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

                              

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 (NYSE: WAG  ) 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.

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