In a difficult economic environment, we look for retailer Family Dollar Stores (FDO; recent stock price, $25) to increase sales to its predominantly lower-income customers by expanding its assortment of daily necessities, including refrigerated and shelf-stable foods, and by improving product quality.
We also expect Family Dollar to benefit from higher-income customers trading down to lower-priced basic goods. In addition, we note easier same-store sales [sales results for stores open more than 13 months] comparisons for the company over the next few quarters and expect to see a lift in average customer transaction value, a same-store sales driver, from Family Dollar's planned acceptance of credit cards in about half of its stores this holiday season.
By providing customers with compelling values and shopping convenience while aggressively managing its cost structure, we expect the company to maintain its historical record of stable sales and earnings growth, which is reflected in its S&P Quality Ranking of A+. From fiscal 2005 [August] through fiscal 2008, earnings per share increased at a compound annual growth rate [CAGR] of 8%. We project 7% EPS growth in fiscal 2009 and a forward three-year CAGR of 12%. We look for the company to generate sufficient free cash flow to fund its operations, growth initiatives, and dividend program.
Prices Range from $1 to $10
The stock carries Standard & Poor's highest investment recommendation of 5 STARS [strong buy].
Based in North Carolina, Family Dollar operates a chain of over 6,500 retail discount stores in 44 states. The company describes its typical customer as a woman in her mid-40s who is the head of her household and has an annual income of under $30,000. Family Dollar stores are operated on a no-frills, self-service basis, and carry an assortment of consumables such as snacks and food, household chemicals, paper products, health and beauty aids, and pet food and supplies; home products, including blankets, housewares and home decor; family apparel and accessories; and seasonal merchandise and electronics.
Unlike some dollar stores that are constrained by a maximum $1 price point, prices in Family Dollar stores range from under $1 up to $10. The once cash-only stores now accept PIN-based debit card payments in most locations. Food stamp and credit-card acceptance is also being rolled out. Family Dollar expects to accept credit cards in about half its stores this holiday season. In our view, broader tender options offer the company an opportunity to improve its share of customer spending as shopping is more convenient and available cash does not limit basket size.
Increasing Its Marketing
Store inventory is made up of both regularly available merchandise, which provides consistency in product offerings, and a frequently changing selection of brands and products that Family Dollar acquires through closeouts and manufacturer overruns at discounted wholesale prices. Low product costs and store overhead enable the company to sell its value-priced merchandise profitably.
Family Dollar's primary growth drivers are same-store sales and chain expansion. In fiscal 2008, same-store sales rose 1.2%, reflecting an increase in average customer transaction value and flat customer traffic, as measured by the company in number of register transactions. By quarter, same-store sales were down 1.0% in the first quarter, flat in the second quarter, up 0.1% in the third quarter, and up 5.6% in the fourth quarter. In our opinion, customers are spending more due to an expanded assortment of consumables and "treasure hunt" items that add an element of excitement and interest to the shopping experience. Family Dollar has also increased its marketing efforts to emphasize the value and shopping convenience it offers.
While core customers are spending more per store visit, they are also shopping less often due to macroeconomic concerns. The company reported lower customer traffic in the first three quarter of fiscal 2008. However, in the fourth quarter, traffic increased, as we believe fiscal stimulus checks gave customers found money to spend. Family Dollar also reported some sales benefit from the trading down of slightly higher-income customers. In the company's view, the economic downturn hurt low-income consumers first and the hardest, and is now affecting higher-income consumers.
Relatively Small Store Size
In terms of expansion, Family Dollar continues to be one of the fastest-growing retail chains in the U.S. The company's stores are located in rural, small town, suburban, and, increasingly, urban markets. A relatively small store size enables Family Dollar to open new stores in locations that provide neighborhood convenience to its customers in each of these markets.
Existing stores are either freestanding or located in shopping centers. From fiscal 2000 through fiscal 2005, the company increased its store count from 3,689 to 5,898, a CAGR of 10%. Family Dollar has since slowed its pace of expansion in an effort to improve the timing of store openings over the course of the year. From fiscal 2005 through fiscal 2008, the company's store count increased at a CAGR of 4%, from 5,898 to 6,571.
