Wednesday, April 17, 2013

Is Family Dollar a Buy?

It’s been an unusual year for the dollar stores. For much of the first half of 2012 they looked overvalued, even as they continued to generate impressive earnings growth. They were seen as the great trading down play, and for good reason. The problem is that when everyone sees it that way, it becomes hard to get a decent entry point. Roll on the second half of 2012 and things became a bit more uncertain as its end markets got tougher. Again the stocks looked attractive, but there was no obvious entry point. Roll on 2013 and their outlooks definitively worsened--and so did their stock prices, but are they good value now?

The Outlook For the Dollar Stores

The underlying story within the narrative above is that there has been a gradual shift in the sales mix for the dollar stores.  In the initial post recession years it became clear that the mass consumer was trading down to the dollar stores and creating new demand. Now that that easy pickings from that big move are over the challenge is to keep generating growth while the established grocers like Kroger $KR take action to gain back market share.

In particular, Kroger has been gaining share in the value segment by offering its own corporate brands. It is doing very well with them and Kroger has the footfall to be able to recapture some sales lost to consumers trading down at the dollar stores.

As for the dollar stores, there are three things that I think they can and have been doing:

  • Expand category sales and try to move into higher margin areas

  • Expand stores and capture new geographies

  • Drive footfall  via tactical expansion into categories like consumables

I’ll come back to these points and give my assessment, but first a few words on their end market prospects.

The Dollar Store Marketplace

It is very easy to fall into the trap of analyzing the retail market in terms of an amorphous mass that moves in the direction of the economy. But a retailer like Family Dollar $FDO shouldn’t be looked at in that way because it tends to sell to lower income customers. To give some perspective, here is a breakdown of the share of net worth in the US sourced from the Bureau of the Census. It is sorted by income holders.

I think it’s fair to say that the dollar stores’ customers will largely come from the bottom 60-80% of the populace. As you can see they don’t have that much purchasing power! In addition, their prospects are more affected by unemployment and job insecurity. So even as the economy recovers moderately, conditions will still be tough for its customers.

Family Dollar Analysis

I'm going to run through the three objectives discussed above in focusing on Family Dollar.

Firstly, it tried to increase higher margin home and apparel based sales but ran into merchandising difficulties. I suspect that this is partly a consequence of not having particular experience in apparel and also due to the fact that its customers shop on necessity and want consumables. Family Dollar may well have seen TJX Companies $TJX and Ross Stores $ROST doing very well in apparel and home goods, but it is another thing to be able to match them.

TJX’s management has vast experience in clothing, and its business model is predicated on ‘off-price’ retailing rather than the kind of discount clothing that the dollar stores may offer. Moreover, TJX’s customer base is largely discretionary, its footfall is generated by people coming to buy clothing and home goods. Whereas Family Dollar shoppers are trying to buy a cheap bottle of ketchup, will they stop and buy the apparel that has been placed at the front of the store?

Second, Dollar Tree $DLTR and Dollar General $DG have also been rapidly expanding stores even while same store sales growth is slowing. Indeed, Dollar General has spoke of aggressive price competition and is (like Family Dollar) taking a more cautious approach to its guidance. Its response to competition is to reduce pricing in certain categories, but this comes at the cost of margins. Similarly, Dollar Tree has seen same store sales slow to low single digits. Falling margins, slowing sales growth and tough competition. Is this the time to be expanding stores?

The third point is that as Family Dollar generates footfall by selling more essential consumables (which now make up nearly 70%) it is likely to suffer gross margin pressure. We can see that in the following chart:

Note how gross margins are falling.

Is Family Dollar a Buy?

In conclusion, there are challenges facing Family Dollar and as attractive as they undoubtedly are I don’t think it’s time to buy in. Family Dollar is increasing capital expenditures and its inventory levels have been rising more than sales as it sells more consumables. 

Analysts have it on a forward PE ratio of around 15, and I don’t think this is adequate recompense for the risk in its expansion program. I would like to see the dollar stores scale back these plans and concentrate on their core competency.

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