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Recommendation: SELL
  • Price Target: $49.30
  • Price at 8/1 close: $66.09

These days the dollar does not get you what it used to. In fact, "dollar" themed stores are not selling many dollar items at all. Walking into a new Family Dollar Store (NYSE:FDO) felt more like a Walgreens (NYSE:WAG) or CVS (NYSE:CVS) without the Pharmacy. There is only one "Dollar" store keeping up with its theme and pitch, competitor Dollar Tree (NASDAQ:DLTR), is strictly selling $1 items. Cheers to them.

The Dollar store category grew out of the idea to micronize the discount concept found in Walmart (NYSE:WMT), be conveniently located, and provide bargains for lower income households. Family Dollar caters to the $30,000 to $40,000 household income demographic and followed by the Great Recession, has benefited from continued trade-down traffic (new traffic that understands the value). As the Family Dollar grows in store count and assortment, they are slowly evolving into a one stop shop for all categories.

The multiline retail landscape is crowded and has competition coming from every angle, (1) Walmart and its smaller store concept rollout (2) Pharmacy retailers such as Walgreens (WAG), CVS (CVS), and Rite Aid (NYSE:RAD) (3) other Dollar themed stores such as Dollar General (NYSE:DG) and Dollar Tree (DLTR). This heavy competition is expected in the multiline business and success depends on convenient locations, low prices, and a strong value perception.

Business and Growth Strategy

At the company's Analyst Day presentation, management coined an 'Adapt and Evolve' initiative. One part of the initiative plans to increase trip traffic through relevance. Relevance will be increased with the introduction of tobacco and a 30% expansion of food & HBA assortment, most notably the refrigerated section (average of 8 Cooler Doors per store by end of FY12). From FY07-FY11, data shows food sales almost doubling and inventory turnover increasing 15%. Most importantly FDO is achieving this with only a small increase to avg food inventory per store. Results from the HBA expansion have not been as impressive. Sales have only increased by 20% since FY07. This could mean the customer does not perceive the value or FDO needs to tweak the HBA assortment. As a store tour participant, I did not see the value in some HBA items. For example, I perceived the shaving razors to be more expensive than other competitors. Tobacco and refrigerated foods have the potential to provide more trip traffic and revenues but are less profitable (Approximately 20% on tobacco and a 20%-30% on Refrigerated Foods).

The second part of FDO's Adapt and Evolve initiative is margin expansion. They plan to achieve this through Global Sourcing Opportunities and increasing their private branding portfolio.

Global Sourcing Opportunities include (1) Converting purchases from domestic importers to direct/agent (2) Converting purchases from agents to direct (3) Increasing total purchases of foreign goods.

Moving away from domestic importers to direct purchasing (from Asia) could prove to be a difficult task and futile. Supplying stores through direct purchasing and agents will most likely include purchasing obligations, exclusivity, loss of payment terms, and new operational/quality assurance teams. The net effect could very possibly be negative. The FY2015 direct purchasing target of 13% looks overly aggressive (from FY2011- 2%). By comparison, Walmart [WMT], the largest importer in the world, directly sources less than 20% of total purchases.

Private branding is the holy grail of retailing. In FY11, 25% of all Family Dollar sales are from privately branded products. FDO plans to double their private branded portfolio by FY15, growing total private brand sales from $2.1 to $3.8 billion. No guidance is given on actual profit margins obtain by the private business.

Store renovations is spending that is vitally important but offers little value to shareholder wealth, 1000 renovations are scheduled for FY12, with a cost of $100k-130k per store. FDO could spend up to $500-600mil on store renovations in the next 4 FYs. This is spending on so-called assets which in no sense increase the volume of business, but which would cause a loss of business if the expenditure had not been made. The competition in this sector demands upkeep and spending. If successful, FDO's additional investments in new categories and product mix may create a net effect of zero, costing them close to nothing to renovate.

New Material Obligations - McLane Partnership

Family Dollar has entered into an exclusive 6-year partnership with McLane Distributors, the largest tobacco and food wholesaler in the country. McLane will solely supply FDO with their two new segments, tobacco and refrigerated/frozen foods. In this arrangement, McLane will only drop ship goods and FDO employees will be stocking shelves. Operational risks include increased shrinkage and inventory mismanagement. FDO will need to maintain a staff at McLane facilities to ensure company's operations and merchandising groups are aligned. Only by doing this, can FDO combine their familiarity with their stores and customers with McLane's inventory management to help ensure optimal inventory levels. Expect SGA expenses to increase to manage this new segment.

This purchasing arrangement is the exact opposite strategy that 'dollar' retailers operate under. For instance, Dollar Tree, believes not having any sort of purchasing obligation with any particular distributor as a competitive advantage. Running an order-by-order basis offers margin opportunities and tighter inventory controls and more flexibility in its merchandising strategy.

Store Tour

Management presented a new store tour in Belleville, NJ and the experience was generally a positive one. Inside the store was FDO's new layout featuring vertically aligned gondolas shelving, with products categorized and well placed. Sale items and featured/comparable products were advertised in traffic zones and easily seen. Smaller gondolas were added closer to the registers for impulse buys.

