Family Dollar Is Undervalued, but Only Because Carl Icahn Owns It

The famed activist investor discloses a substantial stake in Family Dollar Stores and will be determined to see a decent return for his efforts.

Jun 16, 2014 at 6:15PM


Family Dollar hasn't seen blue skies in a while. Image courtesy Mike Mozart under Creative Commons license.

When Carl Icahn disclosed a 9.39% stake in Family Dollar Stores (NYSE:FDO) on June 6, he noted in his SEC filing that he had purchased company shares "in the belief that they were undervalued." Paradoxically, Family Dollar's stock is undervalued only in the context of Icahn's and other hedge fund activists' interests. To understand why, let's take a brief look at the company -- without regard to activist shareholders, and again in the context of their ownership.

A struggling business in a difficult industry
Over the last few quarters, Family Dollar's momentum has deflated. The company's second-quarter fiscal 2014 earnings were particularly disappointing, as revenue declined 6.1%, and income before taxes dropped by 35% versus the prior-year period. Even adjusting for an extra week in the prior year, revenue was essentially flat, despite heavy promotions. Management blamed a mix of products that shifted toward lower-margin consumables, a poorly executed holiday season, and marketing missteps for the uninspired results. But the fact is that the market opportunity for dollar stores has dampened in recent years.

As the U.S. economy continues to improve, the core customer of dollar stores is still tapped out and financially exhausted. To illustrate, on Family Dollar's most recent earnings call, an analyst questioned the impact to the company of reductions in the Supplemental Nutrition Assistance Program, or SNAP, the federal program that administers food stamps, among other services. CEO Howard Levine responded that the result was "difficult to quantify but [I] can tell you that it's not a positive for our customers."

In a similar vein, Richard Dreiling, the CEO of Dollar General, pointed out earlier this month that his company is expanding the number of items it carries in the $1 to $5 range ("dollar stores" traditionally sell items within a range of $1 to $10) and "sharpening" price points. "We are not waiting on the economy to improve for our core customer as she continues to face headwinds in cost increases," he observed.

Challenges ahead dispute the concept of undervaluation
To turn its revenue and income trends around without any friendly propulsion from the economy, Family Dollar is permanently lowering prices on 1,000 basic items, tweaking its product mix, and closing stores. But these actions will strain operating cash flow, which has thinned lately. The company plans to close 370 underperforming stores this year, and will incur a cash burn of $53 million to $58 million associated with the closings. At the same time, management will continue its plan to "renovate, relocate, or expand" roughly 850 stores this year. In reconfiguring its product mix, Family Dollar has bumped up its inventory to levels more than 13% higher than the prior year. All of these actions are capital intensive: In the last two quarters, Family Dollar tapped unsecured credit lines for $296 million, bringing total borrowings to $796 million. This is roughly half of total shareholders' equity, and as a reference point, the company has $157 million of cash on hand.

The company has significant off-balance-sheet obligations as well. As Family Dollar's strategy is to avoid owning real estate locations, it carries a fair amount of operating lease obligations at any given time. Going forward, the company has some significant lease payments looming: $515 million, $475 million, and $427 million to be paid in fiscal years 2014, 2015, and 2016, respectively. These obligations contradict the notion that Family Dollar could be further leveraged to return palpable value back to shareholders -- a common strategy in takeovers of undervalued companies with clean balance sheets.

To draw together the themes discussed above, for investors to regard Family Dollar as undervalued, management would have to turn the revenue trend around via newly lowered prices, manage increasingly tight cash flow without overleveraging, and improve gross margins through its product mix and store closings. These are all entirely possible outcomes, but much depends on future results.

Valuation often depends on the control you can exert
Now, in Carl Icahn's hands, the entire complexion of Family Dollar shares changes because he can exert control in a way that you or I can't. The possibilities of Icahn influencing a merger with Dollar General or perhaps Dollar Tree have been widely covered in the financial press, as well as by my Foolish colleague Nickey Friedman. But I believe Mr. Icahn is also exploring more direct action, including seeking to influence or modify the executive management team, which would allow him to make more extreme changes in the near term.

The current team, led by CEO Howard Levine, has implemented changes based on a long outlook -- it's going to close less than 5% of its stores while continuing to expand the chain, although at a reduced new-store opening schedule beginning in fiscal 2015 (from 525 this year to 350-400 in 2015). Odds are that Icahn, who earned his billionaire street cred as a somewhat ruthless corporate raider earlier in his career, probably doesn't have patience with such a plan.

If Icahn gained control over the company, his marching orders might require new store openings to slow to a trickle, with a more significant number of store closings in order to boost margins. This would deplete some cash in the way of exit fees from leases, but there's ample room in the company's unsecured lines, which have increased from $700 million to $900 million, to absorb this hit. It may be a smarter move for Family Dollar to cede market share growth for now in order to become a smaller, more vigorous, and more profitable organization in the years ahead. Ironically, such actions would likely propel the stock price, justifying Icahn's investment.

A single pill won't solve the Family Dollar board's headaches
Family Dollar's board was quick to react to Icahn's ownership disclosure, adopting a "poison pill," or shareholder's rights plan, which essentially forces any owner of greater than 10% to pay a premium for control of the company. The rights agreement is in effect for one year, expiring on June 8, 2015. But fighting the tide may be folly, as there are too many strong hands around this particular poker table, with Trian Fund Management and Paulson & Co. also holding sizable, if slightly smaller, stakes. Between Icahn and his fellow strong-willed billionaires, we'll surely witness concrete actions to increase the value of Family Dollar, despite the possibility of strong resistance from its board. In this context, it's no stretch to say the shares are undervalued. 

Top dividend stocks for the next decade
The smartest investors know that dividend stocks simply crush their non-dividend-paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

Asit Sharma has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information