CORPORATE STRATEGY
Family Dollar is focused on five multiyear growth initiatives. First, under its Food Strategy, the company has been installing refrigerated food/beverage coolers in its stores since fiscal 2005, as well as adding more shelf-stable foods [with a focus on quick-prep and ready-to-eat products] since fiscal 2007. In our view, an expanded food assortment enables Family Dollar to drive store traffic by better meeting customers' fill-in food needs between visits to the supermarket, much like convenience stores. Stores equipped with coolers also qualify for the federal food stamp program, adding a new source of sales dollars for the company.
Second, under its Treasure Hunt Strategy, Family Dollar has been supplementing its basic assortment with unexpected, limited-time product offerings. Treasure hunt items drive store traffic by creating customer excitement and by differentiating Family Dollar from its competitors. The company uses circulars to advertise treasure hunt items and to reinforce its broader assortment of consumables.
Third, along with sales mix enhancement, Family Dollar has implemented store-level systems upgrades and organizational and process changes aimed at improving store manager retention, reducing inventory theft or shrinkage, and better managing inventory and operational work flows. The company's new Store of the Future technology platform, for example, enables faster customer checkout and facilitates the acceptance of credit cards and electronic benefit transfers, including food stamps.
Fourth, Family Dollar's Project Accelerate is aimed at improving its merchandising and supply chain processes. This multiyear initiative will focus on price optimization, category management, space planning, assortment planning, and merchandise financial planning.
Fifth, to enhance the customer shopping experience, the company has created Concept Renewal lab stores to test improvements in store layout and design, which are then incorporated into new stores.
EARNINGS OUTLOOK
In an effort to drive sales, we look for Family Dollar to maintain a merchandising focus on food and other consumables, to improve its treasure hunt assortments, and to increase the number of stores that accept food stamp and credit-card payments. Balancing these positive factors against a challenging economic environment, we look for same-store sales to rise 2% in fiscal 2009. Coupled with the company's plan to open 125 net new stores, which we estimate will bring its total store count up to 6,696 and increase its total selling square footage by 2%, we project net sales to rise 4% in fiscal 2009, to $7.28 billion.
We anticipate that gross margin pressure from increased sales penetration of lower-margin consumables will be partially offset by Family Dollar's continuing efforts to reduce inventory shrinkage, to expand its more profitable private label offerings, and to improve initial markups by leveraging its buying power to negotiate lower product costs from suppliers. We also look for the company to selectively raise prices to counter inflationary pressures, and to tightly control inventories of more discretionary categories to limit its markdown exposure.
With aggressive cost management, we expect Family Dollar to achieve modest operating margin expansion on expense leverage off of forecasted same-store sales. The company is targeting operating expense leverage at around 2% same-store growth in fiscal 2009, vs. 3% in fiscal 2008.
Assuming limited activity under Family Dollar's $133 million share repurchase authorization, we see EPS rising 7% in fiscal 2009, to $1.78. We look for Family Dollar to generate free cash flow that it can use, in part, for dividends.
VALUATION
Family Dollar shares recently traded at 13.9 times our calendar 2009 EPS estimate of $1.80, toward the lower end of its historical range. Given the company's relatively stable earnings history and our favorable forward outlook, we believe the stock deserves to trade at a higher multiple.
We derive our 12-month target price of $31 by applying the stock's five-year historical median forward price-earnings multiple of 17.0 times to our calendar 2009 EPS estimate. The shares currently have an indicated dividend yield of about 2.0%.
CORPORATE GOVERNANCE
Overall, we consider Family Dollar's corporate governance practices to be sound. We like that the nine-member board is elected annually [with seven members classified as independent] and that both the audit and compensation committees are comprised only of independent board members. Criteria and hurdle rates for executive incentive compensation are also publicly disclosed. In addition, the company has neither a dual-class capital structure nor a poison pill as takeover defenses.
We would prefer to see the chairman and CEO positions, which are both held by Howard R. Levine , who is the son of former chairman and company founder Leon Levine , separated and held by two different people. However, we do not perceive the current management structure as a problem.
INVESTMENT RISKS
Risks to our recommendation and target price include sales shortfalls due to changes in consumer confidence, spending habits, and buying preferences; failure to source merchandise due to lack of availability; late merchandise deliveries; business disruptions during store renovations; and increased promotional activity by competitors. Because many people have brand preferences, we also see the potential for some new customers to be disappointed or frustrated by the frequently changing selection of brands and products acquired by the company through closeout deals and manufacturer overruns.
