Family Dollar Stores, Inc. (FDO – $68.54*) Coverage InitiatedMatthews, NC Market PerformJuly 18, 2013 Price Target: $64.00
STOCK DATA
52-Week Range $72.54 – $54.063-Month ADTV 1,438,534Dividend Yield 1.52%Market Cap (mil) $7,882.1Shrs Outstanding (mil) 115.0Beta 0.42Float (%) 95.4Fiscal Year-End August
EARNINGS DATA
Oper. EPS Aug 2012A 2013E 2014E1Q $0.68 $0.69A $0.772Q $1.15 $1.21A $1.243Q $1.06 $1.05A $1.154Q $0.75 $0.85 $0.93FY $3.63 $3.79 $4.09P/E 18.9x 18.1x 16.8xQuarters may not sum due to rounding.
3Q13Cash & Equivalents $208.0Inventories $1,474.4Total Debt 735.4Stockholders' Equity $1,521.1The calendar year is approximated by the forward fiscalyear. $ in millions unless otherwise indicated.
Long-Term Story Appealing but Near Term LessCertain--Initiating Coverage at Market PerformSummary and RecommendationWe are initiating coverage of Family Dollar Stores, Inc. with a Market Perform ratingand a $64 price target. The FDO story has significant potential upside, but it seemsthat perfect execution is often just out of reach. On the positive side, the low-endconsumer may be showing some signs of life, COO Michael Bloom has mostly builtout his team, and the company is beginning to lap some of the more disruptiveinitiatives undertaken during the last year. On the negative side, we believe thecurrent guidance and consensus estimates are aggressive, the valuation is stretched,share repurchase activity is likely to slow, and management may have lost some costdiscipline in its effort to grow sales aggressively. Given the shares’ recent run (+8%over the last month, versus +3% for the XRT), we are also left wondering who theincremental buyer will be. Longer term, we like the potential for growth, and we areconfident that management will be able to work the kinks out of the model. In thenear term, however, we view both upside and downside as balanced and, therefore,rate the shares Market Perform.
Key Points■ Good longer-term growth strategy. Family Dollar has identified more than
11,000 potential locations for new stores in the coming years, implying that ithas several years of growth ahead. Over a five- to seven-year period, an earningsCAGR of 16% (pre-dividend) would not be unreasonable.
■ Making management changes, moving through the “noise,” and facing astretch of easing comparisons. FY14 will see Family Dollar fully lap a lot of noisecreated by several rollouts, initiatives, and missteps. Additionally, in the pastyear, Family Dollar has made a significant number of hires in a variety of areas.During the next year, we believe that there will be more continuity and betterexecution, as the company has had time to work the kinks out of a lot of thenew initiatives.
■ 4Q13 guidance and initial FY14 talk may be aggressive. A +2% comp for 4Q13is attainable, but not guaranteed, and we believe the company is counting onsome degree of reacceleration in July and August, which may not occur. Flattishgross margins in FY14 are possible, but it is worth noting that tobacco andproduct mix will pressure full-year gross margins. We view FY14 as starting in agross margin hole, and the question becomes whether management can offsetthe negative pressure.
■ Sales productivity gap with Dollar General Corporation (DG – Outperform)unlikely to close materially. We believe that the focus on sales productivity andgross margin is slightly misplaced because the real difference in earnings (andcash generation) between the two companies has to do with SG&A control. Weview SG&A spending as being much more under the company’s control thangross profit, implying that SG&A control could (potentially) be a future lever todrive earnings versus Dollar General.
■ Share repurchase activity likely to slow. Repurchase activity has driven half ofFDO's earnings growth during the past three years; however, we believe thisactivity is very likely to slow materially in the next few years. The vast bulk ofthe company’s future earnings growth will have to be organically driven.
Important disclosures can be found on pages 28 - 31 of this report.
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M Debatable Point Our Thoughts Time Frame Impact
Will we see betterexecution goingforward?
In the next year, we will see Family Dollar fully lap a lot of noisecreated in the prior year, including disruptions caused by theMcLane initiative, the tobacco rollout, product reassortments, andsome merchandising missteps. Also in the past year, Family Dollarhas made a significant number of hires in a variety of areas,including merchandising, marketing, operations, food, and realestate. Over the next year, we believe that there will be morecontinuity and better execution, as COO Michael Bloom hasbasically built out his team and as the company has had time towork the kinks out of a lot of the new initiatives. One notablerecent departure, however, was that of Paul White, executive vicepresident and chief merchandising officer, who left in early July2013.
6 to 12Months
Are Family Dollarinitiatives actuallyworking to drivetraffic and comps?
The tobacco rollout has been a success, but the jury is out on otherinitiatives store remodels, the partnership with McLaneCompany, Inc., and home/softlines/food/health and beautyreassortments as non-tobacco comps slowed dramatically acrossall dollar store retailers right when Family Dollar was introducingmany of these initiatives. Looking ahead, the broader success of allthe recent initiatives will hinge primarily on management abilityto execute.
6 to 12Months
Can Family Dollarclose the salesproductivity gapwith DollarGeneral?
We believe it is unlikely that Family Dollar will ever significantlyclose the gap with Dollar General Corporation (DG Outperform),largely due to structural differences. The common refrain we hearis that Family Dollar has several initiatives in place to drive sales,but we believe it is more appropriate to ask the question Whatcan Family Dollar do to drive sales that Dollar General cannot? Asevidenced recently with the dueling tobacco rollouts, DollarGeneral is very willing to react to Family Dollar quickly andaggressively.
2 Years+
Investment Thesis
We are initiating coverage of Family Dollar Stores, Inc. with a Market Perform rating. The FDO storyhas significant potential upside, but it seems that perfect execution is often just out of reach. Onthe positive side, the low-end consumer may be showing some signs of life, COO Michael Bloom hasmostly built out his team, and the company is beginning to lap some of the more disruptive initiativesundertaken during the last year. On the negative side, we believe the current guidance and consensusestimates are aggressive, the valuation is stretched, share repurchase activity is likely to slow, andmanagement may have lost some cost discipline in its effort to grow sales aggressively. Given theshares’ recent run (+8% over the last month, versus +3% for the XRT), we are also left wondering whothe incremental buyer will be. Longer term, we like the potential for growth, and we are confidentthat management will be able to work the kinks out of the model. In the near term, however, weview both upside and downside as balanced and, therefore, rate the shares Market Perform.
