Fred's Inc: Great Story But Too Expensive

| About: Fred's, Inc. (FRED)
This article is now exclusive for PRO subscribers.

Fred's, Inc. (NASDAQ:FRED) is a retailer of general merchandise and pharmacy operator in the southeastern United States. Through its 715 stores the company sells prescription fulfillment services, food and beverages, various household items and more to low and middle-income consumers in small and medium sized towns. The Memphis, Tennessee company saw its stock lose roughly three quarters of its value leading up to the financial crisis only to recover to multi-year highs recently. While Fred's business is on the mend I believe the run up in shares has come too quickly. I intend to argue that while Fred's has several initiatives in place to improve traffic and profitability, the estimated gains from these initiatives are largely priced into shares already.

In order to determine a value for Fred's I believe it is instructive to review what analysts think of the company's prospects. I'll use these estimates along with other inputs in my earnings model, which you can read about in greater detail here, in order to calculate a fair value for shares. My inputs and sources are as follows: 1) reported earnings, 2) earnings estimates, 3) current book value and 4) current dividend rate all from Yahoo! Finance, 5) discount rate of 9% and 6) perpetual growth rate of 3%, both of which are my numbers.

 

 

 

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

             

Reported earnings per share

$0.81

 

$0.85

$0.99

$1.10

$1.22

$1.35

x(1+Forecasted earnings growth)

 

4.90%

16.50%

11.00%

11.00%

11.00%

11.00%

=Forecasted earnings per share

 

$0.85

$0.99

$1.10

$1.22

$1.35

$1.50

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$12.04

$12.65

$13.40

$14.26

$15.24

$16.35

Earnings per share

 

$0.85

$0.99

$1.10

$1.22

$1.35

$1.50

-Dividends per share

 

$0.24

$0.24

$0.24

$0.24

$0.24

$0.24

=Equity book value at end of year

$12.04

$12.65

$13.40

$14.26

$15.24

$16.35

$17.61

               

Abnormal earnings

             

Equity book value at begin of year

 

$12.04

$12.65

$13.40

$14.26

$15.24

$16.35

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$1.08

$1.14

$1.21

$1.28

$1.37

$1.47

               

Forecasted EPS

 

$0.85

$0.99

$1.10

$1.22

$1.35

$1.50

-Normal earnings

 

$1.08

$1.14

$1.21

$1.28

$1.37

$1.47

=Abnormal earnings

 

-$0.23

-$0.15

-$0.11

-$0.06

-$0.02

$0.03

               

Valuation

             

Future abnormal earnings

 

-$0.23

-$0.15

-$0.11

-$0.06

-$0.02

$0.03

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

-$0.21

-$0.13

-$0.08

-$0.05

-$0.01

$0.02

               

Abnormal earnings in year +6

           

$0.03

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$0.52

               

Estimated share price

             

Sum of discounted AE over horizon

 

-$0.48

         

+PV of terminal year AE

 

$0.31

         

=PV of all AE

 

-$0.17

         

+Current equity book value

 

$12.04

         

=Estimated current share price

 

$11.87

         

As you can see, my model produces a fair value of about $12 for Fred's shares given the inputs discussed above. Obviously, that is appreciably lower than the $17 shares currently trade for. This is a significant disparity and one that should be investigated. There are several reasons why I believe market participants have bid the stock up in recent months and I'll discuss them shortly. However, just for a point of reference, in order for the model to produce a fair value of $17 to match the current trading price, I have to use 19.7% as the earnings growth rate instead of the 11% that is currently included in the assumptions. That is an enormous difference and while I believe 19.7% is within the realm of possibilities, the fact that it is already priced into shares begins to make my point for me. Again, I'm bullish on Fred's business but the price is simply too high right now.

First, the company has been in a tough operating environment commensurate with its core customers' struggles. Low and middle income consumers have been hard hit by the financial crisis and with unemployment still high by historical standards Fred's customers are continuing to have less disposable income in aggregate. This has resulted in some ugly comparables as we saw in the first quarter. For instance, traffic was down 1.3% and the average ticket size was flat. As a result of ugly comparables the company has resorted to closing underperforming stores. However, new locations are still being opened to offset the closings and this year management has guided to close about the same number of general merchandise stores as it opens. The point is that revenue growth isn't going to come from a growing store base with Fred's as the company has decided that, at least for the time being, net new general merchandise stores aren't in the cards.

