Wednesday, January 21, 1998

Fred's, Inc.
(Nasdaq: FRED)
Phone: 901-365-8880
Price (1/20/98): $21 11/16

HOW DID IT DOUBLE?

Wilma may not be behind the counter at Fred's, but this discount retailer does rely on a Stone Age philosophy: give the people what they want at a value price. Not many frills in that -- unless you were a shareholder and enjoyed this chain's smoking run from the $7 range last May to the recent high of $23 1/2. Yabba Dabba Do!

Fred's is a turnaround story. Looking for a niche, the company shifted to an everyday low price strategy in December 1994. Sales climbed in FY95, but profits plunged from $0.72 to $0.23 a share as the company boosted spending to advertise its new value menu and adjusted its operations. Adding pharmacies to many stores to draw in more consistent traffic and experimenting with smaller XPress pharmacies, the firm managed the earn $0.50 a share in FY96 even after a significant restructuring charge.

After a couple of years of pain, shareholders have now seen the gain. Sales for the first nine months of FY97 rose 12.3% while same-store sales increased by 8%. With some higher-margin departments doing well and fewer markdowns required to move merchandise, the company's stores have become more profitable. Earnings jumped 68% for the nine-month period and 79% in the third quarter. Even Dino is wagging his tail.

Net margins are running 50% higher in FY97 in spite of slightly higher operating expenses caused by the company's store expansion program and the September hike in the minimum wage. The company opened 17 new stores during the third quarter with 20 more scheduled to open by the end of January.

BUSINESS DESCRIPTION

Based in Memphis and founded in 1947, Fred's operates 261 discount general merchandise stores and smaller Xpress pharmacies in ten southeastern states. It also supplies merchandise for another 31 franchised Fred's store. Most of its stores are located in towns with fewer than 50,000 people. The stores cater to low- to middle-income families.

Fred's offers 12,000 frequently purchased items such as household goods, apparel, and health and beauty items. It aims to be more convenient than Wal-Mart while providing a wider selection than competitors such as Dollar General or Family Dollar. Selling pharmaceuticals also helps differentiate Fred's from other general stores.

The firm acquired 17 CVS drug stores (with about $50 million in sales) in November. It now has more than 145 pharmacies, about 26 of which anchor the Xpress units. The company plans to have 300 stores by the end of 1998, with 45 being Xpress stores. Just as the pharmacies drive business for the full-line Fred's units, the Xpress units can build a customer base in an area before the firm commits to a full-sized Fred's.

Insiders own 20% of the stock, which split 5-for-4 in December.

FINANCIAL FACTS

Income Statement
12-month sales: $455.1 million
12-month income: $8.4 million*
12-month EPS: $0.72*
Profit Margin: 1.8%
Market Cap: $259.4 million
(*Includes non-recurring items)

Balance Sheet
Cash: $3.5 million
Current Assets: $120.8 million
Current Liabilities: $49.4 million
Long-term Debt: $2.9 million

Ratios
Price-to-earnings: 30.1
Price-to-sales: 0.57

HOW COULD YOU HAVE FOUND THIS DOUBLE?

A surge in same-store sales is often the best way to spot a retail Double. It means that old stores are doing more business, which usually means improved profits. Moreover, this information is reported monthly in the Fool, allowing an investor to spot an improving story perhaps before the earnings report gets other investors excited.

While profit margins were rising throughout FY96, the real key was probably the April quarter, when comparable-store sales jumped 8.6%. Fred's has gingerly danced ever higher since then as the company has proven that it has legs.

WHERE TO FROM HERE?

Sales soared 28% in November and 32% in December. Same-store sales rose at a 9.2% clip each month. So the story keeps getting better.

Plus, Fred's has a pretty solid balance sheet, even after adding the deal to buy the CVS units. It has also upgraded its warehouse management computer system and still has sufficient capacity at its distribution center to handle further expansion.

First Call shows that consensus earnings estimates have recently risen to $0.80 per share for the year ending January 31 and $1.00 for the next year. That suggests 30% annualized growth over the next five quarters, putting the PEG at around 1. YPEG fair value based on one analyst's estimate for 21% long-term growth would be $21.

Like other general merchandise vendors that have survived, Fred's seems to have found a niche that allows it to co-exist with Wal-Mart. Like drug store chains that soared last year thanks to industry consolidation and the continued greying of America, Fred's has also found that turning to drugs is a good way to juice up sales.

While the company can milk its niche and sell more pharmaceuticals, profit margins must rise a good bit for the company to beat the current estimates. At the moment, Fred's looks fairly valued.

-- Louis Corrigan
(TMFSeymor@aol.com)

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