Valuation
We base our $64 price target on the average of a five-year DCF analysis with a terminal multiple of6.5x, an estimated 6.5x 2014 EV/EBITDA multiple, and an estimated 2014 P/E multiple of 15.0x.
The Bull Case The potential is there, just not the execution . . . yet. The bull case for Family Dollar has, for years, centered on closing the sales productivity gap with Dollar General. While the conversation tends to focus on sales per square foot and gross profit per square foot, the most striking difference between the two companies is in EBIT per square foot, where Dollar General enjoys an 81% advantage over Family Dollar. Yet, this was not always the case. As recently as mid 2009, Dollar General had an advantage of only 10% (Dollar General at $9.68, versus Family Dollar at $8.81). We believe it is unlikely that Family Dollar will ever significantly close the sales per square foot gap with Dollar General, largely due to structural differences. This does not mean, however, that Family Dollar cannot drive growth and at least narrow this gap. The tobacco rollout has been a success, but the jury is out on other initiatives—store remodels, the McLane partnership, and home/softlines/ food/health and beauty reassortments—as non-tobacco comps slowed dramatically across all dollar store retailers right when Family Dollar introduced many of these initiatives. Looking ahead, the question remains the same: Can senior management fix the merchandising issues and execute on the broader strategic plan?
Low-end consumer quietly showing signs of improvement. While much has been written regarding the pressures faced by the low-end consumer, we note that FY13 year-to-date sales results have largely been fairly good for retailers that cater to the lower-end consumer. Although there are several headwinds (general economic malaise, the sequester, the expiration of the payroll tax holiday, etc.), sales continue to be fairly robust. One root cause is that there are simply more low-end shoppers today than there were a year ago; according to the Bureau of Labor Statistics, there were 1.3 million more people employed in middle- to low-income jobs in June 2013 than in June 2012. Interestingly, Dollar General, Dollar Tree, Inc. (DLTR – Market Perform), Fred’s, Inc. (FRED – Market Perform), and Family Dollar have all made some sort of public commentary regarding improvement or stabilization in discretionary trends (to be clear, discretionary remains challenged, but there appears to be a positive shift in trends). We view discretionary items as important margin drivers, as they typically carry better gross margins than basics/consumables. Since late 2012, we have maintained our view that the state of the low-end consumer is improving, and it remains controversial; however, we continue to believe that future results will reflect improving spending ability and shopping trends within the low-end space.
Good longer-term growth strategy. Family Dollar has identified an additional 11,200 potential locations for new stores in the coming years, implying that it has several years of growth ahead.
Store Rollout Potential
Source: Company presentations and FBR Research
There is significant conjecture regarding the impact of Dollar Tree, Dollar General, and Family Dollar all aggressively expanding their store bases simultaneously, and we believe it is unlikely that Family Dollar can actually open 11,200 more stores in a reasonable time frame. The company does, however, have significant growth ahead of it. Opening 600 stores per year would result in a chain of 12,000 stores by the year 2020. Assuming only positive low-single-digit comps over that period (+2% to +3%, in line with inflation) and a 9.5% operating margin (less than DG’s current 10% EBIT margin), the Family Dollar of the year 2020 would have approximately $19 billion in sales, $1.8 billion of operating income, and nearly $11 of EPS (using today’s share count), representing an earnings CAGR of approximately 16% exclusive of dividends. While much of the focus is on near-term results, the longer-term appeal of the space remains strong.
Making management changes, moving through the “noise,” and facing a stretch of easing comparisons. FY14 (calendar September 2013 through August 2014) will see Family Dollar fully lap a lot of noise created in the prior year, including disruptions caused by the McLane initiative, the
tobacco rollout, product reassortments, and some merchandising missteps. Additionally, in the past year, Family Dollar has made a significant number of hires in a variety of areas, including merchandising, marketing, operations, food, and real estate. During the next year, we believe that there will be more continuity and better execution, as COO Bloom has mostly built out his team, and the company has had time to work the kinks out of a lot of the new initiatives. One notable recent departure was that of Paul White, executive vice president and chief merchandising officer, who left in early July 2013. Furthermore, Family Dollar is preparing to face a stretch of easing comparisons starting in 2Q14 (or calendar December 2013), which may help comp trends reaccelerate.
The Bear Case 4Q13 guidance and initial FY14 talk may be aggressive. On Wednesday July 10, 2013, Family Dollar reported 3Q13 results. Shares rallied on the news, but we remain cautious regarding the company’s outlook. When we dig into the numbers, we see that 3Q13 was not a good quarter. As indicated within, we believe that tobacco added approximately 3.8% to the quarterly comp, implying that (1) “core” comps were down approximately 0.9% and that (2) the company’s guidance of a +2% comp for 4Q13 would require a healthy reacceleration in core comps in that quarter. Sales per square foot for all the major categories slowed dramatically versus both the prior-year average and sequentially. We estimate that tobacco added just under $100 million in sales for 3Q13; removing tobacco from the consumables category would leave consumables growth of less than 1% on a per-square-foot basis, versus high single digits to low double digits previously. A +2% comp for 4Q13 is attainable, but not guaranteed, and we believe the company is counting on some degree of reacceleration in July and August, which may not occur.
Management also discussed flattish gross margins for FY14. We believe this is possible, but it is worth noting that tobacco will still pressure full-year gross margins by approximately 20 bps to 25 bps, and although the consumables mix shift pressure may lighten, it is unlikely to reverse. As such, we view FY14 as starting in a gross margin hole, and the question becomes whether initiatives such as better inventory management, reduced mix shift, improved assortments, and expanded direct sourcing can offset the negative pressure. We are modeling FY14 gross margins to be down slightly, but it is worth noting that this would be a vast improvement over the prior few years.
