Thursday, September 29, 2011

The Stock Scout View: Family Dollar

For our detailed Excel model, click here: Family Dollar V20

I would recommend against buying FDO at its current $53.00 share price. 
The company lacks a sufficient margin of safety to make it an attractive investment. The fundamental drivers that resulted in significant share price appreciation in shares of Family Dollar are now largely embedded in the current share price. The bull case for Family Dollar is predicated on the company’s ability to continue to improve operating margins and grow sales in a challenging macroeconomic environment as consumers trade down. However, a careful review of the company’s fundamentals suggests that these tailwinds will likely prove to be ephemeral.
Operating margins: A key tenet of the bull case assumes that Family Dollar will be able to increase operating margins from around 7.5% in the most recent fiscal year to between 9-10%, a level more comparable to that of competitor Dollar General.  If sales continue grow and the company is able to realize economies of scale, margins will likely improve gradually as the company is able to leverage SG&A off of a higher revenue base. However, the only way to actually achieve such levels would be to drive outsized sales growth through higher store productivity.  Family Dollar currently derives $171,000 per square foot compared to $200,000 per square foot at Dollar General. This gap can be partially bridged via aggressive store renovations like those done by Dollar General.  However, this will ultimately prove to be a far more daunting task. Family Dollar can only bridge this gap with a combination of driving increased penetration of higher margin private label goods, identifying cheaper sources for SKUs, better understanding customer demand, and improving staff quality to reduce shrink.  The operational risks associated with trying to produce comparable sales and margin thus appears underappreciated. In reality, Family Dollar’s operating margins are already similar to that of Target (approx. 7.8% for FY2011) and Walmart (approx. 6.1% for FY2011). In the long run, it is more likely that Dollar General’s outsized profits get competed away given the lack of true differentiation. Walmart in particular has emphasized its desire to begin expanding small store formats and is always competitive in terms of pricing.
Macroeconomic environment: Family Dollar has benefited greatly from a poor macroeconomic environment as same store sales rose far faster than the 2-4% it experienced for much of the past decade even as consumer spending in the broader economy stalled. However, several factors are beginning to work against the company. Unemployment benefits may not be extended given the constraints on government spending, and various stimulus initiatives will run off in the coming year. Job losses over the past three years have also disproportionately impacted lower income brackets, the key demographic for Family Dollar. These shifts may turn the macroeconomic environment into a headwind and negate the “trade down” tailwind.
Base Case (PT: ~$55 per share): The base case represents my view of the company continuing to grow at its current trend without any margin expansion.  Given the company’s already elevated margins relative historical norms, the company’s growth going forward will be driven largely by revenue growth and store expansion. The base case is for same store sales of 5.5% in 2012 and 4.0% in 2013 and 2014.
Conservative Case (PT: ~$40 per share): The conservative case represents a level where investors should have a large degree of margin of safety.  Due to competitive pressures from large retailers such as Wal-Mart and saturated end markets, margins are forecasted to compress from 7.4%, 7.4% and 7.4% to 7.2%, 6.8% and 5.3% in 2012, 2013 and 2014, respectively. While revenue growth from new stores and SSS may still exist, margin pressures will compress valuations and profit growth.    
Bull Case (PT: ~$75 per share): The bull case reflects a view most similar to sponsors who think that an operational improvement can be executed.  This case represents aggressive store count growth, strong same store sales and considerable margin expansion to levels similar to that of Dollar General.