The times they are still a-changin' at Family Dollar Stores (FDO.DL). While growth is also slowing at competitors Dollar Tree Stores (DLTR -0.25%) and Dollar General (DG -0.34%), and the market fears future competition from Wal-Mart, many of Family Dollar's problems are of its own making.
This is bad news, because no one likes an underperforming company. However, it could also be good news, because it means that Family Dollar could see some upside purely due to internal execution rather than needing to rely on the market.
Family Dollar rings up the changes
The following chart reveals how much the market has fallen out of love with Family Dollar. Over the last year, the company's valuation has fallen relative to Dollar Tree and Dollar General:
Family Dollar EV to EBITDA (trailing-12 months) data by YCharts.
In truth, all of the dollar stores have had issues in recent times. The aftermath of the recession proved to be a strong period for the dollar stores as middle-income consumers traded down to buy items like groceries from them. However, with an economic recovery in place (albeit a weak one), the trading-down effect has weakened as middle-income consumers recover. But conditions remain poor for the dollar stores' core customers in the lower-income bracket.
Unfortunately, Family Dollar's problems have been exacerbated by some poor execution. In 2012, Family Dollar introduced 1,000 new items (including tobacco) and made store layout changes. Fast-forward to winter 2013, and CEO Howard Levine found himself not "aligned" with COO Michael Bloom regarding the merchandising strategy. The result was that Bloom left the company, and Family Dollar began the process of realigning its strategy.
Indeed, the extent of the deterioration in performance can easily be seen in the following table. It shows the way full-year guidance has been adjusted over the last two quarters.
Source: Family Dollar Presentations.
In particular, note how the outlook for comparable sales and the gross margin have gradually been reduced as well as the dramatic decrease in net new store openings. The reason for the latter is that the intended store closings for 2014 have risen from 80 to 400, while store openings remain the same.
Family Dollar bites the bullet
As every investor knows, turnarounds can take time, and managements are often piecemeal in their approach when making them. Such considerations spring to mind when considering the readjustment plans that Family Dollar outlined in its previous quarter. Clearly, those plans weren't enough, and management used the second-quarter results to announce "immediate strategic actions" that include the following:
- Lower prices on 1,000 basic items
- Workforce optimization
- Close 370 underperforming stores in the second half of its fiscal year
- Slow the pace of new store openings in 2015
While this kind of restructuring is welcome, it's also estimated to cost $0.50 of earnings per share in charges in 2014; readers can see the impact from this guidance in the table above.
The lower pricing initiative appears to be proof that Family Dollar got its merchandising strategy wrong. In the words of Levine on the conference call: "It's not necessarily one where we are undercutting competition. It is really coming down and meeting the market on about 1,000 items in our assortment today."
Meanwhile, the workforce optimization (10% of its corporate workforce will be reduced) is partially an adjustment to slower growth.
However, the most interesting changes are the closure of underperforming stores and the reduction in the pace of new store openings from 525 in 2014 to 350-400 in 2015. When growth slows in an industry, it's usually incumbent on a company's management to focus on executing within existing stores rather than use resources on chasing growth.
Moreover, since its current merchandising strategy isn't working as planned, it would be puzzling if Family Dollar continued devoting management's time and resources toward opening new stores rather than to ensure a turnaround at its existing stores.
As for the threat from Wal-Mart, it may not be as relevant as some investors think. Although, if you think that Wal-Mart is taking direct aim at the dollar stores, then it's possible that it may look to Family Dollar as a potential acquisition target.
The bottom line
All told, Family Dollar is starting to get interesting. It's undoubtedly a tough environment for the dollar stores. But given a successful execution of its strategic realignments, the company offers the prospect of relative outperformance in 2014. However, it's probably too early to get overly excited. Ideally, Foolish investors should wait for some evidence of the plan starting to work or at least for one quarter where full-year guidance isn't reduced.