Valuation is rich on both relative and absolute bases. FDO shares have significantly underperformed over the last year (and particularly CY13 to date), despite the broad outperformance of other discount retailers.
FDO’s Return vs. the XRT and One-Year Forward P/E Ratio
Priced as of the close on July 16, 2013.
Source: FactSet and FBR Research
At this point, forward valuation is toward the high end of the two-year range. More importantly, the last time valuations approached these levels, the shares subsequently traded down for the next several quarters.
Our out-year EPS estimates may ultimately prove conservative, but we note that Family Dollar’s business model is not particularly leverageable, and the company is unlikely to be able to manufacture the magnitude of beat that the current multiple implies. In other words, at 15.8x, investors are paying a lot today for earnings that may or may not materialize in FY14 and beyond.
Share repurchase activity likely to slow. Family Dollar has repurchased nearly $1.3 billion in shares since the beginning of FY10; however, we believe this activity is very likely to slow materially in the next few years. In the past three years, post-dividend free cash flow has fallen from $302 million to negative $334 million, as the company has dramatically ramped up its capex spending and increased its working capital needs while EBITDA have grown only modestly. To fund the share buybacks, the company has used its balance sheet and entered into $698 million of sale-leaseback transactions over this period (including the pending 4Q13 transaction). We estimate $60 million to $160 million of annual post-dividend free cash through FY16. We are modeling a dividend load of 70% of free cash flow in FY14 (although this is down from the 96% dividend load in FY13); however, we are also modeling for the load to decrease to 50% to 60% of free cash a few years out as capex moderates slightly. Therefore, we are modeling only $50 million to $200 million of share repurchase activity per year for the next several years, which is not enough to affect EPS growth rates materially.
Only about halfway through the tobacco rollout; have not yet seen the full impact on gross margins. For FY13, we believe that tobacco will add $340 million in sales (approximately +2.8% to comp) but pressure the gross margin by an incremental 60 bps to 70 bps. We also expect it to add slightly more than $0.10 to full-year EPS. It is important to note that while the impact will “roll off” in FY14, it will remain material to FY14 results, with the largest impact felt in 1Q14 and 2Q14. We estimate that tobacco will add $0.04 to 1H14 and $0.06 to FY14 (see below for a full analysis of the impact of the tobacco rollout on Family Dollar’s consolidated P&L).
An LBO is extremely unlikely at current valuations. In February 2011, the Trian Group made an unsolicited offer to take Family Dollar private in the range of $55 to $60 per share (the stock was trading at $43.96 prior to the offer). Ultimately, the Family Dollar board rejected the deal; however, Trian maintains a board seat and 7.3% stock ownership. At first glance, it makes sense that Family Dollar could go private and reemerge as a stronger company, similar to Dollar General. However, it is also important to note that Family Dollar is a very different company today than it was in February 2011. In recent years, the company’s free cash flow generation has deteriorated dramatically, the company has levered up its balance sheet, and most of the owned properties have already been monetized. At current valuations, we believe a takeout of Family Dollar would be nearly impossible to achieve economically. Trian could take more of an activist role regarding the daily operations of the business, but at least in the near term, we view a leveraged buyout (LBO) (or any other strategic alternative) as unlikely until the company can improve its cash flow.
Closing the Gap with Dollar General—Sales May Not Be the Issue For several years, the long-term bull argument for an investment in FDO has been some iteration of “If the company can close the sales gap with Dollar General, and at least keep gross margins under control, then FDO would be a $[huge number] stock.” From a purely theoretical perspective, we agree. If Family Dollar could close the gap with Dollar General, the shares would significantly appreciate. But the question persists: Why does this goal remain elusive?
Trailing-12-Month Square-Foot Metrics
Note: To mitigate the impact of the companies’ different fiscal calendars, we are comparing Dollar General’s TTM metrics beginning in 1Q13 with Family Dollar’s TTM metrics beginning in 3Q13.
Source: FBR Research and company filings
While the conversation on the productivity gap between the two companies tends to focus on sales and gross profit per square foot, the most striking difference between the two companies is in EBIT per square foot, where Dollar General enjoys an 81% advantage over Family Dollar. However, this was not always the case. As recently as mid 2009, Dollar General had only a 10% EBIT per square foot advantage (Dollar General at $9.68, versus Family Dollar at $8.81).
Note: To mitigate the impact of the companies’ different fiscal calendars, we are comparing DG’s TTM EBIT/sq. ft. beginning in 1Q10 with FDO’s EBIT/sq. ft. beginning in 3Q10.
Source: FBR Research and company filings
With regard to sales per square foot, we believe it is unlikely that Family Dollar will ever significantly close the gap with Dollar General, largely due to structural differences. The common refrain we hear is that “Family Dollar has several initiatives in place to drive sales,” but we believe it is more appropriate to ask the question “What can Family Dollar do to drive sales that Dollar General cannot?” As evidenced recently with the dueling tobacco rollouts, Dollar General is very willing to react to Family Dollar quickly and aggressively.
Based on conversations with real estate experts, we also believe that Dollar General has a geographic advantage over Family Dollar because of its store base.
More than 70% of Dollar General’s stores are in small, rural towns with populations below 20,000—towns that are generally too small individually to support a Wal-Mart. This leaves Dollar General competing against grocery stores and other local stores, and it can outcompete them on price and convenience. On the other hand, about half of Family Dollar’s stores are in urban/suburban areas, and the company has historically been unafraid to locate closer to large-format stores and rely on the small-box convenience to drive sales. The consequence, in our view, is that Family Dollar has more competition than an average Dollar General, which is often the only show in town.
