Could the Drugstore Giants See Some Value at Fred's?

Regional discount retailer Fred's caught some good air in late February, after a media report indicated that Walgreen and CVS might be interested in the smaller competitor. Is it a good bet for investors?

Apr 12, 2014 at 7:30AM


Discount retailer Fred's (NASDAQ:FRED) has been taking a page from the drugstore giants' playbooks in a bid to transform itself into a health care-focused retailer of pharmaceuticals and related personal care products. The strategy has generated rising store productivity over the past few years, primarily because of the addition of pharmacies to a majority of stores in its network. While the company's overhaul remains a work in progress, the drugstore giants may have taken notice based on a media report in late February that speculated the company might be talking to would-be acquirers, an event that caused a pop in Fred's share price. So, is the company a good bet for investors?

What's the value?
Fred's operates a chain of roughly 700 discount retail stores, primarily aggregated in the southeast U.S., with a considerable presence in places like Mississippi and Georgia. The hyper-competition in the discount retail space has led the company to pursue a multiyear makeover as an outlet for health care products and services, an area that accounts for approximately 39% of its total sales. At the same time, Fred's has been working to expand its product selection in targeted categories of its traditional general merchandise business, notably auto and hardware, hoping to generate higher-margin incremental sales from its growing base of pharmaceutical customers.

In its latest fiscal year, Fred's posted generally lackluster results, reporting a 1.4% top-line gain after adjusting for the effect of the extra week in 2012. On the upside, though, the company managed to slightly improve its operating profitability, thanks to a small pickup in comparable-store sales and a focus on cost savings at the corporate level. The net result was a greater amount of funds to invest in the completion of its store remodeling program, as well as for incremental product development in its private-label product pipeline.

Struggling to hit 4
Unfortunately, in the absence of a merger transaction, there is very little to like about Fred's current valuation, which, at a P/E multiple of roughly 25, is significantly above its five-year run rate for both revenues and operating profit. More important, the company hasn't been able to create any headway toward its stated goal of a 4% operating margin, reporting a 2% operating margin in FY 2013. As such, investors should probably keep their sights fixed on the industry's stalwarts, Walgreen (NASDAQ:WBA) and CVS Caremark (NYSE:CVS), both of which have operating margins in excess of Fred's long-term goal.

Walgreen, the larger of the two, with over 8,500 stores, continues to try to win back its customers' loyalty after a debilitating dispute with mega-benefits-manager Express Scripts in 2012 that led to customer defections and a drop in prescription volumes. While the company still has work to do in that regard, as evidenced by another year of declining comparable-store sales in FY 2013, it has built up some momentum with its fast-growing Balance Rewards loyalty program, which has attracted an estimated 85 million members. Like Fred's, Walgreen is also building out its private-label offerings in the general merchandise area, accounting for roughly 22% of segment sales, an effort that helped propel its merchandise margin to a five-year high in FY 2013.

Meanwhile, CVS continued to post solid financial results in FY 2013, reporting a 3.2% top-line gain that was aided by another year of prescription volume increases. As the largest integrated pharmacy provider, CVS' retail operation also benefits from the company's ability to spread its overhead across both sides of its business, which ultimately yields a higher operating margin than that of Walgreen or Fred's. The advantage of the higher profitability was strong cash flow during the period, providing funds for CVS to invest in its growth initiatives, including a further expansion of its in-store clinics, so-called MinuteClinics.

The bottom line
Fred's is certainly a potential takeout candidate for a larger competitor that might be looking to expand in the southeast U.S. region, Fred's area of focus. However, since hope is not usually a successful investment strategy, investors should focus on the fundamentals, which say that this work in progress is not a good bet at current prices.

Invest in the next wave of health care innovation
The Economist compares this disruptive invention to the steam engine and the printing press. Business Insider says it's "the next trillion dollar industry." And the technology  behind is poised to set off one of the most remarkable health care revolutions in decades. The Motley Fool's exclusive research presentation dives into this technology’s true potential, and its ability to make life-changing medical solutions never thought possible. To learn how you can invest in this unbelievable new technology, click here now to see our free report.

Robert Hanley owns shares of Fred's. The Motley Fool recommends CVS Caremark and Express Scripts. The Motley Fool owns shares of Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.


Compare Brokers