- FDO has a negative correlation with the S&P 500 that could be exploited by investors seeking to hedge against a broad market correction.
- Discount retailers like FDO have an impressive margin and stock price performance history.
- FDO's business model as a discount retailer is fundamentally simple. FDO does not heavily rely investments with a large amount of inherent uncertainty.
I was previously challenged by a reader to make a recommendation as to what to buy given the current state of the stock market. After some research, I zeroed in on Family Dollar Stores (NYSE:FDO) for a Buy recommendation. Investors will be almost certainly be rewarded by FDO capital gains when the stock market undergoes a significant correction in the near future.
My biggest weakness is calling a timeframe for the general market correction. Maybe next week, maybe in three years. I can't say when the correction will happen, but I do feel that the overall stock market, represented here by the S&P 500 (^GSPC), is at least moderately overvalued. Investors should consider a hedge such as a long position in FDO.
This article examines Family Dollar fundamentals in terms of a few financial metrics and risk evaluation. Also, the price history of Family Dollar stock gives some clues about likely future performance. Financials point to tenuous relationships between key company performance variables and stock price. While these variables are not good price movement predictors, they do hint at consumer behavior that significantly impacts the overall economy. Fundamental risk assessment deserves special consideration. Family Dollar is competing in a tough environment. Cost-conscious consumers, prominent competitors, as well difficult-to-control operation costs cannot be offset with significantly higher prices without risking customer loyalty and brand reputation. Lastly, the stock price perspective establishes a strong, though by no means bulletproof relationship that backs up the Buy recommendation.
Fundamental Perspective: Financial Metrics
Individual investors may be tempted to trust fundamentals as close proxies for stock price. From what I found, they should do so with considerable caution if looking to anything but a significantly long time frame. Given limited resources and access to information, individual investors may have to prioritize which fundamental metrics to consider when making an investment decision. Here, Family Dollar performance variables include:
- FDO adjusted annual stock price
- Operating cash flow (OCF)
- Debt/equity ratio
1. Operating Cash Flow
Chart 1: Family Dollar OCF and stock price
Data gathered from Wikinvest
This data shows that while there is a rough, overall correlation between operating cash flow and stock price (as one might expect), using OCF to find short term buy or sell opportunities is a bad idea. For instance, consider the OCF decrease from 2010 through 2012. In that time, average FDO stock price kept going up at a pretty steady pace. Perhaps counter-intuitively, the rise in OCF in 2013 from 2012 levels corresponded with a gentler stock price increase. Also note that Family Dollar's operating cash flow was in the vicinity of 250% from 1999 levels in 2007 and 2012, yet FDO stock price was starkly different. In 2007, FDO stock gained about 50% from the average 1999 value, while in 2012, FDO shares were visibly upwards of 250%. With 2007 stock price being $25.71/share and 2013 at $63.95/share, it is difficult to reconcile operating cash flow changes as a short or medium-term predictor of stock price movements.
It is also interesting that Family Dollar increased its cash flows by about 50% and then by over 250% in the 2001-2002 recession. After that, stock price lingered while OCF increased in a choppy manner. Between 2008 and 2010, Family Dollar's OCF were once again rosy. Consider that even though the latest recession was over officially in 2009, Family Dollar's operations kept logging higher cash flows through 2010. This was in large part due to the sluggish recovery and uncertainty hovering around job opportunities. The corresponding caution and thrift among consumers accounts for much of Family Dollar's increasing OCF through 2010.
Though one would predict that FDO stock would drop somewhat after the recession, remember that company fundamentals are not the only stock price drivers. Monetary policy enacted by the Fed has been widely credited/blamed for ever-higher stock prices in recent years. FDO is not immune from such macroeconomic effects. Thus the rising FDO stock price since 2008, even though a bull market would imply a generally falling or stable price for discount retailers such as Family Dollar.
Regarding likely future trends, consider the recent uptick in operating cash flow in FY 2013. People are more inclined to shop at discount retailers such as Family Dollar shortly before or and after a recession, when the employment picture is uncertain and more unfavorable to job applicants. Though it's a long stretch from Family Dollar's OCF to overall trends in labor economics, the recent OCF uptick hints that through necessity or a more prominent "save for a rainy day" mentality, people are switching to discount retailers. Since product quality is rarely the draw of discount retailers, this implies weakening purchasing power and/or job security in the near future.
