1 Reason Not to Bite After Family Dollar's Earnings

Investors apparently liked what they read in Family Dollar's (NYSE: FDO  ) latest earnings report. The discounter saw its stock get more expensive -- by as much as 7% -- after releasing its third quarter results.

Still, while the report was better than expected, it included some news that should have investors cautious about jumping into the stock here. The company is paying a hefty price for those surprising sales gains.

Great sales growth
But first, here's the good news: Family Dollar boosted sales by a solid 9% last quarter. That jump came from a 2.9% rise in comparable store sales, or comps, with an extra 129 store locations chipping in the rest of the gain.

By comparison, discount king Wal-Mart (NYSE: WMT  ) saw a 1.4% drop in comps to start the year. And revenue barely budged, rising by just 1%. Yes, that poor trend has probably reversed since the tax refunds and warmer spring weather finally hit, driving traffic back to Wal-Mart's stores. But Family Dollar still looks to be attracting more of the two-thirds of consumers that say they are dealing with financial headwinds by shopping around for deals.

Costly market share gains
The problem is that Family Dollar has had to pay up for its increasing market share and sales levels. The company's gross profit margin fell by more than a full percentage point, to 34.7% last quarter. In contrast, Dollar Tree (NASDAQ: DLTR  ) booked an expansion of profits, to 35.2%, continuing a trend that's seen it pull away from Family Dollar.

FDO Gross Profit Margin Quarterly Chart

FDO Gross Profit Margin Quarterly data by YCharts

That's all thanks to Family Dollar's bigger worry, its growing dependence on consumables. This category, which includes things like food, health and beauty aids, and tobacco, has been a major growth driver for discount shops as value-conscious shoppers look to trade down from more expensive stores.

Too much food
But Family Dollar has hitched itself to this trend to a much greater degree than competitors. Rival Dollar Tree's consumables category, for example, inched up to 51.4% of sales last year, from 50.8% in 2011. Family Dollar, on the other hand, got a whopping 69% of its revenue from that category last year, up from 66.5% the year before.

Since consumables carry a lower markup than things like home goods and apparel, they tend to hurt overall profitability. You can see the growth in reliance on those products pushing Family Dollar's gross margin down over time.

And consumables are also expensive to stock. The company plans to spend more than $600 million in capital outlays in 2013 on things like fitting stores with freezers and refrigerators. That's about double what Dollar Tree plans to spend with its own renovations.

The stock's recent jump has Family Dollar valued about evenly with Dollar Tree right now, at 19 times trailing earnings. But given all the cash and profitability that it's had to give up in exchange for its sales boost, investors shouldn't be cheering Family Dollar's results.

The death of Wal-Mart
As I mentioned, Wal-Mart started 2013 with a whimper. To learn about two retailers aiming to take down the discounter, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.


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