Bad Times Are Good Times at Family Dollar

| About: Family Dollar (FDO)

Early this month, a collision occurred — the kind that takes place when an overpriced “story stock” disappoints investors, even just a little.

Deep-discount retailer Family Dollar (NYSE:FDO) was the stock in question, and its fall, though not a full-blown trip down the elevator shaft, was not small:

Family Dollar’s sin was its disclosure that certain growth-oriented strategies will cause profit growth in upcoming quarters to land a tad below expectations. Not the end of the world. But the stock was priced for no surprises.

The story line that had sent Family Dollar shares sharply higher over the past couple years has a simple logic: U.S. shoppers seek low prices during tough times. Investors have typically turned to discount retailers like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) when the economy weakens. But when really hard economic times hit, when sustained high unemployment sends the number of Americans living on the edge of poverty sharply higher, those mainstream retailers lose market share to ultra-discounters like Family Dollar, Dollar General (NYSE:DG) and Dollar Tree (NASDAQ:DLTR).

In fact, Family Dollar shares went into orbit just as the U.S. economy went into the tank:

Earnings rose, and the North Carolina company’s historically slim margins began to strengthen.

To accommodate the growth spurt, Family Dollar ramped up new-store openings and launched an ambitious store-renovation effort; cap-ex spending is surging and 2011 will be even higher.

It’s been buying back shares recently, too, draining cash levels.

Family Dollar is treating the current sales jump as if it’s a long-term trend. In its latest 10-K, the company says so explicitly:

While general economic conditions may be stabilizing, we believe pressures on low- and lower-middle-income customers continue to be significant … (and) our strategy of providing both value and convenience positions us well to increase our market share.

Fully 55% of Family Dollar’s customers have annual earnings of less than $40,000, and 24% are below $20,000. This is not the Costco crowd.

As the economy improves, plenty of today’s Family Dollar shoppers will no doubt return to the less down-market aisles of Target – store renovations be damned. But the U.S. economy is producing squat in the way of working-class jobs, and inflation-adjusted income for working people has been sliding mostly sideways for the better part of 30 years. The class of people so impoverished they can’t afford Wal-Mart prices may still be a growth market.

The recent sell-off seemed to suggest that Family Dollar is only having a brief time in the recessionary sun, and that its growth will slow markedly as soon an economic recovery takes hold. The unemployment numbers – and projections that the jobless rate will stay high for years to come – suggest otherwise. The selloff was likely overdone. YCharts Pro finds the stock is roughly fairly valued now, and the revenue chart below attests to Family Dollar’s rising popularity.

Disclosure: No position