Why Not to Drink the Kool-Aid on Family Dollar Just Yet

Believe me, I tried mightily to snuggle up to a bullish pre-earnings call on Family Dollar (FDO). In doing a casual pass through of the company, it would appear that a pre-earnings dart throw would be in the offing… The Case FOR Family Dollar •P/E multiple, applying FY13 estimates, below the nine-quarter average on the company (though this speaks volumes as to the disappointing bottom line year for the company). •Two consecutive quarters of sequential same-store sales growth acceleration, implying that expanded assortments in consumables and health and beauty aid categories are bringing in incremental traffic and sweetening the basket size a touch. •Enormous, and ongoing, store remodeling plan (interior and exterior of store) is creating a store base that over the next three years (by FY15, some 90% of the store base will be in the new format) will look meaningfully different to those of competitors. Again, these are a couple important positives that when stacking them alongside a below mean P/E multiple and lowered earnings projections, would normally raise our antenna. However, upon drilling into the heart of Family Dollar, I think there are a host of medium-term structural areas of concern, as well as a bad taste in my mouth left around certain stock market-ee things I view, that render me negative on the stock pre-earnings. Jam Session with Mr. Market •Stock did not gain strength as the economy clearly downshifted from the second quarter to the third quarter. Even accounting for the broader market rally, Family Dollar's shares should have performed better than -0.3% in a 13 week time measurement if the fundamental outlook was tighter. •Stock continued to sell-off following a July 18 analyst/investor conference, where in my view the trained eye was able to unearth the glaring points of weakness in the model (medium-term) that offset the positive attributes/benefit of near-term operating initiatives. Medium-Term Structural Issues •Strong infusion of the store with more national brand goods and health and beauty aids to play into the greater number of $40k-$70k income households walking through the front doors. The problem: this may be alienating (hurts value perception) the $40k and under income head of household, a theory supported by management's continued acknowledgement the company must become “more relevant” to its core customer. Further, management has admitted to not getting enough of the low income consumer's weekly spend on food, households chemicals, paper, etc.; if they are having problems with traffic in staples, they will have problems in driving impulse items that are essential in offsetting gross margin headwinds (such as the shift to low margin consumable sales). •The company is nowhere near complete with its hulking store remodeling plans, therefore constraining top line flow through from increased volume due to an expanded assortment (think inventory shrinkage, overall inefficiencies at the store). •The focus on investing a significant chunk of capital in inventory (primarily consumables) lessens the chance Family Dollar will rip a page from its fourth quarter of last fiscal year and announce a new share repurchase plan at this particular moment. There should be a decent amount of buyback availability under the pre-existing authorization at quarter end, but perception on a stock that needs a perception boost is what the market wants and may not get (note similar to third quarter earnings, the stock is showing life into the print). •Low margin tobacco products are now sold in the majority of Family Dollar stores. Yes, tobacco is a traffic driver, but it's another low margin items that joins forces with a host of low margin items weighing on the company's gross margins. Moreover, the items are behind the register, so I wonder if consumers are in fact shopping the store after picking up a pack of smokes (for Family Dollar's sake…they better be). •Given the structural negatives we see, there is a high probability that in learning its lesson from FY12, Family Dollar guides below consensus on FY13 earnings to establish a base of beat and raise (it would complete the expectations reset happening in drips on the Street).