Should I Buy Family Dollar? 3 Pros, 3 Cons

by Marc Bastow | January 4, 2013 1:57 pm

Discount retailer Family Dollar (NYSE:FDO[1]) 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[2] 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:

Pros

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[3], BRK.B[4]) 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[5]) and Dollar Tree (NASDAQ:DLTR[6]). 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.

Cons

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[7].¬† 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[8]), Target (NYSE:TGT[9]) and Wal-Mart (NYSE:WMT[10]) are now firmly entrenched in the grocery business[11], 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.

Verdict

I’ve been down the road before with the dollar store sector[12], 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.

Endnotes:
  1. FDO: http://studio-5.financialcontent.com/investplace/quote?Symbol=FDO
  2. FDO shares were hammered: http://investorplace.com/2013/01/family-dollar-no-bargain-despite-beatdown/
  3. BRK.A: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK.A
  4. BRK.B: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK.B
  5. DG: http://studio-5.financialcontent.com/investplace/quote?Symbol=DG
  6. DLTR: http://studio-5.financialcontent.com/investplace/quote?Symbol=DLTR
  7. 10-Q filing: http://insurancenewsnet.com/article.aspx?id=368323&type=newswires#.UObpyaz-L08
  8. COST: http://studio-5.financialcontent.com/investplace/quote?Symbol=COST
  9. TGT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TGT
  10. WMT: http://studio-5.financialcontent.com/investplace/quote?Symbol=WMT
  11. now firmly entrenched in the grocery business: http://investorplace.com/2012/10/grocery-stocks-3-to-buy-3-to-shelf/
  12. down the road before with the dollar store sector: http://investorplace.com/2012/08/dltr-hammered-for-future-truths-dgdltr-fdo-wmt-tgt/

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