Is Family Dollar in Trouble?

Shares of discount retailer Family Dollar (NYSE: FDO  ) , which operates a chain of more than 7,900 general merchandise retail discount stores in the U.S., are up more than 20% in the past month. The company's stock moved up considerably after investor Carl Icahn, famous for his activist style, disclosed a massive stake in the consumer goods retailer early this month.

According to Icahn, Family Dollar is the best buy among dollar stores. This view is quite different from other investors who underweight the whole dollar store sector on the back of increasing competition from warehouse clubs and traditional retail players such as Wal-Mart (NYSE: WMT  ) , which is trying to capture market share from the smaller-store segment via its Neighborhood Markets and Wal-Mart Express formats. Family Dollar may already be seeing some effects of the fierce competition as the company announced in its most-recent quarter that comparable store sales decreased 3.8%. Is Family Dollar in trouble?

Source: Family Dollar

Disappointing earnings
The company has missed estimates for earnings-per-share and revenues for the past three quarters. Its operational problems, weak top-line, and decreasing earnings have made the company a ripe target for activist takeover. 

On April 10, Family Dollar announced that comparable-store sales decreased 3.8% in the second quarter of fiscal 2014. Net sales decreased 6.1% to $2.7 billion, and gross profit--roughly 33% of net sales--also decreased 6.7% to $902.3 million. More importantly, as hedge fund analyst Karthik Srinivasan from Briargreen Capital noted, inventories --up 2.1%-- raised at a much faster pace than same-store sales; this suggests that the company is facing operational issues. 

Fierce competition
Note that these numbers were particularly worrying if we consider that in the holiday season, sales usually pick up. However, the holiday season effect was clearly not enough to offset macro-economic pressure, fierce competition, and harsh weather.

In particular, competition from Wal-Mart's small-format stores may be contributing significantly to Family Dollar's sales decrease. The giant retailer had roughly 407 small-format stores in January 2014, and it plans to open 200 new small stores this year, including Wal-Mart To Go, a convenience store that will sell only fresh food, prepared meals, and a few general merchandise and seasonal items. 

Source: Wal-Mart

Although Wal-Mart's latest interest in going small isn't good news for Family Dollar, the strategy is consistent with consumers preferences. In large cities, consumers appear to prefer small stores that are easy to find where they can access fresh produce, meats, and dairy, as well as a pharmacy.

From now on
Aware of the struggles of Family Dollar, CEO Howard Levine decided to change the company's pricing strategy based on price reductions and discounts. This was done in order to adopt an "everyday low price" model that is favored by competitors Wal-Mart and Dollar General. Family Dollar also plans to scale back store expansion and adopt a small-store format. 

It's too early to know if Levine will succeed in causing a turnaround. Note that changing a pricing strategy involves various risks. The most worrying risk is the possibility of turning off loyal customers. For example, J.C. Penney did a similar change in pricing last year, losing various loyal customers. 

Foolish takeaway
Family Dollar has missed earnings consensus for the past three quarters, on the back of unfavorable macroeconomic conditions and fierce competition from Wal-Mart. To improve its top line, CEO Howard Levine is adopting a pricing system similar to Wal-Mart; this could turn off loyal customers, however. Despite the various struggles, though, there's still plenty of value in this company. It has a solid brand. Its cash/investment ratio has been positive for the past three years. It has increased its store count from 6,655 stores in 2009 to 7,916 in 2013. Aware of this, activist investors such as Carl Icahn are going long Family Dollar and are demanding that the company be put up for sale immediately.

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