What Does Billionaire John Paulson See in Family Dollar?

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Billionaire John Paulson was the highest paid hedge fund manager between 2007 and 2009. Unfortunately his performance took a hit in recent years and Paulson's popularity declined tremendously. Nevertheless, we at Insider Monkey believe investors can still uncover profitable investing ideas by going through his mandatory regulatory disclosures.

We track filings from funds such as Paulson’s as part of our work developing investment strategies (for example, we have found that the most popular small-cap stocks among hedge funds earn an average excess return of 18 percentage points per year), and because we maintain this database we can also look for big changes in his portfolio over time.

It turns out that during the first quarter of 2013, Paulson initiated a position of 5 million shares in Family Dollar Stores (NYSE: FDO), making the dollar store his largest new holding for the year (see the rest of Paulson's stock picks.) While we don’t recommend blindly following hedge funds (and Paulson has actually not been doing too well recently), we think that their picks can serve as sources of initial investment ideas.

Dollar-store market

The second quarter of Family Dollar’s fiscal year ended in early March. Revenue grew by 18% versus a year earlier, though there was an extra week in the quarter so in per-week terms the growth rate would be about half as high.

In addition the company’s margins fell, and so the quarterly report actually showed total operating income being about flat (as was the case for fiscal Q1, as well). This suggests that while the market for dollar stores is not being saturated yet- as shown by the continually strong performance on the top line- Family Dollar is having trouble keeping its costs inline. In the first half of its fiscal year, cash flow from operations was down by nearly 40%, and again that is with an extra week.

At its current valuation, Family Dollar trades at 17 times trailing earnings, so the market is actually expecting EPS to improve moderately over the next several years. Family Dollar has been buying back stock, but the multiple is high enough that the valuation likely does depend on improving net income.

Bigger picture

It should be noted that the stock’s beta is low, at 0.4, but the same is the case for other dollar stores and even other discount retailers such as Target (NYSE: TGT) and Wal-Mart(NYSE: WMT)). Trian Partners, managed by billionaire Nelson Peltz, is another major shareholder in Family Dollar with the fund’s most recent filing disclosing ownership of almost 9 million shares (find Peltz's favorite stocks).

Dollar General (NYSE: DG) and Dollar Tree Stores (NASDAQ: DLTR) are two other well-known dollar stores. These peers feature very small premiums to Family Dollar on a trailing earnings basis, with P/E multiples of 19 and 18, respectively--so markets are expecting the entire segment to do well going forward.

Dollar General’s recent financial results look somewhat concerning, then, with revenue flat compared to a year ago. Margins have been increasing a bit, but we doubt that’s a source of sustainable earnings growth. Dollar Tree looks to be doing a bit better- in its most recent quarter net income was up 15% compared to the same period in the previous fiscal year, and if we were going to do more research on a dollar store that would likely be it.

We can also compare Family Dollar to Wal-Mart and Target. These larger retailers are seen as having weaker growth prospects, and so their trailing P/Es are in the 15 to 16 range. Indeed, Wal-Mart’s recent quarterly report (for the first quarter of its fiscal year, the quarter ending in April) showed growth of only 1% from a year ago in both revenue and earnings. We’d note that even during the quarter, reports surfaced that the retailer was off to a bad start of its fiscal year.

Target, meanwhile, experienced declining financials even after we adjust for special items. Specifically, operating income looks to have slipped by 20% though some of that came from the cessation of the internal credit-card business. Given that these stocks are also priced for earnings growth, these numbers would be a cause for concern.

Bottom line

As a result, we would avoid many of these discount retailers with the possible exception of Dollar Tree. Even in that case, we’d have to examine why the company might be doing better than its peers (a trend we’re skeptical would continue). Family Dollar seems to be experiencing lower operating income on a per-week basis and so we don’t think that investor should imitate Paulson’s move here.

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This article is written by Matt Doiron and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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