Store Grading: Belleville, NJ

Floor Presentation

B

Vertical Aisle arrangement made product categories and specials highly visible.

Security

A

Shrink reduction initiatives include:

  • 12 Camera Security System
  • Increased aisle visibility
  • Merchandise tagged with soft tag alarms
  • HBA merchandise shelving with anti-theft deterrents

Audio

F

No music or audio marketing of products. Music enhances customer experience and employee productivity.

Location

C

Pros:

  • Highly visible from street
  • 2 Minute Walk from bus stop, ample parking

Con:

  • On the Edge of the Town.

Customer Service

B

Staff was friendly, helpful and knowledgeable of product location.

Overall:

C+

Investment Thesis

A bear case will center on near-term (1) Operational trouble, which includes the shift in consumables assortment and discretionary weakness (2) Execution risk, FDO is entering the California market with no West coast distribution center, 500 new stores, and 1000 renovations (3) Structural risk, the introduction of tobacco products and refrigerated foods will most likely put downward pressure on gross margin.

It is my viewpoint that Family Dollar will see a surge in top line growth and increase of average basket size with the introduction of tobacco. Unfortunately, the top line growth will be thwarted by the lower profit margins made from these tobacco and refrigerated food sales. Look for Gross Margin % to be in the lower 30% range. This gross margin loss could be offset with leveraging SGA. The prospects of successfully entering into the California market cannot be ignored. This is an underpenetrated territory that could prove to be a fertile ground for growth. The management looks to be on the ball and ready for the challenge. FDO holds a compelling dividend history and yield (1.3%), ongoing and growing for over 35 consecutive years. Family Dollar is the only company providing a dividend in the dollar category.

Digging deeper, potential signs of financial shenanigans emerge. It starts with an aggressive stock buyback program initiated in 2006. Coincidentally, this aggressive buyback program begins the same time management released a 2006 Incentive plan. This incentive plan pays management bonuses on targeted ROE and ROE outperformance versus its peers. ROE is calculated by pre-tax Income divided by total shareholders equity. FDO has spent close to $1.5 billion dollars on stock buybacks during this time. A fantastic way to enhance company's ROE and earn big bonuses.

Being a first time follower of FDO, warning flags were raised when FDO management presented custom Key Metrics such as Leased Adjusted Debt / EBITDAR and revamped ROIC.

With a closer look, the EPS growth rate looks unsustainable. Revenue Growth must not be substantially less than earnings growth. For earnings to continue to grow over time they must be supported by a comparable or better sales growth rate and not just by cost cutting or other non-sales measures. FDO's revenue growth is 6.20%, while its earnings growth rate is 20.28%, Based on the average of the 3, 4 and 5 year historical EPS growth rates.

2007

2008

2009

2010

2011

2012est

Revenues

$6,834

$6,984

$7,401

$7,867

$8,548

$9,124.00

% change from previous year

7%

2%

6%

6%

9%

7%

EPS

1.62

1.66

2.07

2.62

3.12

3.65

% change from previous year

29%

2%

25%

27%

19%

17%

There is also a funding gap. FDO will have to borrow money in order to repurchase more stock, pay dividends, and cover CAPEX. The Sales-Leaseback (found inFY12, 10Q) should be considered a loan and moved down from CF Investing to CF Financing activities.

FDO management has every intention to repurchase shares in order to meet EPS consensus and guidance of FY12 $3.60 per share. This is a reckless and irresponsible use of shareholder money and it looks to have caught up with them. Note how FCF has drastically trended downward.

2007

2008

2009

2010

2011

2012est

FCF (OCF - CAPEX)

$ 284.2

$ 347.8

$ 374.5

$ 379.1

$ 183.1

$ (200.6)

Cash spent on Stock Repurchases*

$257.5

$97.7

$71.1

$332.2

$670.5

$500est

* From FY02-FY11, FDO has repurchased 28% of total outstanding shares.

Valuation

The dollar store category has outperformed most the market for the past 4 years, trading close to a 20% premium to other categories of stocks. My opinion is that the current earnings and growth are "juiced". I hold a high probability of earning misses for FY13. Without the aggressive buyback enhancement, EPS and P/Es would represent the following:

2007

2008

2009

2010

2011

2012est

Adjusted Shares Outstanding*

160mil

157mil

154mil

151mil

148mil

145mil

Adjusted EPS

$ 1.52

$ 1.48

$ 1.89

$ 2.37

$ 2.62

$ 2.90

Adjusted P/E (Cur Price: $66)

25

23

*Based a more conservative share repurchase program of 3 million shares per year.

VS. Reported (EPS enhanced with aggressive buybacks)

2007

2008

2009

2010

2011

2012est

Shares Outstanding

149.6

140.5

140.5

136.6

124.5

117.6

Diluted EPS

$ 1.62

$ 1.66

$ 2.07

$ 2.62

$ 3.12

$ 3.65

P/E (Cur Price: $66)

21.2

18.1

Recommendation: SELL

Price Target: $49.00
Price at 8/1 close: $66.09

Source: Family Dollar: Adapting, Evolving And Enhancing EPS