouble and many retailing concepts withdrawing from B malls. And of course their stores are good "anchors" for strip centers, probably better than traditional supermarkets at this point.

By my calculations, the square footage displacement from dollar stores (their square footage increase multiplied by their increased percentage of sales gotten from their stores) from Wal-Mart's Neighborhood Market and Aldi's growth, plus some initial growth in Wal-Mart Express, which has not yet been ramped by the company, will now be equal to the expected 6.5% square footage growth of the dollar store industry in calendar 2014, one year to 1.5 years faster than I had originally thought. An important corollary to saturation is that margins will very likely start to fall before the saturation level is reached.

I would expect secular pressure on Family Dollar's stores to show up in calendar year 2014, and certainly by 2015, if indeed it is not already affecting FDO now.

Gross margins at FDO have been declining for about 6 quarters as more consumables are sold (70% of total sales) relative to higher margined discretionary items. Because the payroll tax increase is just starting to affect low end consumer behavior in March retail sales numbers and a much lower than expected U of MI consumer sentiment index, it would seem that home and apparel will likely continue the sales weakness of the last two years, unless there is an economic pickup and/or significantly lower gasoline prices.

And, of course the recent results from Dollar General and Dollar Tree were much better.

While stores have been reset with more consumables SKUs and other improvements made to FDO's operations, I believe that relative pricing explains most of the disappointments. I found a Dec 2011 pricing study of consumables by Deutsche Bank comparing Wal-mart, Dollar General, and Family Dollar in Suburban NJ and Metro NYC. Simply put, in NJ, which is probably an example of pricing in most other places, Wal-mart is the lowest with Dollar General 3% higher and Family Dollar 3% higher than Dollar General, or 6% over Wal-Mart. This is in line with older studies I have seen. Also, remember that Target prices consistently at DG's level, 3% over Wal-Mart. Aldi is maybe 4% under Wal-Mart.

That leaves Family Dollar as the obvious highest priced option among its closest competitors, though obviously it will be taking sales from the much higher priced front ends of the drug store chains, something that can increasingly be seen. (Indeed, the 20-25% price premium of the drug stores' front-end merchandise may well be a big positive factor that is not yet discounted in the growth rate of revenue, although the lack of a pharmacy at the dollar stores makes the Neighborhood Market relatively better situated on this).

But overall, experience has shown that consumers notice 5% differentials, and with these low-end consumers and in this environment I believe that 3% over Dollar General gets noticed.

Also possibly in response to this, Family Dollar has for about the last year or more been distributing fliers with coupons. This bothers me. This essential high/low pricing has been a loser's game for the most of the large supermarket chains vs. Wal-mart and Target. It seems to be being used again in this case by Family Dollar as a response to a competitive situation that requires an across the board price cut, probably 3% now and more in the next 2+ years.

Now for the NYC Metro part of the price study: Here DG was the lowest at 2.5% below Wal-Mart (a situation that almost certainly has reversed as Wal-Mart has been cutting prices) and Family Dollar was priced 16% over Dollar General. Amazing! I believe that this is still going on. I can look at the pricing of number of different cookies I buy in Boston and in Meriden CT, part of the sort of suburban sprawl between Hartford and New Haven. For example, Mrs. Freshley's chocolate covered peanut butter wafers are $1.30 in Meriden, where they are near a Wal-Mart Supercenter, while they are $1.50, 17% higher, in Boston near the city line in a close- to- normal- suburban shopping situation. Stop and Shop and the other supermarket chains do not have 17% higher prices there, and BJ's and Costco are within 1.5 miles. What is FDO thinking? I haven't the faintest idea. I do know that my local Family Dollar has prices that are not particularly attractive vs. the local supermarkets in most cases. So, I believe that the company is probably not getting the sales leverage that it might have expected from its entries into denser urban areas. I also am concerned that they will price this way in many of their entry markets in California, thereby not getting the sales growth that they might otherwise get in this big important expansion for the company.

Moving over to apparel and home goods (discretionary), I have no pricing comparisons to look at. But it does concern me that their prices may be higher or equal to those of Target, if the consumables relative prices are indicative. When economic conditions finally do turn for much of the dollar stores' customers, I would not take it as a given that Family Dollar's discretionary sales will come back strongly.

With the one penny per share miss on the November EPS just reported, management lowered guidance for FY14 from $3.80-4.15 to $3.25-3.55 vs. a street consensus of $3.98. Comp store sales are expected to be DOWN in low single digits vs. a previous low singe digit increase. The COO is also gone with no replacement yet named. So, there is a lot of work to do, but I wonder if a $3.40 earnings level is really a good valuation base. I can take FY13 EPS of $3.80, cut a 3% pricing differential to Dollar General (NYSE:DG), then add $5000 of manager and assistant manager pay increase to its 7800 stores, where manager turnover has gone to the high 30s percent range from the low 20s in the face of the many operational changes being made. The result would be a halving of FY 13 EPS to $1.90, before offsets such as better sales and less shrink, and possibly less needed couponing.

My valuation method is the standard 3 stage EPS discount model taught in MBA school. The risk free rate is a 4.2%, which is the 30 year T bond of 3.9% plus 30 bps of leaning against Fed's quantitative easing. I use a 7% company specific risk discount for many retailers, including FDO, and a 1.5% terminal growth rate. Because of the Wal-mart/Aldi juggernaut, I only use a 1 year, not a 5 year EPS growth rate. I also question a five year decline in returns to terminal growth, but I will give FDO the benefit of the doubt and say that it gets its operations improved and does not hit a complete earnings wall.

So, using EPS estimates of $3.25 for FY14 and an 11% (sell side LT EPS growth estimate) gain to $3.60 in FY15 and then assuming EPS growth starts a five year decline to a terminal 1.5%, the stock is worth an optimistic $45. That is absent the Dollar General potential acquisition that keeps the stock at $65. However, I believe that DG's management sees the same competitive intensity increase that I do, which would bear on how much they might pay for FDO, and when they might be willing to buy it, assuming they want to.

My bottom line is that the stock is going much lower and that the only reason not to short it is a strong belief that Dollar General will acquire it, and soon.

Ron Thomas CFA

No Positions

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.