Family Dollar has a business model that is limited by debt. Granted, debt can prove very lucrative if used to finance operations that bring in far higher returns than its associated interest expense. However, if you are enticed by the view of debt as an investment with little downside risk due to low interest rates, remember that FDO and similar businesses strive to under-price the likes of Wal-Mart (NYSE:WMT) while maintaining profit. This is not an easy task. Managerial miscalculations about likely revenues and profit margins derived from debt-fueled operations can be difficult to fix.
So how has debt load affected stock price? Chart 7 tracks Family Dollar's debt/equity ratio since 1999 ratio in comparison to stock price.
Chart 2: FDO Debt/Equity ratio and stock price
Data gathered from Wikinvest
There doesn't seem to be much relevant correlation between debt/equity ratio and FDO stock price. Note that even the highest debt/equity of nearly 1.8 did not appear to dent FDO's price increase between 2008 and 2013. Going back, there are two significant debt/equity dips. In one, lasting from roughly 2000 through 2005, was mirrored by a stock price increase that maxed out in 2003 at a bit over $30/share before falling back to the low $20-range in 2005. After the U.S. emerged from the early 2000s recession, FDO debt/equity spiked in 2007 at approximately 1.2. Then, 2008 witnessed the October stock market drop and corresponding housing-fueled recession of 2008-2009. This time, FDO stock did not dip after the Great Recession ended. Instead, with an increasing debt/equity ratio, FDO stock maintained its price gains, leveling out somewhat in 2012-2013.
Judging by this data, it seems that equity investors can reasonably trust that Family Dollar management will keep the debt burden from pulling down FDO stock to any significant extent.
Fundamental Perspective: Risks and Weaknesses
Family Dollar faces several risks to its business model. Any of these could substantially derail FDO stock from its price boost during recessions.
1. Operating Costs
Family Dollar Stores is vulnerable to high operating costs. Since its customers are very price conscious, this puts management in a bind. Increased real estate prices, passed-down manufacturer production costs, currency fluctuations and labor costs leave little pricing wiggle room without compromising profit margins and market share.
2. Product Quality
There is also a danger of FDO expanding its products beyond what a discount retailer can promise in terms of quality. For example, discount-priced electronics will likely draw more sales, but at the risk of increased complaints about defects and generally poor product quality. Investors have to keep in mind that retailers like Family Dollar tend to compromise on product quality and durability. This compromise is very difficult to avoid considering the constant "race to the bottom" price pressure that customers put on FDO and other discount retailers. If Family Dollar gets too ambitious with the amount of short-lived or sub-par products it offers, the resulting bad reputation will do substantial harm to the FDO brand, with corresponding negative financial impact very likely above and beyond the immediate gains of the product sales.
3. Public Perception
Ironically, the biggest risk to FDO and similar discount retailers is their success. While it markets consumer products on the low end of the income spectrum, FDO and the like are not bottom-barrel when it comes to profit margins. This presents a clash of perspectives:
- Consumers believe that they are getting a great deal
- Investors are getting a solid return with cushy profit margins
The below chart (Chart 8) illustrates the second point in terms of net margin for Family Dollar and some competitors.
Chart 3: Net margin of FDO and some competing retailers
Data gathered from Wikinvest
Family Dollar holds its own in this time frame, with the two recessions in the early and late 2000s making relatively small dents in net margin percentages. But Family Dollar is not alone in reaping generous margins. The consistent net margin dominance of Dollar Tree (NASDAQ:DLTR) is impressive. Here are the average net margin percentages for each company mentioned above from 1999 through 2013:
- Dollar Tree: 5.91%
- Family Dollar Stores: 4.44%
- Target (NYSE:TGT): 3.91%
- Dollar General (NYSE:DG): 3.68%
- Wal-Mart: 3.45%
With the exception of Dollar General, discount retailers did better in terms of net margin than more established big-box centers such as Wal-Mart and Target. The three dollar store retailers mentioned have a combined average net margin of 4.68%, while Wal-Mart and Target have a combined average net margin of only 3.68%.
