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Continued Growth for Family Dollar Becomes a Struggle

By Michael Lewis - Apr 18, 2013 at 10:13PM

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The discount retailer looks to spruce up stores and tackle new segments. Will it work?

A couple of years back, uber-discount stores were the market's retail favorite, as the economy was still in the dumpster, and people liked the idea of spending no more than $1 on any given item. For Family Dollar (FDO.DL), whose five-year chart shows near 200% gains, the dollar business has been a winning formula -- up until recently. Traditional retailers, from food to department stores, have fought back to regain their discount customers -- and with some degree of success. Now, with the bulk of growth behind it, how will Family Dollar and its peers perform going forward?

Earnings recap
Earlier this month, Family Dollar released its fiscal second quarter earnings release. The headline numbers looked relatively encouraging --earnings per share bumped up 5.2%, to $1.21 per share, while comparable-store sales ticked up an attractive 2.9%. Total sales increased nearly 18%, to $2.9 billion, partially driven by the opening of 126 new stores. Investors need to note, however, that this quarter included an extra week. That week yielded an additional $189 million in sales -- or $0.07 per share. Gross margins declined by 146-basis points.

The company is in the midst of an overhaul -- renovating its stores in hopes of continuing its growth pattern from the past few years. During the second quarter, the company renovated, relocated, or expanded 330 stores, and is on track to transform 850 by the end of the fiscal year. Management did not break down comparable sales figures for the renovated/relocated stores, but claims the returns (on investment) are on target and show better numbers than the untouched locations. Management noted that the company gained both foot traffic and market share in the quarter.

Overall, it seems the company is wisely addressing the fact that the immediate period after the financial crisis, which was advantageous to their business, has now passed. Sales are still growing, and comparable sales are up, as well -- but what are we looking at in the future?

Mixed bag
One of the ways in which the company is trying to widen its draw is by expanding into apparel and home goods. Family Dollar, along with its discount brethren, is known for affordable consumables. In the most recent quarter, consumables still accounted for nearly 70% of sales. However, the company's push into discretionary spending is concerning due to the fact that they are going head to head with immensely successful discount discretionary retailers such as TJ Maxx.

Family Dollar is pushing into a hyper-competitive space with a name that does not carry the same weight in discretionary spending as it does with consumables. Management, again, is not blind to this. In the conference call, the COO mentioned: "Our Apparel and Home sales remain challenged. Our customer is making choices, and this has caused us to reset our expectations for the rest of the year."

In an otherwise encouraging quarter (with the exception of margin pressure), this is clearly a troubling new area for the company. Investors need to keep an eye on the renovated stores, and if they are successful in drawing in home and apparel customers.

Family Dollar trades at 14.3 times forward earnings, compared to 13.6x for Dollar General, and 14.66x for Dollar Tree. TJ Maxx, though not a direct competitor, trades at nearly 15 times forward earnings.

Given tepid growth prospects, despite the attractive market share gains, I don't find Family Dollar's valuation to warrant an investment at this point. This company, along with the other dollar stores, has made its fantastic run -- it's likely time to look elsewhere for big gains.

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