Discount retailer Family Dollar (NYSE:FDO) was one of the most battered names in a generally lousy trading day Thursday.
FDO, which operates more than 7,400 stores in 45 states, reported fiscal first-quarter earnings of 69 cents that were a penny better than the year-ago period’s results, but a nickel short of analysts’ expectations. Perhaps more troubling for the Street, the company lowered full-year EPS guidance by around 3% to 4%. The result? FDO shares were hammered almost 13% in Thursday trading.
Was the dramatic drop justified? Or, considering the stock is rebounding about 2% on Friday, should you buy Family Dollar with confidence that the punishment was overblown? Let’s look at the pros and cons:
Revenue Growth: This metric continues to shine, up 12.7% in Q1 to just more than $2.4 billion — ahead of most estimates and in line with the past three quarters of double-digit growth. Expect this to continue as Family Dollar tries to bolster its global sourcing, renovates stores and, perhaps most important, expands its consumables categories, including tobacco and soda. Comparable-store sales rose 2.5% for the quarter, so the revenue track looks solid. Family Dollar also added a net 124 stores during the fiscal first quarter and expects to open 500 stores net during the full fiscal year.
Partnerships: Family Dollar’s six-year arrangement with McLane – a Berkshire Hathaway (NYSE:BRK.A, BRK.B) subsidiary that provides food-service supply-chain support — is paying dividends as FDO ramps up sales in new categories, particularly in refrigerated and frozen consumables and tobacco products. Consumables came in at 74% of revenues in the first quarter and are expected to continue as the revenue growth engine. That makes the partnership particularly critical for FDO as a way to control costs. Speaking of paying dividends …
Dividend: Family Dollar’s 1.5% payout, while not spectacular, is better than the zilch paid out by rivals Dollar General (NYSE:DG) and Dollar Tree (NASDAQ:DLTR). FDO increased its dividend by 16% in early 2012, and it has paid investors quarterly since 1976. Even better: The payout ratio is only 22%, leaving room for the dividend to rise in the future, perhaps sometime in 2013.
Shrinking Margins: Despite the McLane deal, growth in consumables is coming at the cost of margins, as the cost of sales increased by 14.7% in the fiscal first quarter, according to FDO’s 10-Q filing. With the focus on consumables and increasing discounts to compete, lower margins are a cause for concern, and Family Dollar must keep finding ways to eliminate excess cost.
Competition: The discount retail market is crowded. In addition to Dollar General and Dollar Tree, Costco (NASDAQ:COST), Target (NYSE:TGT) and Wal-Mart (NYSE:WMT) are now firmly entrenched in the grocery business, and that should be keeping FDO executives up nights. Trying to stay ahead of these giants is a mighty tough way to live, and with the economies of scale in the big boys’ favor, it’s a losing proposition if discounting is all you’ve got.
Cash Flow: Lower margins and adding stores create a recipe for strained cash flow, and it showed in the most recent quarter as FDO borrowed $195 million under an existing loan facility to boost inventories ahead of the holiday season. That’s not too unusual, but FDO also burned through over $200 million in cash flow through the end of the calendar year. Stock repurchases worth $25 million, a dividend payout of $24 million and long-term debt of $516 million (a 27.6% debt/equity ratio) aren’t quite red flags, but some caution is in order.
I’ve been down the road before with the dollar store sector, and I’m still fairly bullish on the whole lot. In many parts of the country, a trip to the nearest Wal-Mart or Target can be pretty far, but Family Dollar is littering the landscape with convenient stores. Plus, it offers a pleasant-enough shopping experience and still-competitive prices for almost any item you need in a shopping basket. And don’t forget the dependable dividend. All that makes FDO shares still look like a buy to me.
Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing he did not hold a position in any of the aforementioned securities.