This Retailer Is Growing Despite Challenges

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Discount retailer Family Dollar Stores (NYSE: FDO) operates a chain of approximately 7,600 self-service general-merchandise retail discount stores in 45 states, providing consumers with a selection of merchandise in neighborhood stores. It primarily caters to low- and middle-income consumers in the United States, which makes it an interesting stock to buy since it might offer investors the much-needed protection their portfolio may need in times of economic uncertainty.

What sets it apart?

It has a beta of just 0.4 and sells various categories of products, such as consumables, home products, apparel and accessories, and seasonal and electronics. This makes Family Dollar a viable option when consumers want to buy more for less. The company’s typical store is between 7,500 and 9,500 square feet, sporting an average of approximately 7,150 square feet of selling space. It generally carries approximately 6,500 to 7,000 basic stock-keeping units (SKUs). So its wide presence and a huge merchandise portfolio are strengths that investors should consider while investing. 

Moreover, while customer spending in the market has declined over the past year, as reported by Nielsen Homescan Panel data, Family Dollar Stores managed increase its total sales 9% to $2.6 billion in third quarter of fiscal 2013. It opened 129 new stores and closed three stores compared to 103 openings and seven closings in the third quarter of the previous year.

In the third quarter, consumable sales increased about 15% and represented 72.5% of sales compared to 68.9% sales in the third quarter last year. So it is clear that the company put in a decent performance even though the market conditions were not entirely in its favor.

Thorn in the flesh

But the results revealed a downside as well. The shift of sales mix to lower-margin consumables hurt the company's gross margin. The gross margin declined 114 basis points as compared with the third quarter of fiscal 2012. The other reason for the gross margin being hit was an increase in shrink and markdowns as a percentage of sales.

The company managed to partially offset these factors by improved merchandise markups and lower freight costs. The merchandise margins improved due to foreign sourcing and private-brand programs. The freight expenses fell mainly due to the company’s supply-chain relationship with McLane.

What next?

Despite facing difficult times, the company is trying to position itself aptly for the both the short term and long term. For the short term, the company is focusing on controlling expenses, improving supply chain, keeping gross margins intact and improving operational efficiencies. For the longer term, it aims to continue investing in a growth-through-new-store-opening strategy and through a chain-wide renovation program. The company is on track for its commitment to open 500 new stores this fiscal year.

These strategies to drive sales are expected to bear fruit in the fourth quarter as Family Dollar is looking at 3% growth in same-store sales. Sales patterns in the month of June were impressive and a slight relief in gross margin pressure is expected. Lower-margin products are expected to increase overall sales and they might also lead to higher sales of other products, which in turn would probably help Family Dollar's gross margin. 

Competition is stiff

The company faces stiff competition from Dollar Tree Stores (NASDAQ: DLTR) and Wal-Mart Stores (NYSE: WMT).

Dollar Tree is the smallest dollar store in the U.S., but it has been gradually increasing its network. Although the company's same-store sale growth rate was 2.1% in its last quarterly report (lower than Family Dollar's 2.9%), it managed to increase its earnings considerably on a year-over-year basis. The company's $1 items and Deal$ concept have helped it perform better and it will open 340 stores this year.

Dollar Tree is small but it is packing a punch by shrewdly expanding stores and offering the maximum number of $1 items. So Family Dollar needs to be aware of this threat as Dollar Tree might eat its lunch with its own set of initiatives in the long run. 

Family Dollar also needs to keep an eye on the moves of Wal-Mart, which has been focusing on $1 items of late and is also moving aggressively in neighborhood markets, its fastest-growing segment, according to Forbes.

Wal-Mart already has lower prices than dollar stores such as Dollar General. and if it moves into the neighborhoods, then the likes of Family Dollar will have a real problem. Wal-Mart would probably keep the needs of local residents in mind when opening stores in residential areas, use smaller stores and might even put up a rewards program to increase sales and hurt dollar stores in the process.

From an investment perspective as well, Wal-Mart would be a good choice. It is an ideal defensive stock that investors would want in their portfolio with a beta of just 0.3 and a decent dividend yield of 2.4%. The company's diversification across geographies also insulates it against fluctuations in specific regions and a payout ratio of 33% indicates that the dividend can be increased in the future.

Closing thoughts

Despite having to compete with such giants, Family Dollar has been able to show fair growth under the circumstances. Family Dollar Stores is upbeat about the future, though the year has been more challenging than expected. It has re-positioned itself by focusing on what is under its control, such as having an aggressive stance on managing expenses, controlling and improving inventory etc. All this would enable it to compete and grow in the future.

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