What's Going On at Family Dollar?

If Family Dollar's (NYSE: FDO  ) latest set of results are anything to go by, then its turnaround strategy is going to take a while to come to fruition. Moreover, its commentary on the marketplace suggests that its rivals Dollar Tree (NASDAQ: DLTR  ) and Dollar General (NYSE: DG  ) will also face tough conditions in 2014. With that said, Family Dollar is going to interest value investors, and the involvement of activist investor Carl Icahn is going to create added spice. Is now the time to buy Family Dollar?

Family Dollar remains a value
Based on valuation alone, there is no doubt that Family Dollar is the value consideration within the dollar store sector. For example, a look at its enterprise value (EV) to earnings before interest, tax, and depreciation (EBITDA) ratio demonstrates this well. Despite the recent stock price spike -- caused largely by Icahn's call for Family Dollar to be sold, or possibly merged with Dollar General -- the stock remains cheaper than Dollar General or Dollar Tree.

FDO EV to EBITDA (TTM) Chart

FDO EV to EBITDA (TTM) data by YCharts.

Icahn's involvement has lifted the share price, but Fools would be ill advised to make an investment decision solely based on Icahn. He is unlikely to inform investors of what he's about to do before making any declaration that could move the share price either way.

With that said, the sale of the company is a genuine value outer, and should be thought of in terms of the value proposition. In other words, Family Dollar is operationally underperforming Dollar General and Dollar Tree, and someone -- the current management or others -- has the opportunity to improve matters and release the value in the company.

Family Dollar reports weak results
Indeed, Family Dollar's management has undertaken a series of strategic initiatives in order to turn its fortunes around. Fools can read about them in more detail in this article. Unfortunately, the latest evidence from its third-quarter results suggests that it's going to take longer than expected to come to fruition. I've tabulated how Family Dollar's full-year expectations have changed over the course of the year.

Fools should note the reduction in EPS guidance, that comparable same-store sales are now expected to decline, and that net store opening expectations have been slashed as Family Dollar continues its plan to close 370 underperforming stores.

Source: Family Dollar Presentations.

But the most telling issue is probably the ongoing decline in gross margins, which declined to 34.3% in the third quarter from 34.7% last year. Essentially, Family Dollar is undertaking a program of workforce optimization, reducing the growth of net store openings, and making investments in an everyday low pricing, or EDLP, initiative. The latter is a key issue, as many commentators feel that Family Dollar has fallen behind Dollar General and Dollar Tree in terms of making its merchandise affordable to their core lower-income customers.

The problem that Family Dollar now has with EDLP (it invested $50 million annualized in order to lower prices across 1,000 items) is that gross margins are likely to come under pressure as a consequence. Indeed, according to its management on the conference call: "Looking to gross margins, the impact on merchandise markups from our pricing investments was larger than we anticipated," and looking ahead, "We expect to continue to see a little bit of pressure on our markups as a result of the pricing investments that we made." 

Moreover, management revealed a somewhat puzzling bit of color on the conference call. "The decrease in comp sales was primarily due to fewer customer transactions which was partially offset by an increase in the average transaction value." This is paradoxical, because with an EDLP policy in place it's reasonable to expect more transactions to take place but at a lower transaction value. Clearly, Family Dollar has work to do with its EDLP strategy. In addition, management expects to see gross margins pressured by a continued shift toward consumables (which tend to be lower-margin), as it invests in expanding its beer and wine offerings.

The bottom line
All told, investors are faced with a classic investment conundrum. Family Dollar looks like a good value, and it's possible that its management can turn performance around, with or without the assistance of Carl Icahn, Dollar General, or whoever. But its recent performance continues to disappoint, and Icahn's involvement has, arguably, provided a speculative and artificial fillip to its share price. The latter could dissipate -- only Icahn knows what he will do -- leaving investors holding a stock that they wouldn't ordinarily want to hold. Family Dollar probably needs to demonstrate that its plan is on track before Fools can be completely comfortable buying in while Icahn is involved.

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