But those profit margins are offset by cost of purchasing from suppliers. Here, economies of scale apply rigorously. Buying in bulk gets lower prices per unit, and few retailers execute bulk-purchases like Wal-Mart. As such, it is not likely that Family Dollar is getting a better deal from suppliers. The only other alternative that explains Family Dollar's impressive margins is, in fact, relatively high prices. Packaging, marketing, presentation and clever discounting can make dollar store products seem like a deal at first glance. However, the per-pound or quality-adjusted price of products is, overall, higher in dollar stores than one might expect.
This means that adjusting for product amount and quality, quite a few Family Dollar customers are paying more than they could at traditional big-box retailers. Otherwise, investor rewards are difficult to explain at a very simple level. Though dated almost a year ago, this article further explains this tension and risk that is inherent in the dollar store business.
Imagine the PR fallout if the dollar store sector's competitive advantage seeps deep enough into the public consciousness and into the minds of existing and potential consumers. The dollar store industry, of which FDO is a prominent member, carries significant public relations risk. Imagine there is a public backlash against real and/or perceived manipulative advertising or price-gouging on the part of discount retailers. If so, rosy projections about FDO stock as a profitable hedge against a generally falling stock market will not be worth much.
To compare net margin and stock price movements, consider stock price trends of FDO and its competitors in the below chart.
Chart 4: Jan 1999 - Jan 2014
Source: Yahoo Finance
The three dollar-store retailers were highlighted with blue squares, while big-box retailers Wal-Mart and Target were highlighted with orange squares. The first point that jumps out is that Dollar Tree maintains a capital gains lead in conjunction with its net margin leadership. Family Dollar Stores follows, accruing about 220 % since the start of 1999. Likewise, observe that as Wal-Mart lags in terms of net margin, it also has the least capital gains, with a little less than 100% between 1999 and 2013.
Family Dollar has to grapple with the fact that profit margins are very vulnerable to higher operating costs. Discount retailers such as Family Dollar are the last companies to market status or exclusivity. Therefore, management's sales-boosting strategies are limited to discounts and similar under-price incentives like "Buy one get one free." Marketing and packaging that convinces enough consumers that they are in fact getting the best deal for their money is typically a wise investment to make. It is also wise to manage public relations so that consumers and the people at large are not too receptive to the stereotype of discount retailers like Family Dollar being in fact surprisingly expensive, considering the amount and quality of product sold. Such risk is not easy to quantify or encapsulate into a timeframe as, for example, interest rate or operating expense risk might be. Lastly, Family Dollar has to stay on top of significant business strategies executed by major competitors within the dollar store sector as well as big-box giants such as Wal-Mart, Target, and even online retail giant Amazon (NASDAQ:AMZN).
Stock Price Perspective
The following charts detail FDO stock price movements relative to the S&P 500 (^GSPC) since the mid 1990s. The key focus is FDO's behavior in the vicinity of the 2001-2002 and 2008-2009 recessions. The first two charts give some price background during the 1990s. The graphs show that despite common wisdom backing FDO's negative correlation to the general stock market, such price behavior is hardly a foregone conclusion.
Chart 5: Jan 1994 - Jan 1995
Source: Yahoo Finance
Chart 6: Jan 1994 - Jan 1999
Source: Yahoo Finance
We can see that during a flat stock market in 1994, FDO investors needed substantial faith in the company and its business model (Chart 5). While the S&P 500 decreased a paltry 1.36%, FDO stock tumbled 25%. Nevertheless, investors who hung on in the start of 1994 were duly rewarded in time. As the next chart shows, Family Dollar posted gains of over 300% relative to January 1994 levels, while the S&P 500 clocked in a relatively small 170%. (Chart 6)
Admittedly, the two charts starting in the beginning of 1994 do not support the idea of Family Dollar stock as a hedge to a broad market decline. Note the S&P's decline and rebound in the second half of 1999 was mirrored by a very similar and steeper movement of FDO stock. Admittedly, the mid and late 1990s were not supportive of the idea that FDO stock can counter losses incurred when the general stock market declines. However, the 2000s tell a different tale. Consider the below charts.