It is well documented that Family Dollar is priced slightly higher than Dollar General and Wal-Mart for similar items. Typically, Family Dollar is 5% to 15% more expensive that Wal-Mart for a given item, whereas, Dollar General is typically flat to 10% more than Wal-Mart. Given Family Dollar’s proximity to competition and the more recent “rush to consumables” across the space, we believe that pricing is likely costing Family Dollar more customer trips, versus Dollar General. We calculate that the average Dollar General sees 9% to 10% more transactions than the typical Family Dollar, which translates to approximately 30 transactions per day.
Several real estate brokers have told us that Dollar General’s real estate group is among the best in the small-format retail world (not just dollar stores). We note that Dollar General has been opening more than 500 stores per year for several years now (more than 600 per year in the last
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DG's indexed EBIT per sq. ft. has grown dramatically while FDO's has stayed flat since
three years), whereas as Family Dollar will open 500 for the first time this year. Furthermore, Family Dollar opened only 150 stores in a quarter once, whereas Dollar General achieves this feat frequently (in three of the last five quarters). As a result, we believe that Dollar General is often the unofficial “first call” when new properties become available, which gives the company the first pick of the best properties.
As such, we do not believe that Family Dollar will, in either the medium or the long term, be able to close the sales productivity gap significantly, as there is very little that it can do that Dollar General cannot duplicate. Family Dollar has, however, made some headway in the past few years. We view the focus on sales productivity and gross margin as slightly misplaced because the real difference in earnings (and cash generation) between the two companies, in our opinion, has more to do with SG&A control.
Trailing-12-Month Sales, Gross Profit, and SG&A per Square Foot Gap between FDO and DG in FY10 vs. FY13
Note: To mitigate the impact of the companies’ different fiscal calendars, we are comparing Dollar General’s metrics from 1Q to 4Q with Family Dollar’s metrics from 3Q to 2Q.
Source: FBR Research and company filings
In 2010, Family Dollar had a 16% sales per square foot disadvantage to Dollar General (approximately $199/sq. ft. for Dollar General, versus $167/sq. ft. for Family Dollar), and in 2013, that gap is effectively unchanged. The same is true for gross profit—Family Dollar remains at the same 6% discount per square foot, versus Dollar General, despite the positive impact of many of the company’s initiatives (and the tobacco-induced headwinds).
Interestingly, it is the SG&A spending that has driven the profitability gap between Family Dollar and Dollar General. Dollar General has been able to hold SG&A per square foot in the $45 to $46 range since 2010, while Family Dollar has seen it rise from approximately $47 to around $52. We found this somewhat surprising, given that the management team has been very focused on cost control. Furthermore, “SG&A slipping” is not part of the Wall Street narrative for Family Dollar, as most investors with whom we have spoken give the company good marks for expense control. Based on our analysis, however, it is SG&A control that accounts for the difference in profitability between the two companies.
Pinpointing the reason for this divergence is difficult. Some of it has to do with fixed leverage on a growing sales base; Dollar General has grown sales 35% since 2010, versus 30% for Family Dollar, but this is only responsible for a small fraction of the difference in cost structure growth. While Family Dollar has implemented several initiatives (expanding distribution, opening new stores, making infrastructure investments, investing in technology), Dollar General has also been making similar investments. It is possible that the focus on sales growth has reduced the focus on the SG&A side,
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Sales/sq.ft. Gross Profit/sq.ft. SG&A/sq.ft.
2010 2013E
Sales/sq.ft.and GP/sq.ft. have largely been flat. SG&A/ sq.ft. appears to be driving FDO's
but this is speculative (e.g., the focus at Family Dollar has moved from really driving costs out of the business and toward keeping ”cost creep” under control). Yet, on the more positive side, we view SG&A spending as being much more under the company’s control than gross profit, implying that SG&A control could (potentially) be a future lever to drive earnings versus Dollar General.
Cash Generation Slowing and Historical Share Repurchase Rates Likely to Slow Dramatically Family Dollar has repurchased nearly $1.3 billion in shares since the beginning of FY10; however, we believe this activity is very likely to slow materially in the next few years. In the past three years, post-dividend operating free cash flow has fallen from $302 million to negative $334 million, as the company has dramatically ramped up its capex spending and increased its working capital needs while EBITDA has grown only modestly. To fund the share buybacks, the company has used its balance sheet and has entered into $698 million of sale-leaseback transactions over this period (including the 4Q13 transaction).
Free Cash Flow and Impact of Sale-Leaseback Transactions ($ in Millions)
Source: FBR Research and company reports
Sources and Uses of Cash ($ in Millions)
Source: FBR Research and company reports
While it is impossible to track the exact source/use of cash (e.g., it can be argued that the increased capex was funded by the sale-leaseback transactions and the repurchases were from free cash), it is clear that the sale-leaseback transactions have been extremely important in funding Family Dollar’s share repurchases while simultaneously increasing capex spending. However, we believe that Family Dollar may not have a significant inventory of owned stores to sell and re-lease going forward. According to the FY12 10-K, the company had 367 owned stores on its balance sheet. In 1H13, the company entered into a transaction to sell 127 stores for $163.5 million (netting to $1.3 million per store, which is the same rate that Family Dollar saw for the 267 stores it sold for $360 million in
FY12). On the 3Q13 call, management indicated there would be another sale-leaseback transaction closing in 4Q13 that would result in proceeds of $170 million to $180 million. Using the same $1.3 million/store rate, we estimate that the transaction involves 130 to 140 stores. This would leave approximately 100 to 110 stores remaining for the company to sell and leaseback, for which we estimate proceeds of approximately $130 million. Approximately 20% to 25% of the stores that the company is opening are “owned” stores and are, therefore, eligible to be sold and leased. We are modeling approximately $130 million in sale-leaseback proceeds per year going forward, which we believe is sustainable.
We expect capex to stay relatively inflated (although to decline from 7.4% of sales to the 5.0% to 6.0% range) for the foreseeable future. We are modeling FY14 capex of approximately $650 million. Although some argue that capex should decline significantly in FY14 and beyond, we disagree. We believe that (1) Family Dollar will likely open 500 to 600 stores per year for the next several years, (2) the company will need more distribution centers in the coming years, and (3) by the time the company completes its store renovation program in 2016, the oldest stores will be five to six years old and will likely be in need of a new renovation to drive comp sales.