What is in the cards, however, is expanding the company's very successful pharmacy business. Management guided for about 25 net new pharmacies in fiscal 2013 on top of the roughly 350 or so that operate today. The company loves the pharmacy business because it has lucrative relationships with third party providers of medications and it can then sell the prescriptions with relatively high margins. While the company's pharmacies have been showing negative comparable sales for the past several quarters the reason is actually a very good one; consumers' shift into generic prescriptions and away from brand names has shrunk revenue considerably. However, Fred's makes better margins on generics so while revenue is dropping, more of each dollar stays with Fred's. Nobody likes declining revenue but in this case the company is doing the right thing in chasing the lower revenue because it is a net positive to earnings.

Apart from, and sometimes in conjunction with, the pharmacy expansion effort are several reconfiguration initiatives the company has embarked upon. First, the company is outfitting select stores with automotive and hardware products and accessories in an attempt to capture some traffic from other general retailers. As of the end of the first quarter, 175 stores had been reconfigured with automotive and hardware merchandise and those stores had provided comparable sales increases of 15% and 43%, respectively, on the two categories. Clearly, those categories' reconfigurations are working very well. The impact on the company's total earnings from these reconfigurations is unclear as management doesn't break them out but the preliminary results are tremendous and can be rolled out to the rest of the system eventually.

Next, the company has opened discount tobacco shops within its stores as well as expanded the cooler sections that offer food and beverages. The idea of both, to drive traffic to the stores, and the results, which have been good, are similar for both initiatives. The company found that tobacco and food/beverage selection were reasons customers would visit a Fred's store over another retailer where the same goods could be purchased. Thus, the rollout of enhanced food and beverage selections as well as discounted tobacco products has begun and the company cites improved traffic and sales at those stores which have been reconfigured. Again, the impact is difficult to quantify because management doesn't break out these numbers but the company seems quite encouraged by the early results and these initiatives are likely to continue to be rolled out to the rest of the chain. Even though the financial impact was unclear, management was very clear that these initiatives are driving traffic to the stores and thus, driving more transactions.

Finally, the company is slowly introducing more and more private label products as part of its reconfiguration efforts. The effort to improve margins on general merchandise is two-fold. First, more private label merchandise is being offered to customers, ostensibly at lower costs and higher margins, in order to let Fred's capture more revenue and profit from each sale. In addition to this, the company is forgoing lower margin items in general, private label or not, in order to make more shelf space for higher margin items. This focus is key as the only material way for Fred's to grow earnings in the absence of new stores is through increased margins. Management knows this and is very actively addressing that issue.

So given that I like what management is doing with its stores and merchandise selection, why am I advocating for staying away from shares? In the case of Fred's it is simply a valuation call. As I alluded to earlier, I believe shares are pricing in 19%+ earnings growth for the next few years. While I believe this is possible I don't think we should expect it. Since analysts are at 11% that implies to me that market participants are already pricing in earnings beats in the coming years. This is not a good situation for longs as you'd ideally want the opposite situation; you want pessimistic market participants. Since management guided for 77 cent to 88 cents in EPS this year, with analysts at 85 cents, I'd say we are already set up for potential disappointment starting this year. The midpoint of the earnings guidance is decently lower than analyst expectations and that is not a good situation to be in. Either management can pull it off and shares have already priced it in or disappointment will send shares lower.

The bottom line is that Fred's has turned the corner. The company is strengthening its locations and mix of stores in addition to growing its lucrative pharmacy business. It is also making enormous strides towards improving its merchandise mix and margins while keeping operating costs under control. However, the fruits of these labors are probably at least a year down the road, if not more, but I feel as though the full benefits have already accrued to the stock price. Thus, based purely on valuation, I can't justify paying $17 for Fred's. On a pullback I'd be interested if shares trade below $14 but we are a long way from there. Fred's may grow earnings at 19% in the coming years but that would only justify the current price with little potential upside. Wait for a pullback before you add this retailer to your portfolio.

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.