Chart 7: Jan 2000 - Jan 2003
Source: Yahoo Finance
In Chart 7 we have the first good argument for going long on FDO stock. While there is admittedly some positive correlation between FDO and ^GSPC, it tends to be short-lived and relatively insignificant. There are matching price movements right before October 2001 and from FDO's peak in late spring 2002 through the end of the year. Nevertheless, the final gains and losses between the start of 2000 and the start of 2003 tell a story of FDO's substantial success in beating the general market. While the S&P 500 dropped nearly 40% by the start of 2003, FDO stock price more than doubled. Here, Family Dollar's success in countering general market dips is starting to become evident.
Moving forward to the most recent significant stock market decline between January 2008 and March 2009, we see that the S&P 500 wasn't doing too well even before the big October 2008 drop. Note that while ^GSPC gently oscillated into slightly negative territory prior to October 2008, Family Dollar stock traced an upward saw-tooth pattern that would have given investors between roughly 20 and 45% gains. But the real fun comes when ^GSPC bottoms out between October 2008 and March 2009. Chart 8 illustrates the point.
Chart 8: Jan 2008 - Jan 2010
Source: Yahoo Finance
Chart 8 shows that, ignoring short-term fluctuations, FDO has a pretty solid negative correlation to the S&P 500. If an investor went long at the start of January 2008, he could gain as much as 60-80% if selling close to the March 9 2009 market bottom. Of course a bottom (or top) is only apparent as such in retrospect. Therefore, even a rough holding period of two years would have given the FDO investor more than 40% return on his investment, in contrast to more than 20% losses from ^GSPC. The case for FDO is a bit stronger. Lastly, Chart 9 compares ^GSPC and FDO in light of the most recent data available.
Chart 9: Mar 2009 - Feb 2014
Source: Yahoo Finance
Chart 9 shows that even though Family Dollar does not have a consistently negative correlation to the general stock market, there's enough to warrant some optimism about FDO's use as a hedge against a broad market decline. Ignoring short-term fluctuations, the following approximate time frames show a negative correlation between FDO and the S&P 500.
- March 2009 - February 2010: 11 months
- March 2012 - March 2013: 12 months
- October 2013 - Present: 5 months
In the last five years, FDO and ^GSPC had a fairly negative price movement correlation for about 47% of the time (28/60 months).
This trend makes sense at a fundamental level. During hard times and recessions, people are more worried about saving money. Quality will be sacrificed for low cost to a greater extent. The pressure to spend wisely, coupled with Family Dollar's reputable brand name and consistent, widespread marketing campaigns as a discount store, translates into a temporary boost of customers and sales for FDO and similar retailers.
Past price actions are interesting, but are not enough to hint at large-scale future behavior. For a deeper look into how Family Dollar operates, we will now dive into some of the company's financial metrics.
Chart 10: U.S. Market Cap and GDP. Last 10 years.
Warren Buffett quipped that the Total Market Cap to GDP ratio (TMC/GDP) is a quick and fairly reliable indicator of overall stock market valuation. The above chart captures the last ten years of GDP and Wilshire Total Market Index. We can clearly see the run up to the recession and a prominent bubble that peaked in late 2007. When the bubble burst, TMC/GDP bottomed out at 0.57 in early 2009. Since then, the market has logged an impressive recovery up to the time of this writing. Throughout the recovery, skeptics and market bears have claimed that the market was overvalued and due for a significant correction. So far, any such corrections have been short-lived and quickly negated by further gains. Of course, one hears the same thing again. However, recently there is some more justification for a bearish outlook on the stock market. For most of the time since the 2008-2009 recession, TMC/GDP was less than 1. Recently, TMC/GDP has shot past 1 and is currently at about 1.175. The following 30-year graphs give more perspective on the historical magnitude of TMC/GDP.
Chart 11: U.S. Market Cap and GDP. Last 30 years.
The second "Ratio" part of the chart clearly implies that when TMC/GDP is much greater than 1, investors long on the general stock market need to cool their enthusiasm. Of course, a bubble can continue for a while, as the second half of the 1990s showed. However, over a longer time frame, note that TMC/GDP over 1 does not last long. The near future is not likely to see a GDP boost. This leaves a declining stock market as the only way to bring down the TMC/GDP ratio. This is not to claim that the peak is here. The market can continue rising for another year or two, but if it does so, I feel that it will be (and already is) running on fumes with regard to economic fundamentals.
Those who invest in FDO stock now or in the near future and hang on through the inevitable market correction will be handsomely rewarded.
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.