We estimate $60 million to $160 million of annual post-dividend free cash through FY16. We are modeling a dividend load of 70% of free cash flow in FY14 (although this is down from the 96% dividend load in FY13); however, we are also modeling for the load to decrease to 50% to 60% of free cash a few years out as capex moderates slightly. Therefore, we are modeling only $50 million to $200 million of share repurchase activity per year for the next several years, which is not enough to affect EPS growth rates materially.
What Is the Full Impact of the Tobacco Rollout, and When Will Family Dollar Anniversary the Effects? We originally published our analysis of the impact of tobacco on Dollar General in December 2012, and we have updated it several times. In this report, we present the same analysis for Family Dollar, but we are adding a level of depth beyond the work we have done for Dollar General.
In summary, for FY13, we believe that tobacco will add $340 million in sales (approximately +2.8% to comp) but will pressure the gross margin by an incremental 60 bps to 70 bps and will add slightly more than $0.10 to full-year EPS. It is also important to note that although the impact will “roll off” in FY14, it will remain material to 1Q14 and 2Q14 results.
To determine the impact of adding tobacco on Family Dollar’s financials, we first looked at one of the company’s smaller competitors. Fred’s is broadly similar to both Family Dollar and Dollar General with respect to sales per store (excluding Fred’s pharmacy sales), and the companies share a similar customer demographic within the Fred’s footprint. However, Fred’s has sold tobacco at the majority of its locations for some time. Based on our conversations with industry experts, we believe that 5% to 6% of Fred’s general merchandise sales are tobacco transactions. This translates to approximately 240 to 260 tobacco transactions per location per week, a similar rate to what we expect to see at an average Family Dollar location. We also believe that tobacco carries a 9% store-level cash margin and that the incremental fixed cost (to both gross margin and SG&A) is minimal due to the distribution agreement with McLane, which handles the vast majority of the supply and stocking issues.
To analyze the aggregate impact on Family Dollar, we look first at a non-tobacco store. Note that the gross profit rate we are using is fully allocated (i.e., not a four-wall cash margin) because we are looking at the company on an aggregated basis.
The sales benefit of adding tobacco is twofold—incremental sales to existing customers and drawing new customers. In our analysis below, we assume that (1) only 7% of sales are to new customers, (2) the average transaction value (ATV) for a tobacco transaction is $13, compared with $10 for a non-tobacco transaction, (3) tobacco sales “season” very quickly (which is consistent with industry conversations), and (4) tobacco carries a 9% cash margin.
We are assuming 7% new customer traffic at Family Dollar, versus 10% at Dollar General. We are making this assumption due to Family Dollar’s more urban store base; we believe that Dollar General faces slightly less competition for low-cost cigarettes due to its more rural store locations and should, therefore, drive more new traffic. Additionally, management previously indicated that it was seeing about 40% tobacco-only transactions, with the remaining 60% being tobacco plus one or more items. The average basket with tobacco and additional items is roughly $17. We arrive at our $13 ATV via weighting all tobacco transactions at a $7.00 rate for tobacco-only transactions (40% of transactions) and at $17 for “tobacco-plus” transactions (60% of transactions). These metrics are basically in line with both Fred’s and Dollar General’s experiences.
Impact of Tobacco on Store-Level Sales
Source: FBR Research and company filings
Non-Tobacco Store 4Q12A 1Q13A 2Q13A 3Q13A 4Q13E 1Q14E 2Q14E 3Q14E
Impact of Tobacco on Store-Level Gross Profit and Gross Margin
Source: FBR Research and company filings
We believe that as Family Dollar has ramped up its tobacco sales over the past year, tobacco stores have seen a 4.3% increase in comparable sales (approximately $1,100 per store per week) and a 1% increase in gross profit dollars (approximately $160 per store per week), both of which are roughly similar to our analysis of Dollar General. However, the gross profit rate per store should decline by as much as 95 bps.
Now that tobacco has been fully rolled out, stores are beginning to anniversary the impact. In the red boxes below, we highlight that 4Q13 should still see a +1.9% benefit, and 1Q14 and 2Q14 should see slight comp benefits. By 3Q14, we estimate that the total impact will be fully anniversaried. Similarly, the net impact of store-level gross profit hit an apex of approximately 90 bps in 3Q13; however, the realized impact should begin to decline (although remain material) from 4Q13 through 3Q14.
Consolidated Impact on Family Dollar
Source: FBR Research and company filings
We estimate that the total number of Family Dollar stores with tobacco will hover around 90%. As such, in the chart above, we gross up our store-level analysis to represent the fleet. Importantly, tobacco should lift the consolidated comp by 1.9% in 4Q13, and gross margins will still feel nearly 50 bps of pressure, although this pressure should fade over the next several quarters.
Lastly, we examine the consolidated impact that tobacco has had on Family Dollar. Interestingly, the net impact on the EBIT margin is negligible (the 9% cash margin plus incremental trips and basket size less incremental SG&A almost exactly equals the non-tobacco EBIT margin); however, increased sales result in a slight benefit to EBIT dollars. We estimate the benefit to FY13 to be approximately $0.10 and the benefit to FY14 to be approximately $0.15 (or $0.05 in addition to the $0.10 from FY13).
Is an LBO Back on the Table? Family Dollar is occasionally the subject of LBO discussions, dating back to 2011. In February 2011, the Trian Group made an unsolicited offer to take Family Dollar private in the range of $55 to $60 per share (the stock was trading at $43.96 prior to the offer). Ultimately, the Family Dollar board rejected the deal; however, Trian maintains a board seat and 7.3% stock ownership.
