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Family Dollar Analysis

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By yttire
August 18, 2005

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Here is a rough look at Family Dollar.

Revenue and earnings:

The revenue has grown nicely and steadily since 1995 with a fairly consistent 15% growth rate. COGS has stayed at a fairly consistent basis, meaning gross profit also grows at about a 15% growth rate. This implies it would be difficult for them to grow any faster than about 15% in a sustainable way with earnings or cash flow. Thus, on a PEG level in a normal market (assuming that SG&A and R&D can be held constant) it is roughly correctly priced at this moment if they can sustain this historic growth. However most recently it is taking hits to net income and also raising depreciation & amortization due to accounting changes which is pushing down both its share price and its future quarters earnings projections.

The next two quarters estimated EPS are either down from last year or roughly the same. Looking at the 10k it appears that a partial cause of this was a change in accounting to become in conformance with GAAP. Leaseholder improvements were formerly amortized over a ten year span, and now are being amortized over a five year span (doubling the cost of Depreciation & Amortization presumably, even though cash flow has not changed). This actually is a good reason for the stock to drop if you are looking to buy shares- because the actual business is still the same; it is just an accounting change, which does not affect cash flow. The question remains if the leaseholder improvements will actually last 10 years or 5- if 5 then this is actually a very good thing.

Net sales climbed 9% for the last quarter compared to 11% growth from a year ago. For the year it is up 11%. Recent margin problems have been caused by the slow movement of higher margin inventory and also the rising cost of fuel. Also recently they over ordered seasonal items and marked them down substantially to move the inventory. They warn that also they are adding more management inspections of stores, which is going to cost some money to implement. It is difficult to tease out what exactly is causing the dip in net income from all these different sources. My read through the 10k demonstrated a number of things but I think a closer scrutiny would be in order to fully grasp it. I do get that the accounting changes are good from a new stock buyer perspective, and some of the margin problems are temporary (small one time inventory problems and failing experiments in inventory). However rising fuel costs are something of a concern, which will further impact margins of course.

Balance sheet:

The balance sheet looks fine, with total current assets exceeding total current liabilities and total assets more than double total liabilities. There is no accounts receivable problem and inventory is growing in a normal way relative to revenue.

Legal:

The company is embroiled in a legal battle over whether or not it owes overtime wages for historic work performed by managers. This legal issue is to the tune of $50 million dollars, which recently ended in June in a mistrial without a new trial date being set. The resolution of this trial may change the pay rate for employees (if the managers are paid for overtime, their costs will be rising accordingly)

Stores:

The company opened 278 stores and closed 63 in 2005 so far planning to open 500 in the total fiscal year- the same as fiscal year 2004.

My take:

The company appears to be in a good market with more room for growth of stores- although it is not cheap to move into new markets and requires capital expenditures. They are (not surprisingly) failing to move larger margin items considering their target demographic, and I suspect they will not be able to move a lot of higher margin items generally, though they may be able to in certain select cases (such as through the refrigerated products they are now introducing to all stores). It does not seem plausible they will be able to substantially improve on margins and in fact will probably end up paying people for the hours they work so margins could get thinner for a while yet.

The stock price:

I could see the stock price falling a bit further actually with more rising fuel costs and the added expenses of management inspections pushing down margins even a bit more, even omitting them. However, long term this looks like a good stock to own considering their long record of steady expansion assuming they have not reached a point of market saturation. They are spending aggressively on capital expenditures to create new stores and renovate old ones: this is definitely impacting their cash flow situation but of course should improve revenue.

If I were thinking of buying I'd personally wait for more of a drop. It looks historically overvalued and is now coming into a more normal valuation IMO. If you were relying on its historic overpricing to come back, you certainly would be a buyer at this point. It is trading at 2001 levels and certainly they are going to be able to control the temporary inventory problems. However it does not look like a steal either, but if the market can maintain its malaise over this one it could be becoming one soon.


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