BHOFailed's  Instablog

 

Interesting restructuring story developing with FRED 

What is interesting :

a.) improving operating margins
b.) under performing store closings
c.) leaner inventory monitoring enacted in 2009
d.) lower exposure to discretionary cutbacks
e.) better focus on mix
f.)  push into pharmacy format 

What hinders my bullish thesis

a.) optimistic guidance from management was revised lower in Q4
b.) Co. still sees continued consumer cautiousness through Q1 
c.) flat comparable store sales and EPS for Q1 ($0.15 to $0.20) vs a $0.23 First Call consensus

FY’10 guidance indicates a net sales growth of 1-3% but a flat SSS number. Street estimates at $0.76 for 2010 (company guidance implies $0.81/share) Trading at 0.2x EV/sales and 13x next years forward P/E.

 

FRED continues to disappoint on its Q's, SSS  continue to disappoint. What is causing the misses?
 
a.) higher markdowns
b.) bloated operating costs
c.) recognition of revs coming from layaway sales causing drag ~1% of total sales
(These sales are recognized when transaction is completed)
 
Gross Profit was down 1% on year/year, while margins for first 9 months declined - 60 bps to 29.1%.The decline in margins was attributed to higher markdowns on promotional advertising and a 20 bps impact as a result of 9 store closing.
Co. sees margin improvment coming from a higher mark-up in merchandise and shrink controls.

As of April 3, 2010, it operated 669 discount general merchandise stores, including 24 franchised stores

Sales mix breakdown is as follows: 35% pharmacy, 21% household, 16% food and tobacco, 10% paper/chemicals, 8% health and beauty, 7% apparel, and 3% franchise.

Another interesting development:  
 

Cash Improved to $38.6 Million from $8.5 Million Y/Y comparison (or ~ $0.97/share). Working capital saw favorable effect as inventories decreased. The average inventory per store reduced by 9%, Cap Ex. slightly higher Y/Y as remodeling and new concept stores being rolled out. Accounts Payable stood at 35% of inventory up from 32% prior year. Total Debt stood at $5 Million and no borrowing under revolver line. Furthermore has a 3.7 million share buy back authorization (~39 Million outstanding)

 

Reasons why I am getting bullish: a.) continued roll out and focus on pharmacy concept b.) Continued stress on improving cash flow c.) debt free d.) share buyback e.) productivity per square foot continues to improve f.) major rebranding initiative to take hold in 2010 g.) remodeled stores showing double digit comp growth h.) initial mark-ups starting to take hold

 

Things to remain cautious about i a.) cost associated with re-modeling through 2011 b.) continued increased promotional activities c.) flat comps d.) flattening out of new remodeled stores e.) pharmacy script margins pressured due to competitive landscape (ie: WMT) f.) lower Medicaid reimbursement levels g.) management shaky comments on 2010 estimates

 

Prior guidance implie(s) a 3-5% top line over the next 3 years.
While realistic in recessionary environment, My model assumes a 6% growth rate for growth rate for FY11 or (~$8 Billion+) top line. The street number for 2011 implies a 5%, currently below the 7% anticipated for 2010. Indicates to me revisions will be headed higher and which is being reflective in the run in the shares. With global macro conditions perceived to be on the mend, FY 2012, 8% top line growth  may prove to be conservative. 


Management color, indicates 5% growth for 2011 is low even with modest improvements in North America alone. Better driver coming from outside N.A. China accounts for only ~ 3% of sales (company targeting north of 8% by 2015) or

~$600 Million in additonal sales. Emerging markets Brazil, China, Russia and Turkey attribute to low low teen's of total sales, yet growing at a double-digit rate. Expectations are $1 Billion + to the top lineover next 2-3 years.

Executing on narrowing channels that translate to better visiblity across various price points and have been capturing market share from competitors. Ad spend will continue to ramp, but think will be consistent with 2009 levels of 67% of total sales. A flat spend Y/Y on top of the sales growth yields anywhere between 0-200

bps of leverage on their gross margin. The ad spend is focused to their emerging market base, where the leverage on market share gain will offset the additional spending. Other margin drivers are supply chain consolidation, back office integratio and lower promotional activities. Leverage should continue through 2015 based on management aspirations.

What kind of multiple does this story deserve? With the catalyst(s) kicking in, a 25 multiple is acceptable. At the lower end of the range for FY10, at 25x, stock is can trade at $66. The current average estimates, implies a 25 multiple or $69 a share. My assumption for this year is $3.25, indicating, $65- 77 a share. For 2011, I assume full year EPS of ~ $3.71, average consensus at $3.35. Indicates to me the street still looking for proof company is executing and not exposed to larger rivals like PG and REV. Under my assumption, shares currently trade around 15x and under the streets estimates at a discounted 16x. 
 

 

Revenues        $ 7,332         $ 7,597         $ 8,035         $ 8,550

Sales Growth            3.5%    5.5%    6.0%

Cost of goods sold      $ 1,875         $ 1,889         $ 2,031         $ 2,052

% of sales      3.9     4.0     4.0     4.2

Gross profit    $ 5,457         $ 5,708         $ 6,004         $ 6,498

Gross Margins   74%     75%     75%     76%

 

SG&A    $ 4,947         $ 5,103         $ 5,269         $ 5,636

SG&A % of Sales 67%     67%     66%     66%

D&A     $ 254   $ 255   $ 256   $ 260

 

Operating income        $ 256   $ 350   $ 479   $ 602

Op. Margins     3.49%   4.61%   5.96%   7.04%

EBIT    $ 764   $ 860   $ 991   $ 1,122

Net interest income / (expense) 76      78      73      70

Other income / (expense)        -       -       -       -

Tax rate        0.31

Income taxes    $ 260.40        $ 290.78        $ 329.84        $ 369.52

Net income      $ 579.6         $ 647.2         $ 734.2         $ 822.5

 

Diluted shares outstanding      197     199     198     198

 

EPS     $ 2.94 $ 3.25 $ 3.71 $ 4.15

Reporting Tomorrow April 27