At first glance, it makes sense that Family Dollar could go private and reemerge a stronger company, similar to Dollar General. It is also important to note, however, that Family Dollar is a very different company today than it was in February 2011. In 2011, the company was generating simple free cash flow (EBITDA less capex) of approximately $450 million and had only $500 million of debt on the balance sheet. The takeout would have put FDO at approximately 8.0x debt/EBITDA, which is heavy but similar to DG’s high point during its takeout. Most importantly, the company could have covered the interest load with free cash, and there was still approximately $830 million worth of owned real estate in the Family Dollar portfolio that could have been sold and re-leased to generate incremental cash.
In recent years, however, Family Dollar’s FCF generation has deteriorated dramatically, the company has levered up its balance sheet, and most of the owned properties have already been sold and re-leased. At current valuations, we believe a takeout of Family Dollar would be approximately $8.9 billion in size ($8.4 billion in equity and the remainder in net debt assumed). If Trian were to again make an offer for the shares it does not already own, it would need approximately $7.8 billion in funding. Assuming an 8.5% rate on this funding (which is extremely generous given recent market trends), Family Dollar would see cash interest payments of approximately $690 million, versus cash from operations of $761 million (or EBITDA less capex of approximately $290 million). This would
leave approximately $70 million for capex, fees, incremental working capital, etc. We remain very skeptical that a deal such as this could be completed. Any deal would require a significant cash equity injection to both lower interest payments and provide liquidity; the current balance sheet cannot handle the debt level required for a traditional LBO structure. Trian could take more of an activist role regarding the daily operations of the business, but at least in the near term, we view an LBO (or any other strategic alternative) as unlikely until Family Dollar can improve its cash flow.
3Q13 Review
3Q13 Summary
(1) FCF defined as EBITDA less cash taxes, working capital changes, interest, and capex. Note: $ in millions except per share and square-foot data.
Source: FBR Research, FactSet, and company filings
On Wednesday, July 10, Family Dollar reported 3Q13 results. Sales of $2.57 billion were essentially in line with the consensus, as the company reported a comp of +2.9%, versus the consensus of +2.5% and previous guidance of “towards the lower end of the 2% to 4% range.” However, margin performance (both gross margin and SG&A margin) was weaker than anticipated. The gross margin of 34.7% was approximately 10 bps below the Street, and the SG&A margin of 27.4% was well below the consensus of 26.9% (it should be noted that the SG&A consensus is typically inconsistent for Family Dollar because some analysts exclude depreciation and amortization from their estimates; however, Family Dollar still missed the SG&A margin that we had anticipated by 20 bps).
Management reduced guidance, but this was largely anticipated. The company now expects 4Q13 comps to be approximately 2%, versus previous guidance of “towards the higher end of the 2% to 4% range” and the consensus of 3.8%. The company lowered FY13 EPS guidance from a range of $3.73 to $3.93 to a range of $3.77 to $3.82 and guided 4Q13 to a range of $0.82 to $0.87, versus the Street at $0.85 for 4Q13 and $3.77 for FY13.
FDO shares rallied on the news, but we remain cautious on the company’s outlook. When we dig into the numbers, we see that 3Q13 was not a good quarter. As indicated above, we believe that tobacco added approximately 3.8% to the quarterly comp, implying that (1) “core” comps were down approximately 0.9% and that (2) the company’s guidance of +2% for 4Q13 would require a healthy sequential reacceleration in core comps during the quarter.
Year-over-Year Change in Sales per Square Foot by Sales Category
Source: FBR Research and company filings
In 3Q13, sales per square foot for all of Family Dollar’s major categories slowed dramatically, versus the prior-year average and sequentially. We estimate that tobacco added just under $100 million in sales for 3Q13; backing this out of the consumables category would leave consumables growth of less that 1% on a per-square-foot basis. While some of the shrinkage is due to the reallocation of floor space away from discretionary categories, consumables also slowed dramatically.
As indicated in the tobacco analysis above, we believe that tobacco should add approximately 1.9% to consolidated comps in 4Q13, versus the company’s guidance for approximately 2% comps. This implies that “core” comps should be approximately flat in 4Q13, versus –0.9% in 3Q13. We believe this may be somewhat challenging. Management indicated on the call that discretionary categories were still posting negative comps (although they had stabilized). Additionally, non-tobacco consumables have seen basically flat year-over-year growth per square foot (implying roughly flat comps). We believe that a +2% comp for 4Q13 is attainable but not guaranteed. We also believe that the company is counting on some degree of reacceleration in July and August, which may not occur.
Earnings Sensitivity: Base Case, Bull Case, and Bear Case
The Family Dollar operating model has average leverage; a 100-basis-point increase in the EBIT margin translates to approximately $0.99 in EPS, an increase of approximately 23%. A 10% increase in sales translates to approximately $0.66 in EPS, a roughly 16% increase, both of which are similar to Dollar General. We base our FY14 bear case on a slightly negative comp for 2014 (non-comp store contribution should drive 6.0% to 6.5% sales growth, depending on new store openings and new store productivity) and on a 30-basis-point decline in the operating margin below our base case. Under this scenario, we see earnings around $3.65 and a 14.0x multiple; however, it is important to note that the company may de-leverage more than we are modeling.
Our bull case assumes comps in the 3% to 4% range for the year and total sales growth of approximately 10.6%; we are also modeling 30 basis points of EBIT margin expansion over our base case. Under this scenario, the forward P/E multiple should expand to approximately 16.0x (from 15.0x today). Our bull case (green), base case (blue), and bear case (red) are detailed below.
Based on our analysis, we believe that upside and downside are roughly balanced, resulting in our Market Perform rating.
2014E EPS Sensitivity to Changes in Sales and EBIT Margins
Source: FBR Research
Upside/Downside in Base Case, Bull Case, and Bear Case
Note: the implied share price in our base case does not match our price target because our final price target is based on several valuation measures, of which forward P/E is only a single factor.
Source: FBR Research
Business Overview
Company Description Family Dollar Stores, Inc., headquartered in Charlotte, North Carolina, is a discount retailer that offers a range of products from less than $1 to $10 primarily to low- and middle-income consumers. The company’s merchandise includes health and beauty aids, packaged food and refrigerated products, home cleaning supplies, housewares, stationery, seasonal goods, apparel, and home fashions. The first Family Dollar store opened its doors in 1959, and the company was incorporated in 1969. As of the end of FY12, the company operated 7,442 stores in 46 states; the stores are 7,500 square feet to 9,500 square feet in size.
Store Concentration and Geographic Presence The company’s stores are mainly located in Texas and the eastern U.S. in areas that have relatively high proportions of low- and middle-income consumers. As of September 29, 2012, Family Dollar operated 7,475 stores in 45 states, with its largest concentration of stores in Texas (approximately 13%), Florida (approximately 7%), and Ohio (approximately 6%). Family Dollar has few stores in the Midwest and Northwest, with no stores in Oregon, Washington, and Montana. In FY12, the company opened 44 stores in California and plans to open 50 additional stores in FY13.
Family Dollar’s U.S. Footprint
Source: Company Web site and FBR Research
Supply Chain Family Dollar sources merchandise from a network of domestic and international suppliers, with its largest vendor accounting for 9% of products sold in stores. In FY12, the company purchased 14% of its overseas manufactured products from domestic suppliers and imported 10%.
The company has 10 distribution centers that are responsible for maintaining inventory and supplying stores; these distribution centers are located in North Carolina, Arkansas, Virginia, Oklahoma, Kentucky, Iowa, Texas, Florida, New York, and Indiana. Family Dollar’s 10th distribution center located in Ashley, Indiana, became operational in June 2012 and supplied 605 stores by the end of FY12. The 11th center in St. George, Utah, will supply Family Dollar’s West Coast stores and is scheduled to open in 4Q13. In addition to its own trucks, the company uses contract carriers to deliver approximately 94% of its warehoused merchandise to its stores.
1959-69
1970-79
1980-89
1990-99
2000-02
2003-09
• 1961-1965 -Firststores open in S. Carolina, Georgia, and Virginia.
• 1969 - 50th store in Charlotte.
• 1970 - FDO goes public at $14.50/share.
• 1977- Annual sales exceed $100million.
• 1979 - Listed on NYSE.
• 1982 - 500th store opens.
• 1989 - 1,500th store becomes operational.
• 1992 - Annual sales exceed $1 billion.
• 1993 - 2,000th store opens.
• 1996 - 2,500thstore operational.
• 2000 - Annual sales exceed $3 billion.
• 2001 - Added to S&P 500 Index.
• 2002 - Listed on the Fortune 500.
• 2003 - Opens 5,000th store.
• 2004 - Annual sales exceed $5 billion.
• 2009 - Celebrates its 50th anniversary.
1959
•Mr. Leon Levine opens the first Family Dollar Store in Charlotte, North Carolina.
In FY12, Family Dollar signed an exclusive distribution partnership with the McLane Company to supply its consumables segment. McLane operates a network of 21 groceries and 19 food-service centers that service every state and county in the U.S.
Category Breakdown Family Dollar sells a diversified mix of products, including consumables (69.0%), home products (11.4%), apparel and accessories (8.8%), and seasonal merchandise and electronics (10.8%). As illustrated in the table below, the consumables segment has accounted for a growing portion of revenue in the last three years. With the introduction of tobacco, we are modeling for consumables to reach 75% of total sales by the end of FY13.
Product Mix
Source: Company reports and FBR Research
Store Model As of year-end FY12, Family Dollar operated 7,442 stores in 46 states. The stores are leased for five to 10 years, with a number of five-year renewal options. In FY12, the company opened 475 new stores, including 41 in California, and plans open an additional 500 in FY13. It is planning an aggressive West Coast expansion and has identified a number of potential new store locations in California, Oregon, Washington, and Montana.
Additionally, in FY11, the company launched a comprehensive store renovation plan to improve store appearance, enhance operating processes, and expand its consumables merchandise.
Management plans to renovate 90% of its stores by FY15, with an expected cost of $600 million to $650 million.
Store Rollout Potential
Source: Company presentations and FBR Research
Focus and Initiatives Expansion into California. In FY12, Family Dollar opened its first store in California and plans to open 100 stores in the state by the end of FY13. The company believes that California represents significant growth opportunities and could support approximately 1,000 stores. Management does not expect profits from its West Coast stores until its distribution center in Utah is operational. Its West Coast stores are currently supplied by its Odessa, Texas, distribution center, which is located approximately 1,300 miles from California.
Store renovation and leaseback. In FY11, the company launched a store renovation plan; 854 stores were renovated, relocated, or expanded in FY12, and management expects 90% of its stores to be renovated by FY15. In FY12, the company announced a sale-leaseback program that should help to fund new store development. Under this program, the company will sell the new stores it constructs, including the land, and lease them back from the buyer.
Family Dollar completed the sale of 276 stores in two sale-leaseback transactions during FY12. The store sale generated $359.7 million and carries an initial lease term of 15 years with renewal options.
McLane partnership and expanded consumable merchandise. In FY12, Family Dollar consolidated its 50 regional suppliers of refrigerated and frozen food through a six-year channel-exclusive agreement with McLane Company, Inc., the largest wholesaler of tobacco and food in the U.S. The partnership will add more national brands to Family Dollar’s consumable product offerings, including Velveeta, Gerber, Wise Snacks, Gatorade, Russell Stover boxed chocolates, Pepsi, Schick, L'Oreal, Maybelline, Pantene, Nice 'n Easy, and NIVEA. Family Dollar also added tobacco products to 1,300 stores and expanded coolers from five to 10 doors in 1,400 stores. The company plans to add tobacco products to 6,000 stores and to install 18-door coolers in all new stores.
Family Dollar plans to aggressively increase the direct sourcing of merchandise from overseas to 13% of total purchases by FY15. In FY12, the company increased direct sourcing to 4% of total purchases from 2% in FY11. Management plans to achieve the 13% target by first switching from domestic importers to direct/agent purchases and then by directly purchasing merchandise from manufacturers. In FY11, Family Dollar opened its first overseas offices in Asia, located in Shenzhen and Hong Kong, and plans to open an office in Shanghai in FY13.
Management1 Howard R. Levine, chairman and CEO. Mr. Levine has been Family Dollar’s CEO since 1998 and chairman of the board since 2003. He served as COO and president of the company from 1997 to 1998. Previously, he was senior vice president of merchandising and advertising from 1996 to 1997. He also served as general merchandising manager of softlines in 1996. Prior to that time, he was self-employed as an investment manager from 1992 to 1996. He also served as the president of Best Price Clothing Stores from 1988 to 1992. He was employed in various capacities in the merchandising department from 1981 to 1987, including as senior vice president of merchandising and advertising.
Mary A. Winston, executive vice president and CFO. Ms. Winston has been the executive vice president and CFO of Family Dollar since April 2012. Before joining the company, she was associated
with Giant Eagle as the CFO and earlier as senior vice president. Previously, she was CFO and executive vice president of Scholastic Corporation. She also served as vice president, treasurer, and then controller of Visteon Corporation. Before then, she was vice president of global financial operations for Pfizer.
Michael K. Bloom, president and COO. Mr. Bloom has been Family Dollar’s COO and president since 2011. Prior to joining the company, he served as the executive vice president of merchandising, supply chain, and marketing and advertising for CVS Caremark from 2006 to 2011. He also held several other positions during his 20-year career with CVS Caremark, including those of vice president of consumer healthcare and senior vice president of merchandising. Before then, he served as a manager/executive for People’s Drug Stores and Shoppers Drug Mart.
Bryan Venberg, senior vice president of human resources. Mr. Venberg has been the senior vice president of human resources for Family Dollar since 2008. Previously, he was employed by ShopNBC from 2004 to 2007. His last position at ShopNBC was that of senior vice president of operations, customer service, and human resources.
Scott T. Zucker, senior vice president, merchandise operations. Mr. Zucker is responsible for driving the strategy and execution of merchandise initiatives, category management, merchandise planning and replenishment. Most recently, he served as vice president, IT solutions. In 2007, he was promoted to vice president, merchandise operations. Mr. Zucker joined Family Dollar in 2006 as divisional vice president, pricing. Previously, he was with BearingPoint Consulting. After graduating from Davidson College, he started his retail career with Belk. He earned his M.B.A. from the University of North Carolina at Charlotte in 1997.
Stock Ownership As illustrated in the table below, insiders own 4.58% of FDO common stock, and institutions own 89.02%. Mr. Howard R. Levine is the largest insider holder, with a 3.7% share, and Trian Fund Management LP is the largest institutional holder, with a 7.3% share.
Stock Ownership Summary
Source: FactSet and FBR Research
Corporate Governance We believe that Family Dollar’s corporate governance policies and procedures are considerably shareholder friendly. All of the board members are independent, with the exception of Chairman and CEO Howard R. Levine. Board members are elected by plurality on an annual basis.
AC: Audit Committee; NCG: Nominating/Corporate Governance Committee; LD: Leadership Development Committee; CC: Compensation Committee; EA: Equity Award Committee.
Source: Company reports and FBR Research
Significant Events July 10, 2013: announced Jason Reiser as senior vice president, merchandising, replacing John
Scanlon, who retired from the company. Also announced that Paul G. White, executive vice president and chief merchandising officer, had left the company to pursue other interests. Until a replacement is found, Michael Bloom will assume responsibility for merchandising.
March 15, 2013: announced Scott T. Zucker as senior vice president, merchandise operations.
January 17, 2013: increased regular quarterly dividend payments to $0.26 per share, a 23.8% increase.
January 17, 2013: announced that the board of directors had authorized the company to buy $300 million of common stock though its existing share repurchase program.
May 4, 2012: entered into a strategic partnership with McLane.
April 10, 2012: appointed Mary A. Winston as CFO.
December 19, 2011: appointed Paul White as executive vice president and chief merchandising officer.
November 17, 2011: entered California market.
August 11, 2011: opened 7,000th store (in Memphis).
January 25, 2011: priced $300 million of senior unsecured notes.
October 6, 2010: announced a $250 million accelerated share repurchase program.
November 18, 2009: announced the purchase of $400 million of common stock.
November 5, 2007: announced the purchase of $150 million of common stock.
June 19, 2007: announced the purchase of $5 million of common stock.
Name Age Position Insider / Independent Committee Membership
How ard R. Levine 53 Chairman/CEO Insider EA
Dale C. Pond 66 Chairman Independent LD, CC
Glenn A. Eisenberg 51 Chairman Independent AC
James G. Martin 76 Chairman Independent NCG
Pamela L. Davies 55 Director Independent LD, CC, NCG
Sharon Allred Decker 55 Director Independent LD, CC, NCG
Edw ard C. Dolby 67 Director Independent AC, LD, CC
Risks U.S. consumer spending. Consumer spending could materially accelerate or decelerate, causing the share price to diverge from our price target.
Management risk. A loss of a key member of the management team and/or the inability to attract quality candidates could negatively affect the company.
West Coast expansion risk. With no West Coast distribution center currently, the company may experience margin pressure due to increased transportation and logistics costs for product delivery to its West Coast stores.
Vendor concentration risk. We believe that Family Dollar’s partnership with McLane, which includes exclusive distribution rights for tobacco and refrigerated products, increases vendor concentration risk.
Unexpected moves to the upside or downside. We rate FDO shares Market Perform and expect the shares to trade within range. For unforeseen reasons, the shares could materially rise or decline relative to our price target.
Company Profile Family Dollar Stores, Inc. operates a chain of more than 7,400 general merchandise retail discount stores in 45 states, providing value-conscious consumers with a selection of competitively priced merchandise in convenient neighborhood stores. The company’s merchandise assortment includes consumables, home products, apparel and accessories, and seasonal goods and electronics. Family Dollar sells merchandise at prices that generally range from less than $1 to $10. The first Family Dollar store opened in Charlotte, North Carolina, in 1959.
*Closing price of last trading day immediately prior to the date of this publication unless otherwise indicated.
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